Animal Spirits Pt. 3: Natural Wage Theory, Money Illusion, and Wages

I just finished reading Chapter 9 of Animal Spirits. Now I see the point of criticizing Natural Rate Theory. I mentioned in an earlier installment that I suspect that, over the long time, wages will tend to track inflation, but lag behind. Akerlof and Shiller appear to be saying that this is precisely the point. Steady inflation holds wages at a lower level, one which allows a lower level of unemployment. Employers can grant employees raises for the financial purpose of keeping it in line with the purchasing power of money, while still giving the employee the feeling that they are being rewarded for their efforts. In the absence of inflation, the employer can't afford to give so many raises, the employee feels he's not being treated fairly, and worker productivity falters. So, in their analysis, because of money illusion and fairness, a certain level of inflation is required to keep productivity up.

Outside factors they failed to take into account (which I will get into below), I can find no fault with their analysis. Particularly in a world in which people have, over multiple generations, come to regard raises as a regular obligation, perceived unfairness (that very phrase is redundant, given all fairness is subjective) could well result in productivity losses in the absence of inflation-motivated raises.

Of course, this likely leads to the recommendation that a level of inflation should be maintained at all times. Further, it makes something like a commodity money seem untenable. However, there is something else to put into the analysis: the credit cycle. Wages are downwardly rigid, therefore deflation can damage employment levels, as falls in wages fail to keep pace with falls in other prices. But what if "fractional reserve" banking were abolished, and therefore the bank created inflation that ultimately leads to deflation never occurred in the first place? The downward rigidity of wages could become irrelevant, in this scenario. But then, it could also lead to an extended (possibly multigenerational, meaning it would be politically unsustainable in reality) period of adjustment, until people finally realized psychological satisfaction is not going to come from making the numbers bigger.

It's a big hurdle to get over. From a strictly logical standpoint, wages generally rising over time, but lagging behind prices is not as good for workers as wages falling slowly but lagging behind prices. But falling prices, though it is good for a person whose wages have not yet fallen, is an impersonal phenomenon. Rising wages, though, feel like a personal reward, even if the employer is only keeping the wage in line with rising prices, and even lagging behind. The gradual price drops of a stable money supply may be better for workers materially, but rising wages, even insufficient to cover rising prices, are more emotionally satisfying.

Were it not for the dangers inherent in a fiat token-based (whether paper or digital) currency (which we are seeing today, as the results of bad monetary policy hit the economy like a hurricane), a fiat currency would definitely be better... IF the money supply expanded evenly. Unfortunately for fiat money supporters, it does not. Industries grow beyond what they should because of investment bubbles, and then people lose their savings, workers lose time building knowledge and experience in bad industries (not to mention their jobs for no good reason), people lose confidence (which the authors just spent a chapter talking about). I'm presently convinced the negatives of fiat money and an inflationary policy outweigh the negatives.

That, and I have moral difficulties with the idea of a monetary elite making things better by deliberately deceiving laborers.