Krugman is right, but his arguments do more than defend the Fed. They also unintentionally demolish the foundations on which central banks have based monetary policy the past twenty-five years. In effect, re-thinking the inflation of the 1970s also compels re-thinking economic policy.

Re-thinking That ‘70's Inflation Show, by Thomas I. Palley : The Federal Reserve has recently received much criticism from economic conservatives who claim it has ignored inflation, thereby risking a rerun of the 1970's inflation show. In response, renowned Princeton economist Paul Krugman has come to the Fed's defense arguing today's inflation is fundamentally different from that of the 1970s.

Thomas Palley says "if the union price - wage spiral story of inflation is correct (which it is), Friedman's natural rate theory is wrong. My comments, along with supporting graphs, are at the end:

The essence of Krugman's argument is that we are not watching a rerun of the ‘70's show because this time round there is no mechanism for creating a price - wage spiral. That is because unions are now dead so that workers are unable to ask for wage increases that match prices. As an example, Krugman contrasts the United Mine Workers contract of 1981 which bargained a three year eleven percent annual average wage increase with current conditions. Where now are the unions demanding 11-percent-a-year increases? Indeed, where are the unions, period? Today's reality is indeed characterized by absence of a price - wage spiral mechanism, and it is the reason why the Fed's easy monetary policy is unlikely to cause general inflation. However, that raises a critical additional point. Recognizing that the inflation of the 1970's was the result of a price - wage spiral triggered by conflict with unions over income distribution, compels rejection of the theory of the natural rate of unemployment. This theory has dominated economists' thinking about inflation for over a generation and has twisted public thinking. The late Milton Friedman was the originator of the theory of the natural rate of unemployment, yet according to Friedman unions have absolutely nothing to do with inflation. Instead, inflation is everywhere and always an exclusively monetary phenomenon. For Friedman, the only role of unions is to increase unemployment, which fundamentally contradicts the union wage – price spiral story of inflation That means if the union price - wage spiral story of inflation is correct (which it is), Friedman's natural rate theory is wrong and policymakers should abandon it. Instead, the focus of policy can formally return to probing the boundaries of full employment. Moreover, since inflation involves conflict over income distribution, there remains an unsolved policy challenge of how to fairly distribute income at full employment without triggering inflation. Seen in this light, it becomes clear that Friedman's natural rate theory has been used to justify running policy in a business friendly way. Thus, in the 1980's high interest rates were used to tamp down inflation, thereby causing unemployment and weakening unions by weakening manufacturing. In effect, fighting a price - wage spiral with high interest rates is a form of class based policy that breaks the spiral by undercutting the bargaining power of workers. A final implication concerns the economics profession and its teaching of economics. In the 1980s Friedman's natural rate of unemployment theory became the mainstay of economics textbooks. However, if the union wage – price spiral story of inflation is correct, it is time to re-write those textbooks. Today's students deserve a theory that explains both the inflation of the 1970s and why the Fed is right in downplaying current inflation fears. Natural rate theory asserts the economy self-organizes with full employment, and that inflation is the result of monetary policy trying to push the economy beyond the natural unemployment rate. The theory is fundamentally ideological and it flooded into the academy as part of the conservative capture of economics in the 1970s. It has always struggled to fit the facts, and now may finally be the time to discard it.

Here's how I understand the union's role in the wage-price spiral of the 1970s (in a natural rate framework). Start at equilibrium with employment at the natural rate of output (Y*) and prices (P) that are stable:

The position of the short-run aggregate supply curve (SRAS) depends upon input costs, including wages. As costs increase, the SRAS curve shifts inward (to the left).

Now, suppose workers are unhappy with the current level of real wages, W/P, and, through unions or other means, they demand a higher wage. The goal is to get a larger share of output consistent with the distributional arguments above :

This causes higher prices and lower output and employment. (But initially the real wage, W/P, does rise since W increases more than P increases. As a side note, however, the distribution of income for workers as a group depends upon what happens to the product of real wages times the number of employed, real wages increase but employment decreases so the change in total real income could potentially be postive or negative, and this needs to be compared to the new smaller level of output to see how the overall share of output for workers has changed.) If policymakers do not respond, natural rate theory says that since resources are unemployed (Y' < Y*), input costs will fall. As input costs fall, the SRAS begins to shift outward toward the natural rate, and this continues until the equilibrium shown in the first diagram is restored. This is natural rate theory in action, i.e. there are automatic mechanisms to return the economy to the natural rate whenever shocks (including policy shocks) move output away from Y*.

