US Living Standards and Productivity

By: Gerard_Jackson

Boring as this might seem to some of our rightwing pundits, we can get no where in economic debate without the application of theory. Many of the questions that are popping up these days are linked to the alleged connection between productivity, unemployment and inflation. There are no links here in the functional sense. In a free market unemployment will not rise even where productivity is falling.

Of course, in such a situation real incomes will also be falling. In other words, productivity is linked to real wages and not the volume of employment. So long as there is sufficient capital and land available there will always be jobs for those able and willing to work. The alleged link between productivity and inflation is paraded in the press as if it is an established economic fact while in reality it is an economic myth. The source of the myth is the erroneous belief that rising prices are inflationary or cause inflation.

Irrespective of what politicians and their economic advisors think, inflation is a monetary problem. There is no way you can get a continuous rise in general prices (assuming output is not falling) without a monetary expansion. What rising productivity tends to do, however, is offset the price effects of an expanding money supply by continuously lowering production costs. The result is then stable prices or a lower rate of 'price inflation'. The point is that in the absence of inflationary policy prices would be falling. Therefore any attempt to stabilize prices requires an inflationary policy.

Unfortunately the confusion gets even worse. I have frequently said that people never seem to learn from economic history. But this view should be qualified with the observation that we need a theory if we are to learn the correct lessons. This is rarely the case as is evidenced by what passes for economic debate in the media. Now it is still being argued by some that the Fed should have applied the monetary brakes in 2000 because the labour market was tightening and a tightening labour market — in their opinion always signals inflation. Others argued that America was on a new growth path and its rising productivity could easily accommodate rising wages without triggering inflation.

Who was right? Neither, is the answer. During the 1950s the German and British economies suffered very tight labour markets, but for very different reasons. Rapid growth in Germany's capital structure created severe labour shortage which had to be alleviated by introducing guest workers'. There was nothing inflationary there. Quite simply, capital accumulation outstripped the labour supply. In Britain, on the other hand, labour shortages were created by Keynesian policies that generated inflation and balance-of-payments problems followed by recurring credit crunches.

Clearly, a tight labour market in itself is never evidence of inflationary pressures, even where real wage rates are rising. So which is it for America, the Germany of the '50s or Britain? In my view it is Britain. Productivity is not the clue because it was also rising in Britain during the '50s. The clues are savings, money supply and the current account deficit. American savings fell, the money supply rapidly expanded and this in turn fuelled the growing current account deficit, and still is, by sucking in imports. The dollar depreciation is now reversing the flow of trade. However, the fall in the dollar was the result of the Fed's Keynesian policy of using interest rates to stimulate the economy*.

Like Britain of the '50s the American economy was driven by credit expansion instead of genuine savings as was the case with German economy. The real consequences of the Fed's reckless monetary policy were largely hidden because America's flexible labour markets allowed the economy considerable room for cost adjustments. This means that labour and capital tend to be more efficiently used than in countries like Germany and Japan. Combined with newly applied technologies this meant rising productivity.

Now by real consequences I don't just mean the misallocation of resources (what the Austrian School of economics calls malinvestments) but also the distinct possibility that Keynesian policies reshaped America's capital structure in a way that has kept living standards lower than they would otherwise have been.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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