Thursday, March 17, 2011

Woodward: Interest and Inflation


I want to review another section of G. Thomas Woodward's Money and the Federal Reserve System: Myth and Reality.

Under the heading Interest and Inflation, one reads:

A criticism occasionally leveled at the Federal Reserve is that in raising interest rates to fight inflation it actually makes inflation worse, and that, indeed, it is a fundamental part of the problem with the monetary system because of its role in a system of lending funds at interest. According to this view, interest is the primary cause of inflation. Adherents maintain that interest payments are a cost of production, so that interest costs enter into the prices of individual goods and services. When these individual prices are aggregated into a price index, the influence of the interest rate on the inflation rate is direct.

Interest payments ARE a cost of production. Look at the recent years:


The historical record shows that in the 1950s, interest costs were negligible but growing. In the 1960s, interest costs became significant. In the 1970s, interest costs started hindering growth. Since then, interest costs have high but variable, while the accumulation of debt continued to grow. Even today, policy favors the accumulation of debt because policymakers still think credit-use is good for growth.

That hasn't worked for forty years. Policymakers equate new uses of credit, which contribute to growth, with accumulations of old debt, which only hinder growth. A large accumulation of debt offsets the benefit of new credit use, while new credit use only makes the accumulation bigger.

Interest-based cost theories of inflation are not uncommon. But they are not commonly embraced by economists. Their major shortcoming is ...

Interest-based cost theories of inflation are not commonly embraced by economists.

Oh -- You mean, not embraced by the people who didn't see the crisis coming? Not embraced by the guy who said the central problem of depression-prevention has been solved, and not embraced by the people who bought that absurd claim? We should reject "Interest-based cost theories of inflation" because those people reject them?

Sorry about that. But the statement that economists reject a particular theory is not an explanation of what's wrong with the theory, and deserves no more respectful a rebuttal than I have given. Nevertheless, I will start again:
You won't miss anything if you skim or skip this excerpt:
Interest-based cost theories of inflation are not uncommon. But they are not commonly embraced by economists. Their major shortcoming is that the effect of interest costs on the price of individual goods cannot be aggregated into an increase in the general price level. The assumption that such price increases result in inflation is considered an example of the fallacy of composition.

To say that the price of a good has increased is to say that it now costs more to buy the good in terms of whatever is used to pay for it. For an individual good or class of goods, an increase in price can mean an increase relative to other goods that are indirectly exchanged for it. Even though money must be used to purchase the higher-priced good, money was acquired through the sale of some other good or service. The rise in price of one good means the relative decline in the price of another. The total need for money in the economy does not necessarily increase when one price increases, because other prices can decline at the same time. Thus, the decreased need for money in transactions involving lower-priced goods can offset the additional need for money generated by goods that increase in costs.

But inflation is the continuous increase in the general level of prices. That means prices of all goods on average are going up -- not just some relative to the rest. And when all goods are rising in price, they cannot cost more in terms of other goods; they must cost more in terms of money. Hence, when inflation occurs, it takes more money on average to buy goods than before prices went up.

Consequently, for inflation to take place, there either must be more money to make the larger transactions, or money must be circulated more frequently to handle the extra need. But there are limits on just how much money can be recycled for more frequent use to accommodate the higher prices. Hence, if the additional supplies of money are not forthcoming, then the inflation cannot continue for very long.

Well, that was painful.

Woodward provides a standard explanation. Actually, if I prune it, his explanation is quite good:
1. "Inflation is the continuous increase in the general level of prices."
2. After prices go up, "it takes more money on average to buy goods than before prices went up."
3. "If the additional supplies of money are not forthcoming, then the inflation cannot continue for very long."

In short, prices cannot increase unless the quantity of money increases. Therefore (according to Woodward) inflation is not caused by costs: Not by the cost of interest, and not (one presumes) by the cost of wages.

Know what? I agree with that. At least, I agree that prices cannot increase unless the quantity of money increases. But there is more to the story.

From my comment at Winterspeak:

Suppose there's an oil-price shock that wants to create a recession. The Federal Reserve may respond by printing some extra money to avoid recession. One of the Fed's mandates is to promote growth. It's part of their job to avoid recession.

