Better Than Interest Rates

08 Jul

In my past two blog posts, I explained how wage-based inflation is caused by a prisoner’s dilemma contest between millions of wage earners, and how the reserve bank uses interest rates to change the contest to force people to cooperate.

Basically, inflation occurs when people can demand wage rises without actually doing any more work – this means that it costs more for businesses to make stuff or provide services – inflation!

By raising interest rates, the reserve bank slows down the economy. This makes it harder to demand a payrise, and slows down inflation.

The problem the reserve bank is trying to solve is simple enough. In a prisoner’s dilemma game, all players do better if everyone cooperates. Unfortunately, any individual who reneges finds themselves better off at everyone else’s expense. With wage-based inflation, if I renege (by obtaining a payrise without actually becoming more productive at work), I benefit greatly. Everyone else suffers a cost, but the cost is tiny. Nobody will notice. Nobody, that is, until several million people renege the same way I do. Then, it’s reflected in the inflation figures, and people begin to notice their bills are higher, and they have a little less money at the end of the month.

The reserve bank’s approach works partially, but there are problems with it. For example

Some people end up unemployed.

If you raise interest rates, it means some people can’t demand a payrise. It also means some people can’t keep a job. This is devastating for those individuals. It’s also bad for the economy – they could be producing something useful, but instead, they spend time at home sending out resumes and waiting for phone calls.

Some people can still renege

Raise interest rates too much, and everyone would lose their job. The reserve bank doesn’t do this – if the economy slows down too much, they lower interest rates to bring down unemployment. However, even when they have interest rates “just right”, some people can still demand wage rises that are not linked to productivity. Hence inflation still exists.

The Gap Between Rich And Poor Gets Wider

The people who remain secure in their jobs (or in their ability to get a job) tend to be those with more specialised skills – better educated – better paid. Those who are most affected by interest rate rises will be those with generic skills – in other words, the less well off. This will widen the gap between the rich and the poor.

It’s Sub-Optimal

It makes no logical sense to slow down the economy, as long as the alternative – full cooperation – is possible. It is theoretically possible for everyone to cooperate, but it’s against human nature. We do need to change the game so that cooperation is the best play for each individual, but perhaps there’s a better way than punishing economic growth.

It targets the wrong thing

In any case, the real problem is not wage rises, it’s wage rises that are not linked to productive work. It’s fine if someone gets paid twice as much after a training course or a new machine makes them twice as efficient – the product or service still costs the same to make. Raising interest rates directly targets production, not wages – it may even make people less productive if they have to sit idle on full pay waiting for new clients in a slow economy. Wouldn’t it be better to have an approach that attacked the problem directly?

Here’s a possibility.

When I was in the United States, I saw something that I never see in Australia. The police wanted to slow down speeders on the highway. A police car started driving on the highway, swinging back and forth across all the lanes. Nobody had any choice – we all slowed down. This is a bit like the reserve bank raising interest rates. When the economy is firing ahead, and some people’s wages are outstripping the work they do, the reserve bank slows everybody down.

In Australia, if the police want to slow down speeders, they will identify the speeders, pull them over and give them a fine – or impound their car if they are really hooning along. Of course, this is harder work. However, with enough hard work, it’s certain to be at least as effective, without slowing down all the law-abiding drivers.

Why could we not have a similar policy to control wage-based inflation? For example, while productivity may be sometimes hard to measure, there are surely ways to do it. If we don’t know what those ways are, we could sponsor the work of those doing the relevant research. Then, wage-productivity targets could be set, monitored and enforced. Companies would be allowed to give workers payrises, but such payrises would need to be linked to the workers’ economic value to the company.

If this were done well enough, it would change the game. It would no longer be a prisoner’s dilemma. Cooperation to keep inflation low might become the natural outcome of the game.

Some people might find their pay goes up slower, but prices would also go up slower. There would be a greater inclination for people to save, and less inclination to take on debt. People who want to raise their standard of living would do so more via education, innovation or efficiency, and less through office politics or job-hopping.

To implement such a plan, we wouldn’t need to abandon interest-rate based inflation control – nor would the new plan need to be plonked in place all at once, fully complete. It could be implemented incrementally, so that people had time to adjust to the new game.

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  1. Why Can’t The Reserve Bank Lower Interest Rates Below 0%? « Second Thotz

    September 20, 2012 at 1:27 am

    […] (when things slowed down) and inflation (when things sped up). Interest rates are not a perfect tool for this, but they are what we […]