Monthly Archives: December 2012

The “Fiscal Cliff” is Really a Slope

I wrote earlier about how the “Fiscal Cliff” is a bad name for it. It’s really a slope, albeit one with increasing steepness. Unless fear turns it into a chasm.

This is from the Associated Press:

“If New Year’s Day arrives without a deal, the nation shouldn’t plunge onto the shoals of recession immediately. There still might be time to engineer a soft landing.

So long as lawmakers and the president appear to be working toward agreement, the tax hikes and spending cuts could mostly be held at bay for a few weeks. Then they could be retroactively repealed once a deal was reached.

The big wild card is the stock market and the nation’s financial confidence: Would traders start to panic if Washington appeared unable to reach accord? Would worried consumers and businesses sharply reduce their spending? In what could be a preview, stock prices around the world dropped Friday after House Republican leaders’ plan for addressing the fiscal cliff collapsed.”



Ask an Economist: Why do prices have to go up?

Why is it inevitable that prices go up? In other words, why do we just /assume/ that it makes sense for everything to cost twenty (or so) times today what it cost a hundred years ago?

In theory, the Fed could try and manage the money supply in a way that tries to hit a 0 percent inflation mark. But there are lots of problems with this, and aiming instead for a 2 to 2-and-a-half rate arguably has advantages.

First, it’s important to realize that managing the money supply with regard to inflation is an imperfect science. It’s like trying to steer an aircraft carrier looking out of a warped and blurry porthole. It takes months to turn the ship, CPIand you’re never sure of what ahead or what the currents really look like. Even with some of the best macroeconomic minds in the business working on this full-time, it’s impossible to anticipate everything that could happen.

A big problem with aiming for 0 percent inflation is that there’s a big risk that at some point you’d have deflation, when prices are actually decreasing. This might sound like a good thing, but it’s actually traumatic for an economy – just ask Japan. If consumers believe that prices will be lower next month than they are today, they delay purchases – which can lead to even more deflation. When 70 percent of GDP is driven by consumers, this can be devastating for the economy and lead to prolonged recessions and higher unemployment.

Another point to remember is that when average prices are rising by 2 percent a year, some prices are rising much more, and some are actually falling. This is always the case. The inflation numbers reported in the news are just the overall, Price Changes by Categoryweighted averages for urban consumers. There’s always actual deflation occurring in some product categories, and depending on what you buy, the average prices you pay could actually be decreasing overall.

There’s also an (arguable) advantage to having prices increase by 2 or 3 percent a year. This allows employers to give some workers pay cuts by holding their (nominal) wages constant. This actually can be helpful to the economy in declining industries, or with poorly-performing workers. It’s very difficult to give employees actual (nominal) pay cuts, even when it’s necessary and appropriate. Having inflation allows employers to freeze wages and give employees (real) pay cuts. The workers know what’s happening, of course, but they’re less likely to riot than they would be if their nominal wages were cut.

Finally, having low, steady rates of inflation do very little harm to an economy. Borrowers, lenders, firms, consumers, and everyone else expects prices to rise by small amounts, and they build them into prices, contracts, and decisions. The small “menu costs” involved with changing prices every year or so are a small price to pay for the relative advantages of having low inflation.

Two Lines Diverge in a Labor Graph

I came across this graph in a paper* the other day, and I found it rather disturbing (yeah, economists get disturbed over odd things). It shows labor productivity and real hourly compensation from 1947 to 2010.


The disturbing part is that the two lines are different. Not the same. Distinct.

In fact, starting around 1970, the real hourly compensation line increases at a slower rate than productivity, until by 2010 the two differ considerably.

This might not seem like a big deal. Why get disturbed by two lines?

The trouble is that standard labor economic theory says that these two lines should be the same. Workers are supposed to be paid, on average, their marginal product of labor. It says so in all the textbooks. I’ve taught it in economics courses.

If productivity increases, then wages should increase by the same amount. That’s how standards of living improve. Productivity increases, wages increase to match, and people’s lives improve. That how it’s supposed to work.

This graph says this isn’t happening, and not just for one or two years. Productivity and wages have been diverging for decades in the U.S. Workers have been growing more and more productive, yet haven’t been rewarded for that.

So who’s benefited from this increased productivity?

Have consumers benefited through lower prices? Possibly some. But productivity increases only get passed on to consumers if competition forces firms to lower prices. That doesn’t seem to be happening.

Instead, corporate profits have been reaching record levels. On the one hand, that’s a good thing. Profits are good, and increased profits mean increased stock prices. Anyone who own stock benefits from that.

The problem is that the stock owners are benefiting at the expense of the workers. After all, it’s the workers who are causing that increased productivity (possibly through more or improved capital, but still). By all rights, they should be compensated for it. Why aren’t they?

That’s a good question, and it’s hard to come to any firm conclusions based on one report. However, the only explanation that comes to mind is that workers simply haven’t had the leverage and clout to demand that management pay them for their increased productivity. Union membership has declined pretty steadily during the same period that productivity and wages have diverged.

If workers organize and demand increased compensation, firms simply shut the U.S. factories down and move overseas, where wages are lower. Productivity is, too, but there’s often still a net benefit to the firms.

That’s great for firms and shareholders. It’s just not that great – nor fair – to the workers.

Decreasing labor clout. It seems to have made all the difference.

*”The compensation-productivity gap: a visual essay”, Fleck, Glaser, and Sprague, Monthly Labor Review, January 2011

The Mis-Named Cliff

“Fiscal Cliff” is a bad name. It’s one of those terms that the media love, because it sounds dramatic and terrifying. People stay tuned when they hear terms like “Fiscal Cliff”.

That’s not to say that the Fiscal Cliff isn’t serious or important. It is. But it’s not a cliff.

A “cliff” is something sharp and jagged and high, something that, should one fall off it, one plummets hundreds of  feet to one’s inevitable death. (“Fiscal” just means having to do with finances. I’m okay with that part.)

When pundits and politicians speak of “going over the Fiscal Cliff”, they mean essentially passing the milestone of midnight on December 31, 2012, the implication being that as of 12:01 on January 1, 2013, the U.S. economy will immediately be in free fall, plunging precipitously toward our collective death.

The reality is less dramatic and less headline-grabbing. If Congress and the President fail to resolve the current political impasse, on January 1, 2013, there will be substantial spending cuts to many federal programs, and tax rates will increase significantly for most Americans.

How much of an immediate impact this would have depends mostly on how long it lasts, and on how consumers and firms react to it. If the impasse lasts just a day or three, or even a week, into 2013, the direct impact would be relatively small. Even a spending cut of 10 percent and a tax increase of 20 percent would only represent a small sliver of GDP, if it only lasted for one-fiftieth of the year.

What’s more substantial are the indirect, psychological effects, particularly from news anchors throwing around ominous-sound words like “cliff”. Firms already are balking at future investment spending, and consumers who are already edgy about their future prospects are going to be very leery about spending money over the holidays if the impasse remains unresolved. Uncertainty is rarely a good thing for an economy.

One thing we don’t need is fear-mongering and over-dramatization. The current political standoff about federal spending and taxation is many things, but a “cliff” is not one of them.

Let’s call it for what it is: A Fiscal Impasse. No one’s falling off of anything on January 1.