Saturday, September 19, 2009

This Is Getting Krugly

Inflation and the VietNam War

Krugman writes:

For the late 1970s was when macroeconomics experienced its great divide. It’s a period engrained in the memory of those of us who were young economists at the time, trying to find our own paths. Yet I haven’t seen a clear explanation of what went down at the time. So here’s a sketch, which I hope a serious intellectual historian will fill in someday.

Wow. Was I excited to read that! I'm no economist. But I was young then and finding my own path, and all that.

I was disappointed in the rest of Krugman's article. It is an analysis of the ideas of economists. I was expecting an analysis of economic conditions. Heh. I suppose Krugman thinks he knows what the conditions were. Maybe he thinks there's general agreement on what those conditions were. Maybe there is. If so, I disagree with it.

I know that my disagreement (with what I see as the 'standard' understanding of economic conditions) goes back to the latter half of the 1960s. At that time, people attributed the inflation to the "guns and butter" policies of President Lyndon Baines Johnson and the war in Viet Nam. That's still the standard explanation of the inflation of that era, far as I know.

I attribute that inflation to the excessive reliance on credit -- then in its early stages -- and to the "extra" cost of interest associated with that reliance.

If your analysis of economic conditions is wrong at a point in time 40-plus years ago, there's a good chance your analysis of conditions today only compounds the error.

Oh, well. Krugman would rather talk about the ideas of economists.

2 comments:

The Arthurian said...

"Guns and butter" spending was excessive spending; excessive, meaning sufficient to upset the economic equilibrium and nudge prices up. Guns-and-butter was an idea economists had, to explain the inflation of the latter 1960s. Normal domestic spending (butter) plus VietNam war spending (guns) was a version of too much money chasing goods. And the result was said to be inflation.

As I have it, by the early 1960s the excess money in circulation had been drained away. At that point "money supply relative to output" was just about right. But spending continued to grow faster than the quantity of money. Increasingly, that spending made use of credit. The interest cost of that credit-use was an extra cost imposed on the economy. This cost was passed along in price increases. And that was the origin of the inflation of those years, as I have it.

There is a significant difference between these two stories of inflation. The guns-and-butter version is a story of demand-pull inflation: Excess demand pulling prices up. My "excessive reliance on credit" version is a story of cost-push inflation.

Demand-pull inflation raises gross business income, increasing the margin of profit. Cost-push inflation raises business costs, squeezing the margin of profit. Demand-pull inflation is a good business environment; cost-push inflation is a bad business environment. It's that simple.

Too simple for ya? Okay. Both stories are true. But the guns-and-butter story became less significant as the reliance on credit became more significant. And "guns-and-butter" does not explain post-war inflation; the cost of credit reliance does explain it.

The Arthurian said...

There is an interesting relationship between the first and second paragraphs of my previous comment. The second paragraph can be used to understand what is described in the first.

The first paragraph presents my version of the standard view: this spending plus that spending equals too much money chasing goods.

The second paragraph presents my view: The quantity of money was not a problem. But spending grew faster than money. My "spending" is the same as their "this and that" spending. Except I don't care about the this-and-that.

But where the first paragraph fizzles down to the stock answer about why prices go up, the second paragraph pinpoints the cost that was driving prices up: The extra cost of interest.

For the record, I don't care about who is spending too much money on what. I'm not an economist, but that ain't economics! In The Wealth of Nations, Adam Smith broke spending down to three cost factors, and he repeated it over and over again: "In every society the price of every commodity finally resolves itself into some one or other, or all of those three parts" [Book 1, Chapter 6, p.153].

I simply add a fourth factor to Smith's three: the interest cost of money. When Smith looked around him, he saw an aristocracy and the huddled masses and a rising business class. So his cost factors were land, labor, and capital.

When I look around I see a mature economy, over-ripe with finance. I see that the cost of interest has grown in significance since Smith's time. So I split out the cost of interest as factor number four. And there you have it.