Model of Japan's low inflation & need for higher labor share

I have been presenting a new model to explain the forces around inflation. (link1, link2)

Antonio Fatas poses a very good question. You can lower interest rates, but can you raise inflation?

"But if monetary policy is being successful we expect inflation expectations and growth expectations to increase. Both of these forces should push long-term interest rates higher not lower!  Something is fundamentally not working when it comes to monetary policy and it is either the outcome of some forces that the central banks are unable to counteract or"

I stop right there. For me, there are forces that the central banks cannot counteract. And the new model is revealing some preliminary mechanism to show how.

I applied the model to Japan's situation of low inflation and low nominal rates.

The model builds on the idea that capacity utilization is a force that affects inflation. The current low capacity utilization is a force to push down inflation.

Another force is net profit rates (corporate profit rates - nominal rates). High net profit rates also push down inflation.

Another force is labor share. The current very low labor share in advanced countries, including Japan, leads to an environment where inflation wants to go lower.

 

So now I input some preliminary data into the model for Japan.

• Natural real rate is negative = -0.6%
• Effective labor share = 70%
• Capacity utilization optimized at 5% unemployment
• Adjust exponential equation of core inflation to allow for deflation, i = 0.036 * e^{(-13*net profit rate)} – 1%

Here is the model assuming a 2% inflation target...

Two things to note here...

1. The central bank nominal rate (solid red line) stays at the zero lower bound almost up to the natural limit of capacity utilization (vertical green line)
2. Core inflation hovers on the edge of deflation the whole time up to the natural limit.

Even by keeping nominal rates low, inflation still stays low. Antonio Fatas talks about forces. Here we see the forces at work.

Now I solve for the inflation target that brings monetary policy into balance with the forces.

Look at the horizontal dashed green line of the inflation target. It now sits at -0.3%. The model shows that a mild target of deflation is the best monetary policy to balance the forces affecting inflation.

Also note that the base central bank nominal rate sits at the zero lower bound all the way to and past the natural effective demand limit. (vertical green line)

The model reflects the situation in Japan. Loose monetary policy cannot counteract the forces that want to go into balance at a mild deflation level.

Keep in mind that the model probably needs some tweaking to get coefficients right, but the model can explain forces that Antonio Fatas mentions.

The success of Abenomics depends upon raising labor share. A higher labor share would raise the balanced inflation target. I and others have said this from the beginning. This model gives a logic behind the view..

Comments

[JimH]

Edward,

I believe that Japan's largest problem is the competition for the American and European consumer markets from the rest of southeast Asia. With that competition, Japan can not raise labor share.

Their monetary policy is not going to fix that. Their monetary policy has just kept the Japanese economy on life support for about 25 years. And the Japanese government's fiscal policies have provided only intermittent relief. Japan should be a warning to us all that fiscal policies and monetary policies are at best, a temporary and inadequate respite from the real world. (Good enough for ordinary recessions but not good enough to resolve deeper problems in the real world.)

The US is in a very different predicament. We have much more of our own raw materials so we could go back to consuming the product of each other's labor. (And thus raise labor share.)

In the end, if the powers-that-be want to raise inflation then they must raise labor share. Our economic system is dependent on consumers and those consumers must have sufficient incomes. Eventually the powers-that-be will accept that limitation. But watching this play out is like watching grass grow.

[Edward Lambert]

Economists are not going to understand labor share. It is not talked about with models like I do.
I like being able to see things differently. I like it when my models work and theirs don't.

[JimH]

Edward,

I understand that it will require your work on effective demand or something very like it, for mainstream economists to see the errors in their assumptions.

Antonio Fatás wrote: "Either this is the end of growth as we know it or the start of a 30-year period of extremely low inflation combined with deflation or our expectations are seriously off and we are up for an interesting surprise."

To put it kindly, he is looking at the economic world from 30,000 feet so he is not seeing the details.

The changes to our economy over the last 20+ years should be all the motivation needed to give up on Say's Law.

Supply does not create its own demand and today it is very difficult to understand how economists thought that it ever did.

My guess is that economists before 1992 always implicitly assumed that the vast majority of production and consumption would occur within the same country. Then the production workers were the consumers. Today in the US and much of Europe that is no longer true.

Production workers were also less the consumers before Henry Ford's voluntary raises in wages and very active labor unions.

One would think that mainstream economists would take note that our economy expanded and flourished during the period after working class wages rose dramatically and before free trade reduced those working class wages.

Perhaps deflation will be the medicine that will bring on the 'Aha' moment.

Let the federal government stop running up debt trying to prop up the economy. Let our current version of capitalism wreck consumers and corporations. No bailouts, just bankruptcy and nationalization. Then the mainstream economists will be more open to rethinking their assumptions and inadequate models.

Or we can continue on our current path for a couple of decades.