Is a little bit of inflation just what the doctor ordered to keep unemployment down?

June 16, 2013

My colleague Dylan Matthews wrote today on one of the mysteries of global economics in the last few years: The combination of weak economic growth out of Britain yet decent performance on employment. Economists think of this as a "productivity puzzle," in that what has happened mathematically is a downshift in the productivity of British workers-- less economic output per hour of labor (or at least a failure of productivity to rise at its historical rates).


It's been a dreary few years for Britain. But has inflation helped keep the unemployment rate down? (Andrew Winning/Reuters )

That's all true, but there's a dimension here that's important to the story, and one with real consequences for the United States and the rest of the world. It is true that Britain has had stagnant growth over the last three years. But it has also had inflation a good bit above the 2 percent that the Bank of England aims for (the UK consumer price index rose 3.7 percent in 2010, 4.2 percent in 2011, and 2.7 percent in 2012). This often has been characterized as a bad thing--evidence that the British economy was in a nightmare of 1970s-style stagflation, or stagnation plus inflation. Mervyn King, the governor of the Bank of England, had to write letters to parliament explaining why the bank failed to achieve its target.

But maybe that view looks at things all wrong. That outburst of inflation may have been just what the doctor ordered to keep from having higher unemployment despite Britain's weak economic growth.

It's a well-established fact, across time and geography, that there is "nominal wage rigidity." That is, people hate, hate, hate seeing their wages cut, and businesses are thus reluctant to cut salaries even when business conditions would seem to warrant it. This is an important factor behind why recessions tend to result in higher unemployment, rather than lower wages. If the labor market worked the way most markets do, when demand for workers fell, prices (in this case, wages) would fall, and the same number of people would have jobs, just at lower pay rates. But because of nominal wage rigidity, wages don't fall, and so the market fails to clear. There are more people who want to work than there are jobs (in other words, high unemployment).

But inflation offers a workaround to the problem of rigid nominal wages. What happened in Britain from 2010 to 2012 seems to be this: Many people, as experience suggests, saw their wages frozen in place. But because inflation was quite high, their "real," or inflation-adjusted wages, actually fell a good bit.

That meant that employers who would be expected to have slashed jobs due to weak demand (remember, there was little to no economic growth in this period) instead kept employing people at lower rates. Weak demand translated into lower real wages rather than higher unemployment.

That would help explain why Britain has about the same unemployment rate as the United States right now (7.7 percent versus 7.6 percent here), despite much weaker growth since the end of the recession in 2009.

It gets better. If the high British inflation of 2010 to 2012 were to translate into permanently higher inflation expectations, it could have the counterproductive effect of pushing up longer-term interest rates. But the inflation was caused primarily by one-off factors, like an increase in the value added tax that pushed up retail prices and a one-time decline in the value of the pound on currency markets that hiked import prices. And, it should be added, markets view the Bank of England as credible; if they started to expect that the bank would make a habit of running 4 percent inflation, long-term interest rates would rise, causing all kinds of problems for British economy.

I get little sense that British officials were intentionally trying to drive up inflation in the 2010-2012 time period; indeed many in London spent the last few years hand-wringing about it. But it may have been just the thing needed, at just the right time, to keep weak growth from translating into mass unemployment (or, perhaps, more mass unemployment). Against that backdrop, the Fed's "success" at keeping inflation well below its 2 percent target over the last few years looks less like something to be proud of and more like something that has kept American unemployment from coming down more.

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