Asking the wrong question By Scott Sumner

I saw this in the Financial Times:

Many economists think the government can help a weak economy by convincing people the rate of price increases is poised to accelerate. In theory, households will spend more whilst businesses will boost their hiring and investment. New research presented at the Brookings Panel on Economic Activity, which we attended, suggests this is mostly nonsense. A detailed survey of business executives in New Zealand suggests inflation expectations have basically no direct impact on the way companies make decisions. (Inflation expectations could affect how banks and capital markets charge firms for funding, but that’s an indirect effect.) When asked what they would do if they learned prices would increase more over the next year than they were currently expecting, 65 per cent of managers wouldn’t raise prices, 75 per cent wouldn’t raise wages, 73 per cent wouldn’t increase employment, and 71 per cent wouldn’t increase investment. Moreover, almost no manager would do any combination of those four things. Just 13 per cent of businesses would respond by raising both wages and prices — and that’s the most popular combination!

I’m not a fan of using inflation expectations to steer the economy, but this isn’t really a fair criticism. They haven’t even asked the right question. It makes no sense to ask the average businessman if they’d raise prices if they expected more inflation—of course the average businessman would raise prices—how else would you get the inflation! Here’s what they should have asked:

1. Suppose economic conditions evolve in such a way that you yourself will decide it’s appropriate to raise prices next year. In that case would you be more likely to boost employment and investment today?

But even that doesn’t really get at the question of interest to economists. A businessman might think to himself, “Hmmm, it sounds like there will be a big rent increase, or oil price increase, forcing me to raise prices next year. No, I don’t think I want to hire more workers or increase investment if there is a negative supply shock.”

The problem here is that the (New Keynesian) economists who talk about higher inflation expectations boosting the economy don’t really mean what they say. They talk about inflation, but in context it’s clear that what they really mean is “inflation caused by a positive AD shock.” That is, a rise in NGDP. So here’s an even better question to ask:

2. Suppose the economy goes into a boom next year, and aggregate demand is so strong that you feel it is appropriate to raise prices in response. In that case would you be more likely to boost employment and investment today?

And I think the answer would be yes. Not from everyone, but from enough to be of macroeconomic significance.

HT: Tyler Cowen

PS. Tyler responded to my recent post on Chilean copper:

I think it would be hard to privatize Chilean copper and then tax the mines at the proper rate, given the resulting power of the owners.

I think that’s a good argument, but not quite good enough to fully convince me. And that’s because there’s another good argument that cuts the other way, which is that privatized industries are far more productive. Consider this graph of public and private copper production:

If the industry were completely nationalized, I believe the tax revenue per ton of ore produced would be higher, as Tyler claims. But I also think it likely that total production would have been much lower without privatization. The net effect is unclear. And even if there’s slightly more tax revenue with total nationalization, it may not offset the other drawbacks of nationalization. It’s even possible that the current 1/3 public and 2/3 private industry mix maximizes tax revenue, especially if the private sector produced output that the public SOE would have overlooked.