Fourteenth Installment
The Vision of Monetary Economic Fluctuations
Labor wedge worsened even with no change in the labor environment
The presumption that financial crises, ordinary business cycles, and other macroeconomic fluctuations are caused by the generation and disappearance of money (in the broad sense of the term) would afford us a new understanding of the factors in macroeconomic fluctuations and would have unprecedented policy implications. I discussed this vision as one theoretical hypothesis in the previous article, and data from the financial crisis since last year offered circumstantial evidence supporting this idea in connection with the labor wedge (to be examined later). In this article I would like to look more closely at this point.
Business cycle theory has thus far maintained the primary factors causing economic fluctuations are changes in productivity, changes in markup (labor wedge), changes in real interest rates due to monetary policy, and changes in the inflation rate. Changes in productivity are thought attributable to technological progress, restructuring of company organizations, market restructuring and other changes in external factors beyond the influence of macroeconomic policy. Neoclassical arguments purport that, if changes in productivity are the primary cause for the business cycle, the business cycle is the result of the economic system reacting optimally to a productivity shock and thus there is little point in counteracting the business cycle.
If one accepts this argument at face value, then it follows that the economic system is in an optimal condition whether in boom times or bust; a conclusion quite divorced from reality. This criticism levelled by the New Keynesians and others has garnered greater attention for the labor wedge as a key cause in the business cycle.
The labor wedge is defined as the gap between the marginal rate of substitution (the rate indicating how much leisure time would need to rise marginally for a consumer to forego marginally one unit of consumption for the sake of leisure time) and marginal labor productivity (the volume by which production would increase with the marginal investment of an additional unit of labor by a company). Here the labor wedge will be defined as the ratio of the marginal rate of substitution to marginal labor productivity. When the economy is in an ideal state of perfect competition, the marginal rate of substitution and marginal labor productivity will be equal and the labor wedge will be 1. Given the various market distortions present in the real economy, however, the labor wedge is generally less than one. It is known from macroeconomic data that the labor wedge improves (approaches one) in boom times and worsens (diverges from one) during bust times.
Because the factors causing fluctuations in the labor wedge have thus far been associated with the labor market, the factors underlying business cycles have been presumed to be related to the labor environment. The current U.S. financial crisis strongly suggests, however, that the labor wedge changes due to monetary factors.
Various theories have been put forth on the causes of fluctuations in the labor wedge. That offered by the New Keynesians, for example, is that wages have become rigid because they are determined by the monopoly power of labor unions and that the labor wedge has worsened as a consequence. The idea is that the level of the labor wedge falls due to the distortions caused by this monopoly and the labor wedge worsens because nominal wages cannot suitably adapt to changes in the money supply determined by the central bank. Presupposing that the monopoly power of unions cannot be changed, the central bank should then adopt a price stabilization policy (a policy designed to stabilize price levels at a predetermined level) to ensure that the labor wedge does not deteriorate excessively.
Additional factors known to worsen the labor wedge are higher labor income taxes and higher search costs in the labor market (the various costs associated with recruiting and job seeking). Some analysts have suggested that tighter regulation in the form of reduced working hours at the end of the 1980s may have worsened the labor wedge in Japan.
Business cycle theories have thus far contended that changes in the labor market environment and changes in the money supply affect the labor wedge and produce swings in the economy as a result. The change in money supply in this case is a change in the monetary base supplied by the central bank and not the generation and disappearance of scrip money on which we have been focusing our attention. It should be noted that the labor wedge in the U.S. economy has changed dramatically in the current financial crisis despite almost no change at all in these factors.
The disappearance of money prompted a worsening of the labor wedge
When the author's research group (Kengo Nutahara, a full-time instructor at Senshu University, and Masaru Inaba, a research fellow at the Canon Institute for Global Studies) measured the recent labor wedge of the U.S. economy, they discovered that the labor wedge rapidly worsened at a speed three to five times the norm from the 1st quarter of 2008 through the 2nd quarter of 2009. When data going back to the 1960s was checked, it became apparent that the pace of deterioration was the worst in the past 50 years, on par with the rate at which the labor wedge worsened during the Great Depression of the 1930s. Consumption, production and unemployment began worsening noticeably in 2008. The declines in consumption and production have eased in 2009, but the rise in unemployment has shown no signs of letup. The deterioration of the labor wedge is believed to reflect this worsening in economic circumstances.
This outcome is extraordinarily suggestive. No major changes took place in the U.S. labor market (changes in the labor tax system, the labor market system, the political power of unions, etc.) around the 1st quarter of 2008. This implies that the principal cause for the deterioration of the labor wedge is neither the labor environment nor the rigidity of wages. With the disappearance of scrip money being a key feature of the current financial crisis, the disappearance of money could also be seen as a cause for the deterioration in the labor wedge. The labor wedge may have worsened because the disappearance of money led to tighter liquidity restrictions and lower consumption and employment. Given that the labor wedge is a major factor in ordinary business cycles as well, a connection between the generation and disappearance of scrip money and the causes of the ordinary business cycle is strongly suggested.
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the November 16, 2009 issue of Kinzai Financial Weekly
