Tuesday, July 6, 2010

Ignorance is Bliss

re: "stoking demand" versus "boost[ing] costs"

"Printing money causes inflation." This is a notion associated with Milton Friedman, in my mind at least. But as Friedman pointed out, printing money influences prices via its affect on spending. Spending is the process by which demand is exercised. Demand is the driving force. It is a shortcut to say printing money causes inflation. Sometimes, it is a confusing shortcut. Demand is the driving force. But there is a problem with "demand" theory as well.
Demand has been supposed to cause prices to rise, as Anna Schwartz supposes, and Milton Friedman and, well, everybody. [See sidebar.] But prices are not supposed to start rising as soon as we start growing out of recession, nor while we are still in one.

That's why "stagflation" was such a big deal, way back when. The price increases are only supposed to happen, as Anna Schwartz explains, as capacity limits are approached.

Then again, as Bill Conerly's Capacity Usage graph shows, we've been reaching capacity limits at lower and lower levels since the 1960s.

So I have to say these things:

1. The argument that inflation is "demand-pull" -- that prices are pulled upward by growing demand -- does not explain the circumstances of the greater postwar period. This is important, for it was inflation that undermined the Keynesian consensus.

2. The alternative explanation -- cost-push inflation -- is often immediately rejected. "There's no such thing," I've been told by a very confident fellow. But rejection of ideas is not the same as evaluation or understanding. Anyway, the economy changes. What was true once may be true no more. Not only madmen in authority, but also men mad at authority may be slave to some defunct economist.

3. Inflation arises much sooner than it should, sooner than the standard explanation can explain. But this does not seem to bother anyone. We've settled for "low" inflation as an adequate substitute for "no" inflation. And we ignore inflation: Politicians and the media ignore inflation, until we can no longer ignore it. These are the only reasons the standard demand-pull story seems to hold true.

4. Why do we get inflation before we reach capacity limits? Why does capacity utilization peak at progressively lower levels? These are key questions, questions that if answered might help us solve the inflation problem, and help us understand the economy a little better. But it seems we prefer to ignore such questions, for they endanger our standard explanations of the world we live in.

1 comment:

Jazzbumpa said...

Friedman's canard that inflation is always and everywhere a monetary phenomenon, the cost push idea, and the demand pull idea can be thought of - and perhaps often are - as mutually exclusive propositions.

But there is no reason for that to be the case. On the one hand, I'm prepared to believe that NOBODY understands inflation. On the other, I'm willing to believe that all three of these things can play a part.

I do believe that you cannot get hyper-inflation without a huge monetary contribution, and you can't get 70's style inflation without demand pull.

But inflation such as we have seen over the last decade + can easily be cost push - especially with serial bubbles and what has happened to energy prices.