## Thursday, May 31, 2012

### A Prediction

How does NGDP Targeting work? Nick Rowe says:

If real GDP falls 10% below what was expected, the price level rises 10% above what was expected...

David Andolfatto says something similar:

Adopting a NGDP target implies that policymakers can commit to (say) a 5% NGDP growth rate. But what if inflation turns out to be 4% and RDGP growth turns out to be 1%? (Or how about 7% inflation and -2% RGDP growth?)

I summarize:

NGDP targeting does nothing for growth.

The goal of NGDP targeting is to stabilize the path of Aggregate Demand (AD). Using "P" for "prices" and "Y" for "real output", Nick Rowe says:

When a negative AD shock hits, both P and Y will fall. When AD recovers both P and Y will rise. But we know very little about how that rise in AD will be divided into a rise in P and a rise in Y.

Rowe says we do not know how the increase will be distributed between inflation and real growth. But I think we have a pretty good idea. If cost-push forces exist, as I claim, then NGDP Targeting will give us lots more inflation than real growth.

So I got thinking about how to see that on a graph: to see how AD (or something) is distributed between inflation and real growth. I came up with a graph, and I'll show it to you. But it's crude. It's a first draft. So take it for what it's worth.

I started by getting quarterly data for Real GDP, the Consumer Price Index, and U.S. recession dates from FRED.

The US Recessions column shows a "1" -- TRUE -- when there is a recession, and "0" otherwise. I wanted to look at just the peak-to-peak data for RGDP and prices, so I wanted to look at the last "0" before a "1". So I deleted all the rows from the worksheet except the rows with the last "0" before a "1". That left me with a dozen rows.

Starting with the second data item, from the date I subtracted the previous date; this gave me the number of days from peak to peak. From the RGDP I subtracted the previous RGDP, to get the increase in real output. And from the CPI I subtracted the previous CPI, to get the increase in prices for the peak-to-peak period.

Next I divided the increase in real output by the number of days, to get the average daily increase in real output. (This is crude, so again: take it for what it's worth.) And I divided the increase in prices by the number of days, to get the average daily increase in prices for the period.

Finally, I normalized these series. I divided each of the Average Daily RGDP values by the first of them; and each of the Average Daily CPI values by the first of them. Then I made my graph.

 Graph #1: Distribution of Growth and Inflation across business cycle peaks
The blue line shows RGDP data; the red line shows price data. The dots on each line represent business cycle peaks -- dates of the last "0" values before the recession's "1" in the original FRED data. (Except, the last dot is just the most recent data.)

For the first few dots -- 1953, 1957, 1960, and even 1969 -- prices and output travel close together. (For 1953, normalization forces them to be identical; my reason for doing that was to see whether the lines move together or move apart.)

For the first few dots, prices and output move together. Then suddenly in the 1970s -- the Great Inflation -- the red line shoots up. It peaks in 1981, about the same time inflation and interest rates also peaked.

Then the red line falls, but only about half as much as it rose. Thereafter, the two lines run more or less parallel.

The peak represents the Volcker squeeze. The two lines running parallel thereafter suggests that there is a fairly stable division between what adds to real growth and what fizzles away as inflating prices. Note, however, that after the Volcker squeeze the red line never again comes close to the blue.

Before the Great Inflation, the two lines travel together. This suggests that out of every \$4 gain, \$2 ended up as real growth and \$2 ended up as inflation.

After the Volcker squeeze, the red line values are roughly three times the blue. This suggests that out of every \$4 gain, \$1 ended up as real growth and \$3 ended up as inflation.

I expect the 3-to-1 ratio to continue under NGDP targeting, unless the gap widens again.

So, there's my prediction.

To see if the above story fits other peoples' reality, I went back to FRED and graphed RGDP and the CPI with less manipulation of the numbers. All I did was express each series as "Index (Scale value to 100 for chosen period)". For each series, the chosen period I picked was the 1953 business cycle peak. That is as close as I could get to mimicking the normalization I used in Graph #1.

 Graph #2: Real GDP (blue) and the CPI (red)

Normalized to 1953, the two lines start out together and run close at first. When first they separate, prices run below real output: Growth increased faster than prices.

By the mid-1970s the lines come together again, and cross. Thereafter, prices run higher than real growth. A sign of cost-push, I might say.

It's not an exact match to my Graph #1. But it's not that far off.

## Wednesday, May 30, 2012

From the 27th:

Sure, you can suppress the quantity of money and thereby keep demand, and inflation, and growth, at a low level. But that does not mean it was demand-pull inflation.

