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Canada’s Job Growth Quandary

Canada's Job Growth Quandary

Canada’s economy added a stunning 150,000 jobs last month, and it’s the second straight month jobs numbers widely exceeded expectations. But to control inflation, doesn’t Canada need to shed jobs to bring inflation under control? The short answer is no.

In a recent article by CBC senior business reporter Peter Armstrong titled, “Canada’s job growth is challenging basic economic theory. Are the models wrong? he points out the fact that inflation is decelerating in much of the world while unemployment either remains low or falls even more. It cites Canadian data in doing so and concludes that something unusual is afoot in the economy, as neo-Keynesian theory argues that can’t happen—at least not for long.

That theory argues inflation and employment are linked since higher employment raises wages and therefore demand, driving prices up. This connection between unemployment and inflation originates from the Phillips Curve theory. According to this theory, low unemployment leads to higher wage growth due to higher worker competition. That forces employers to pass on higher labor costs to consumers, driving broadly rising prices, which drives wages higher, which drives prices higher, rinse, repeat. Economists will also refer to this as a wage-price spiral. Sadly, nearly all policymakers at central banks are taught the Phillips Curve theory, and as you know, many policymakers work off a dual mandate of maximizing employment while keeping inflation low and stable. 

A problem is this practice is based on a flawed mid-20th-century model. In 1958, William Phillips noticed a superficial link between unemployment and wages in Britain. Economists took his idea and ran, presuming that since firms link wages and prices to preserve profit margins, wage inflation must cause price inflation. Hence, the widespread belief that low unemployment creates inflation as wages and prices spiral together. The trouble is, if you are saying that rising wages create inflation, you are essentially saying inflation creates inflation. Sorry, but that is not how it works.

An additional difficulty with the Phillips Curve is that it has never held up to reasonable scrutiny. Example: The 1970s stagflation in the US featured rising prices and rising unemployment. At that time, President Nixon put into place wage and price controls in response to the oil price shock due to OPEC’s embargo and years of the Fed’s increased money supply. Nixon’s controls distorted normal price signals. Fixed prices incentivize companies to produce the minimum, as there is no profit reward for producing more. That causes rationing and shortages, which can increase prices across the economy once the price ceiling resets. Moreover, if companies’ prices are capped, they may fear losses in the future, so they boost prices to the cap almost immediately, which turns it into less of a ceiling and more of a target.

In addition, the 1990s and 2010s situations disproved the Phillips Curve with low unemployment and low inflation. So if three of the past five decades worth of broad-based economics disproved the Phillips Curve, why hasn’t it incentivized central banks to rethink their practices and analysis? Maybe because the more Keynesian-based theory a government subscribes to, the easier it is for them to spend. (But this is a discussion for another time and probably a libation.)

Furthermore, there is nothing inherently special or forward-looking about wages. They represent the price of labor—determined by supply and demand. Too many headlines today worry the former can’t keep up with the latter, with a heightened focus on supply constraints (e.g., workers remaining on the sidelines due to other obligations, including caregiving). But the labor supply isn’t fixed, and it has been improving, and overall, workers are returning to the labor force, in part responding to the signal of rising wages.

As Nobel laureate Milton Friedman taught, the trouble is wages follow inflation—they don’t lead to inflation. That is a fatal flaw in neo-Keynesian models that history has repeatedly backed. Milton Friedman offers another possible, more helpful explanation of inflation expectations’ role: It takes time for people to adjust to a new state of demand. Producers will tend to react to the initial expansion in aggregate demand by increasing output, employees by working longer hours, and the unemployed by taking jobs now offered at former nominal wages. This much is pretty standard doctrine.

Isn’t it time that more reporters and economic commentators start asking questions like those in Armstrong’s article? Even better would be if they took a deep dive into the non-theoretical history of economics, which may prove more educational than quoting a bunch of people calling the current environment a weird post-pandemic anomaly. Especially when it is fully accepted that the Russia-Ukraine war drove a fresh batch of supply-side spikes, which will likely keep prices elevated for a while longer. That isn’t great, and I definitely don’t dismiss the severe economic hardships for many households. But as experts discuss why inflation will be high, it is worth keeping in mind that labor market developments aren’t the reason why.

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