So the Fed's response to the cost-push shock is to provide money enough that prices in general go up a little. That said, the question is: Is this demand-pull inflation, or cost-push? I say cost-push, because it started with a cost problem.

On this model, the single most significant cost-push force since World War II is the rising factor-cost of interest due to our increasing reliance on credit. Not oil.

If there is a cost problem that interferes with economic growth, and if inflation is applied as a solution to this problem, then:
1. it is cost-push inflation; and
2. the right solution is not to stop the inflation, but to solve the cost problem.

In a normal economy yes, inflation is caused by "printing money." But in our economy, rising costs throughout the economy created significant problems. The only solution policymakers could come up with to avoid decline was to create a little inflation. The policy worked for a generation, because everybody remembered how bad inflation was in the 1970s, and the "little inflation" looked like nothing, compared to that.

Since the crisis, everybody lost confidence, and now the little inflation is seen as a problem again. People are fickle. The inflation was always a problem. But it wasn't the main problem. The main problem is rising cost. The cost problem arises from interest costs and the growing reliance on credit.

This explains why money growth is necessary for inflation. Higher costs - regardless of source -- cannot generate inflation unless the money supply grows to permit the price increases. If enough additional money is not generated to handle the increase in the size of each transaction, then the number of transactions must shrink. That is, when costs drive up prices in the face of a money supply that does not grow commensurately, economic activity must decline. Purchases drop, workers are laid off, and output falls.

Yes: Higher costs cannot generate inflation unless the money supply grows to allow it. Yes: If the money is not generated, economic activity must decline. Purchases drop. Workers are laid off. And output falls.

Yes. So if there is a cost problem that permeates the economy, and if we do not use inflation against it, the result will be unemployment and recession and decline. And beginning in the 1970s, we did use inflation as a solution to the cost problem.
But growth has not been good, even so.

The trouble is, inflation is not a solution to the cost problem. So, since the 1970s, the cost problem has grown worse. And economists stood by, patting themselves on the back and talking about the Great Moderation. Great... job... Brownie.

We have a cost problem, and three possible solutions:
1. The solution we went with, which was to accept some inflation.
2. The solution Woodward proposes, which is to accept decline.
3. The Arthurian solution, which is to solve the cost problem.

The decline in economic activity reduces the ability of firms to pass their higher costs on to consumers. Despite whatever pressures there may be on producers from the cost side, the reduction in demand holds back price increases. Whether the cost increase is from higher oil prices, interest costs, or increased wage demands, the increase in prices cannot be sustained without accommodation from the money supply. True inflation -- in the sense of continuously rising prices -- is never cost driven.

Y'know, sure: true inflation is never cost driven. But "interest-based cost theories of inflation" arise because problems exist, and explanations are needed. Are we going to reject these theories because of one "true" definition? Or are we gonna examine the problem, look under the hood, kick the tires, and figure the thing out?

Inflation is caused by printing money. If that's the end of the story, we will never solve the cost problem. If it's the end of the story, it's the end of The Land That I Love.

Moreover, the theory of interest-cost inflation has an additional shortcoming. Even if higher interest rates caused prices to increase, they could not explain inflation. Inflation is not high prices; it is not higher prices; it is rising prices; prices that go higher and higher continually. That means that interest costs would have to continually increase to produce inflation. Moreover, whenever interest costs fell, there would be deflation -- not slower inflation.

Note well, precious reader: In the paragraph above, Woodward writes of interest costs. But in his next paragraph, he writes of interest rates:

Of course, this is not what happens. Interest rates have fallen many times in the United States over the last 45 years. But not once did the U.S. price level fall. Inflation slows, but prices keep rising, even though -- according to the interest cost theory of inflation -- prices should fall because costs have fallen. If nothing else, this simple observation shows that the interest-cost theory of inflation is fallacious.

Woodward misses the obvious. Interest rates go up and down, he says, and prices don't, so the interest-cost theory must be wrong.

But it is Woodward that is wrong.

If you have one loan for a hundred dollars at ten percent interest, your interest cost is ten dollars. If you have five loans of four hundred dollars at one percent, your interest cost is twenty dollars.

Woodward overlooks the excessive reliance on credit. He misses the big problem.

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