++"Wealth Shock"

Krugman has an interesting take on James Bullard's "Wealth Shock" idea:

Maybe the idea is that the burst bubble reduces demand, and hence leads to lower production.

Yeah, that's how I took it, though I had to wait for Krugman to make it clear. But what else can it be, if a "wealth shock" leads to lower GDP? It's not that we're suddenly able to produce less. It's that we're suddenly buying less. That follows from the wealth effect.

I don't buy the "wealth effect" story, myself. I'm with Jazz on that:

given empirical data that closely links consumption to income, how can consumption depend "primarily on wealth rather than income?"

But falling demand due to a "wealth shock" and its wealth effects, was the only way I could make sense of Bullard's rather direct words: "The negative wealth shock lowers consumption and output."

Krugman, again:

Maybe the idea is that the burst bubble reduces demand, and hence leads to lower production. But at that point you’re into a Keynesian world of deficient demand, and you should be talking about ways to close the gap, not accepting it as a fact of life.

I thought that was clever, rubbing Bullard's nose in his own Keynesian poo.

...you should be talking about ways to close the gap, not accepting it as a fact of life.

I'm with Krugman on that. Here's mine:

If [Andolfatto] was trying to explain why GDP was slumping and why potential GDP was slumping -- because of excessive private debt, for example -- I would have some use for his analysis. But like Bullard, he brushes aside any concern with "special factors and headwinds". David Andolfatto seems to be saying only that things are bleak and we ought not expect anything better.

We do expect better. However, Krugman tells only one side of a story. Yes, demand is inadequate. The other side of the story is that demand must be excessive. According to Bullard, remember, inflation is already above our new explicit 2% target level. He wouldn't tell us that unless he thought it time to start pushing interest rates up again, to curtail demand. So demand must be excessive in Bullard's view.

Only two percent? Yeah. And if I thought Bullard's "wealth shock" analysis was right, I'd support him at two percent. Other people think we ought to push the inflation target higher, up to four percent maybe. If I thought that would solve the problem, I would support it. But the problem is certainly not that prices are going up too slowly. That's not the problem at all.

The problem, as Krugman said, is that we're in a world of deficient demand. But it's an inflationary world of deficient demand. So, wait: Let's not talk about ways to close the gap. Let's talk about how we got into this mess. Because this world of simultaneously insufficient and excessive demand is a result of the problem that needs to be fixed.

We got into this mess when everybody started deleveraging. Paying down debt. Rather than borrowing more and spending more, we started borrowing less and paying off more. So the reduced borrowing is spending that we're not doing, and the paying off is more spending that we're not doing. A double-whammy on spending.

So, paying down debt is the problem? No. Paying down debt is our solution to the problem. The problem is that we had so much debt in the first place. Private debt.


I left Bullard hanging.

Bullard is concerned about inflation. Now I know, a lot of people just want to dismiss that concern, because we have bigger problems. But you can't just dismiss arguments you don't like. You have to deal with them and show them wrong, or accept them.

Or bide your time and don't jump to any conclusions. That's always a good rule.

So, the inflation. I don't think inflation is a crisis. But I don't like a two percent target. I like a zero target (even if I can only fail to achieve my target). And I really don't like the doublespeak that says "a constant price level" when it means "a constant inflation rate". Bill Mitchell recently pointed out an example of that:

In that Press Release, the ECB said it main role was to achieve “price stability” (that is, stable inflation)

Anyway, Bullard. He says if we overestimate potential output and set policy by it, we will encourage excessive demand and we will get inflation like we got in the 1970s. (And, he says, inflation is already above target.)

Everybody else says the economy is not growing enough, and we don't have jobs enough, and unemployment is too high, and demand is insufficient, not excessive.

How can there be such a difference in views? I think the trouble arises from the way we explain inflation. Here's Mitchell again:

Inflation is driven by nominal aggregate demand growth that exceeds the capacity of the economy to respond in real terms – that is, to increase output.

Too much money chasing too few goods. For Billy, as for Milton and Anna, inflation is caused by excessive demand -- by demand "that exceeds the capacity of the economy to respond". Demand being excessive relative to potential output is the cause of inflation, they say. Exactly what Jim Bullard says.

If you think of inflation along those lines, and you admit we're getting inflation already, then you end up thinking that "the capacity of the economy to respond" must somehow have been crippled. You end up thinking that there must have been a sudden drop in potential output. Exactly what Jim Bullard says.


But all we need -- if we wish to undermine Jim Bullard's argument -- is to realize that demand-pull isn't the only inflation story there is. There is also a cost-push inflation.

Economists seem always to pooh-pooh and ha-ha the concept of cost push inflation. But it makes perfect sense to me.

There is a nice short Wikipedia article on cost-push inflation and if I take two parts of it and put them in reverse order, I get what seems to me an excellent explanation of cost-push inflation:

Monetarist economists such as Milton Friedman argue against the concept of cost-push inflation because increases in the cost of goods and services do not lead to inflation without the government and its central bank cooperating in increasing the money supply.

Keynesians argue that in a modern industrial economy ... a supply shock would cause a recession, i.e., rising unemployment and falling gross domestic product. It is the costs of such a recession that likely causes governments and central banks to allow a supply shock to result in inflation.

I accept both sides of that disagreement. It doesn't even seem to be a disagreement, with the order reversed like that. Here's what I see:

Yeah, it is demand that affects prices. More demand pulls prices up more. Less demand pulls prices up less. And demand expresses itself as spending. And spending is done for the most part with money -- money and credit. With things that work like money.

So, the quantity of money has to have an influence on prices. The quantity of stuff that works like money. I accept that. (I accept it even though I do not accept the graphs Milton Friedman offered to convince us of the truth of it.)

But if something happens -- a "shock" call it, pathetic as that explanation is -- and it drives costs up, then the existing quantity of money has to stretch to cover the higher prices that accompany increasing costs. And if the money doesn't stretch enough, then the spending has to shrink. And if the spending shrinks enough, you get a recession.

And if the central bank has a "dual mandate" to keep prices stable and to keep the economy growing, getting a recession means it has failed to meet its mandate.

And if the central bank decides to take a safe, "middle of the road" position, it ends up compromising between recession and inflation, and getting some of each.

And the inflation we get in such circumstances arises (as monetarists argue) because the quantity of money was allowed to expand. But actually, the prices had to go up anyway, because the costs were going up; and the central bank opted to allow some of that cost-push inflation to continue rather than creating another recession.

That's what it was like in the 1970s. That's the future Jim Bullard sees. The alternative is to figure out why we have cost-push, and to fix that problem.

At the root of cost-push you will find the ever-increasing cost of accumulating debt.

[ Part 1 ]	This is Part Two	[ Part 3 ]