But suppose instead that policymakers have a full-employment target, and are obligated to try and meet it. Let monetary policy be the policy instrument (I'll explain why I didn't use use fiscal policy to illustrate this below). Then the monetary authority will increase the money supply and this shifts the aggregate demand curve (AD) to the right:

So output is back where it started (Y*) and hence so is employment, and prices are higher at P''. So far, we have an increase in the price level from P to P', but we don't have continually increasing prices, i.e. this i snot inflation.

How to get inflation? Let workers say to themselves: For a little while real wages rose and I was doing better (when the economy was at Y' and P'). But then that darn inflation came along and eroded all of my hard-earned gains away (as AD shifts and prices go up to P''). I was ahead when the union helped, now I'm behind again, so it looks like it's time to demand higher wages as before.

Suppose they do. If we use the first diagram as the new starting point (i.e. relabel the equilibrium Y* and P''), the process repeats itself, except now prices would rise even higher by the time it is all done (i.e., if the graphs were actually drawn, as the SRAS shifts in the second diagram, prices go up from P'' to P''', then as AD goes up in the third diagram, prices go up even more to P'''').

Let workers have the same reaction, i.e. we were ahead for awhile, but then inflation eroded the gains, so we need to do this again. As they demand higher wages as before this leads, after all is said and done, to even higher prices. As it repeats over and over, prices continue to rise and we have inflation. [Point of clarification after reading comments: If there is no union power to speak of, as today, then there is no way to get this process started and then sustain it. That is, there would be no way to make effective wage demands and shift the SRAS curve inward, and no way for the process to repeat and cause inflation.]

So it is policymaker's pursuit of a high employment target within the natural rate framework that generates inflation. Note also that this is consistent with Friedman's contention that inflation is always and everywhere a monetary phenomenon. If we define inflation as a continuous increase in prices over a long time frame, and we try to use fiscal policy to do it, then in the story above each time the AD curve shifts outward government would get bigger (G increases) or taxes would get smaller (T decreases), but both G and T are bounded. G can't increase above output (and practically would be limited before that), and taxes cannot fall below zero. So in either case, eventually inflation would end since G could not go any higher and T could not go any lower after some point. This is not a problem with money since more can always be printed, hence there is no bound to price increases and that is why I chose monetary policy to illustrate the example.

Thus, I don't see the conflict Thomas is pointing to when he says that this "compels rejection of the theory of the natural rate of unemployment." What have I missed in his argument?

Update: Let me add that in this story, it is not the unions that are causing the inflation. It is the continuing increases in the money supply in pursuit of the full employment target that cause the inflation.

To see that unions are not directly causing the inflation, note that if there is no policy response at all, then under the natural rate story the SRAS in the second diagram would return to its original position and the price level would stabilize (though it might take longer to get back to Y* than it would if there is a policy intervention). Thus, if the Fed stops increasing the money supply, the inflation will end.

One more update: This model can also be used to tell a declining unionization story. Lets go back to the second diagram, but add an arrow showing the automatic return to the long-run equilibrium if policymakers do not respond to the initial shift in the SRAS:

The shift in the SRAS curve labeled "a" is from the higher wage demand, and the shift labeled "b" is the self-correcting response that returns the economy to full employment.

Suppose, at first, that there is only one factor of production, labor. Then the return to full employment shown as "b" comes about as, over time, wages are bid down by the presence of unemployed workers. To the extent that workers and unions are able to resist these downward wage adjustments, the SRAS curve will be sticky, i.e. it will take a long time to adjust. The persistent unemployment that would result could cause union support to erode (policy intervention can help by reducing the time it takes to get back to full employment by shifting the AD curve outward).

Now suppose there are two factors of production, labor and capital (or the potential to purchase goods from foreign suppliers and/or move production offshore). Again, let labor demand higher wages resulting in the shift labeled "a" above, and once at Y' suppose the union strongly resists any cut in wages. In this case firms, facing higher labor costs can substitute capital for labor (this might impact the natural rate but let's abstract from that complication) or shift production to foreign countries where wages are lower. To the extent that firms are able to use these strategies and substitute away from high cost labor, unions will be undercut so that in the long-run support and membership is likely to erode (and technological change may make capital an increasingly effective substitute for labor, and make it easier to produce where labor is cheapest so that these pressures have intensified over time). Again, though, this is a model based story - there may be other reasons for the decline in union membership.