For less inflation, the French would be prepared to see unemployment rise

13:59, 25 October 2022

Launched in the 1960s by the American economists Robert Solow and Paul Samuelson, the idea of ​​a possible arbitrage between inflation and unemployment orchestrated by public authorities immediately penetrated the economic literature and political practice. From this perspective, aggregate demand boosted by fiscal policy can reduce unemployment. In turn, this fall in unemployment creates tension in the labor market, leading to increases in wages and prices.

The inverse relationship between unemployment and inflation is known as the “Phillips curve”. With inflation missing for three decades, economists had de facto abandoned the concept, although it was occasionally referred to. Today, massive inflation is back, and the question of sacrificing growth to reduce inflation resurfaces.

During an important speech given at the end of August 2022, Isabel Schnabel, a member of the Governing Board of the European Central Bank (ECB), indicated that the institution was determined to contain inflation, even at the risk of harming the labor market. In the United Kingdom, on the contrary, volatile Prime Minister Liz Truss seemed tempted to revive growth rather than defend price stability before it returned under pressure from the bond market.

Figure 1 shows the unemployment rate and the inflation rate as recorded on 31 August 2022 for 31 European countries for which Eurostat publishes data. The scatter plot reveals similarities and differences. All countries have inflation rates above 2%, with some where inflation is high (between 5% and 10%) and others where inflation is very high (above 10%).

These differences are largely due to the country’s dependence on imports of Russian oil and gas, but also to the energy price regulation policies that some governments have introduced to limit price increases.

Macroeconomic genes

The functioning of the labor market is another explanatory factor. In some countries, income is officially or unofficially indexed to inflation, while in other countries this is not the case. In France, for example, the minimum wage is indexed, but not the other wages. The weight of unions and the nature of collective bargaining (company, branch or national level) is another determining factor for wage increases and any price feedback.

The current inflation shock was not foreseen, either by private agents or by the ECB, which even had to apologize for its forecasting errors. To the extent that the wage adjusts very slowly to the price increase, the “real wage” (the wage in relation to the price) has therefore fallen with a stimulating effect on the demand for labour.

However, this positive effect is counteracted by the reduction in purchasing power and the restrictions on consumption and investment in the presence of high inflation. Figure 1 also shows a relatively robust labor market, as if the first effect currently outweighs the second. This is a trade-off between inflation and unemployment, mainly driven by the quasi-rigidity of wages, which may not last.

Unemployment and inflation are both macroeconomic nuisances that destroy citizens’ well-being in their own way. It is normal for governments to seek to combat them with all the means at their disposal. However, it is not easy for a government to determine the combination of inflation and unemployment that minimizes the loss of social welfare because it is very difficult to know citizens’ preferences and aggregate them to achieve a coherent social goal.

“Misery Index”

In the 1970s, the American economist Arthur Okun of the National Bureau of Economic Research (NBER) offered a direct answer to this question with the “Misery Index”. It is given by the simple sum of the unemployment rate and the inflation rate (in absolute value) in a country at a given time.

The index has no unit of measurement, it is an approximation of the loss of social well-being resulting from two common phenomena. By construction, the index implies a form of perfect substitution between inflation and unemployment: at constant social disutility, citizens accept one point more unemployment for one point less inflation.

Figure 2 shows the misery index for the same countries based on inflation and unemployment recorded at the end of August 2022. It is 14 for France and 12 for Germany.

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In the 1980s, many critics argued that the index gave too much weight to inflation compared to unemployment. Some authors have investigated whether the misery index, as an approximation of an objective loss of social well-being, is consistent with subjective measures of satisfaction.

Thus, in the early 2000s, Argentine economist Rafael Di Tella and his co-authors developed regression models to explain subjective well-being by inflation and unemployment and other macroeconomic variables. Their estimates showed that unemployment remained the biggest fear among European citizens, well ahead of inflation. In contrast, German economist Heinz Welch’s 2007 study of European data provided empirical support for Okun’s original hypothesis of an equal impact of inflation and unemployment on well-being.

The weight of inflation underestimated

In the current situation, the question of social preferences with regard to inflation and unemployment takes on strong and renewed sharpness. To locate the state of our citizens’ preferences today, we used a survey administered by the OpinionWay institute on September 28, 2022, on a sample of 1008 people representative of the French population (aged 18 or over). Participants had to choose between several combinations of unemployment and inflation, all of which added up to 12 percentage points (hence a misery index of 12).

Figure 3 shows the distribution of responses. It appears that 27% of those questioned express a preference for an equal distribution between 6% inflation and 6% unemployment. Only 17% of respondents prefer combinations of low unemployment and high inflation, while 56% prefer low inflation in exchange for higher unemployment.

To date, the misery index in France therefore seems to underestimate the weight of inflation. There is therefore a very interesting reversal of the social preferences on which previous economic policies were built, preferences which in the 1970s led governments to let inflation slip away in the hope of reducing unemployment, a hope which turned out to be failed.

This result is not so surprising, insofar as inflation affects all French people and its costs are immediately tangible, while unemployment represents only a low risk for the majority of those interviewed. It is not surprising that the return of inflation after a long period of “moderation” feeds anxiety as a new negative phenomenon.

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These results are very important for economic policy. The government is supposed to act in accordance with what the citizens expect from it, especially since it bears a great responsibility for the emergence of inflation, most of which predates the war in Ukraine and after the difficult period of confinement.

The government has chosen to deal with rising energy prices through administrative price caps, a policy that has the effect of further increasing the budget deficit. Freezing prices is an absolute emergency to block a massive, abnormal and potentially catastrophic increase in collective well-being.

A price freeze that is maintained over time has the major disadvantage that it removes the incentive to reduce consumption as a result of the price increase and the incentive to seek alternative solutions. In the specific case of fossil fuels, the context of climate emergency pushes to reduce their use and not to promote their consumption.

To combat inflation, the government has no choice but to limit aggregate demand. It can do this in several ways, the best of which is the reduction of public spending or the increase of certain taxes, given the current context of rising interest rates on public debt. Based on our findings, there is currently a favorable window for this policy that the government would be wise to exploit.

This article is republished from The Conversation under a Creative Commons license. Read the original article.

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