If there are cost-push forces at work, suppressing demand will not solve the problem. It will reduce or "moderate" economic growth. It will reduce or "moderate" inflation. But cost-push forces will continue to eat away at profits and living standards.

From Marcus Nunes' A last ditch defense of Inflation Targeting:

According to Robert Hetzel, during the period of the Great Inflation, the prevailing view, and the one embraced by Arthur Burns, Fed chairman from 1970 to 1977, was that inflation was a real (cost-push), and therefore non-monetary, phenomenon.

On becoming chairman of the Fed, Volker challenged the Keynesian orthodoxy which held that the high unemployment high inflation combination of the 1970´s demonstrated that inflation arose from cost-push and supply shocks – a situation dubbed “stagflation”.

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.

From the 29th:

So, where Arthur Burns was willing to accommodate the forces that were pushing prices up, Paul Volcker was not.

Before Volcker we had 15 years of worsening inflation. After Volcker we had 30 years of worsening economic growth, attenuated by acts of supply-side desperation and government deficits, leading nonetheless to the system shutdown we call "the crisis".

Yes, you can suppress the quantity of money and thereby keep demand, and inflation, and growth, at a low level. But that does not mean it was demand-pull inflation.

And it certainly does not mean you have solved the problem.

To be perfectly clear on this: I spent a lot of time going over Marcus's post, while writing mine of yesterday. And along the way there was a brief moment when I thought Hm, maybe NGDP Targeting would be better than Inflation Targeting.

Just a brief moment :)

But anyway, that's not the point. The problem in the world today is the cost arising from excessive finance. That cost works itself out as a "cost-push" force, tending to cripple economic growth unless prices increase enough to compensate for that cost.

This cost, which shifts income from the productive sector to the financial sector, is not eliminated by the change from Inflation Targeting to NGDP Targeting. Perhaps NGDP Targeting is a better way to cope with the problem; but it does not solve the problem.

Nor did Paul Volcker solve the problem by suppressing inflation on the assumption that it was "demand-pull". Those cost pressures remain. Those cost pressures bring us to ruin.

## Tuesday, May 29, 2012

### Marcus Nunes: A last ditch defense of Inflation Targeting

Writing a blog is like kneading bread -- you have to work it, and work it, and work it again. So we ought not be surprised to find JoÃ£o Marcus Marinho Nunes, reminded of his old post by one at The Everyday Economist, not surprised to see him rework his old statement and post it anew.

As it happens, I am no less fascinated than Nunes by his topic. So I am happy for the chance to review his most recent thoughts on the subject. My review will consist of three parts:
1. Summary of his post.
2. Summary of the summary.
3. An "alternative view" of my own.

#### 1. Summary of the post

Nunes opens with a quote from Roger Farmer, describing "increased responsiveness" of the Federal Reserve to inflation during the Great Moderation:

After 1983, the inflation-reaction coefficient increased; the Fed raised the short-rate by a larger percentage in response to inflation than it had done in the period from 1951 through 1979.

As if in response, Nunes quotes Anasthsios Orphanides:

But if policy is to be evaluated based on information that was actually available when policy decisions were made, a different conclusion emerges.

In other words, if we evaluate the policy decisions of the 1970s based on information available at the time, those decisions were no less "responsive" than those of the Great Moderation. As Nunes puts it,

...when using data available to policymakers in real time, monetary policy during the 1970´s was characterized by a rule that is consistent with the estimated rules for the period after Volker

Orphanides, if his information is correct, undermines Roger Farmer's view and, as Nunes points out, undermines the "consensus view" as well. This opens a door to an alternative analysis.

The alternative Nunes presents is that there was a change of "doctrine" at the Fed when Paul Volcker took the big chair in 1979. Under Fed chairman Arthur Burns in the 1970s, inflation was seen as cost-push, arising from forces beyond the Fed's control. But Volcker challenged that, seeing inflation as demand-pull. According to Volcker, "the inflation process is ultimately related to excessive growth in money and credit”.

So, where Arthur Burns was willing to accommodate the forces that were pushing prices up, Paul Volcker was not. A change of doctrine.

On the 27th I wrote:

I like to read Nunes because he will often add a parenthetical phrase that works, for me, to make sense of a technical concept.

Now I can give you an example. Here's a paragraph from Nunes' post:

An alternative view of the change in monetary policy from the Great Inflation to the Great Moderation is that there was a change in the “doctrine” of the Federal Reserve. According to Robert Hetzel, during the period of the Great Inflation, the prevailing view, and the one embraced by Arthur Burns, Fed chairman from 1970 to 1977, was that inflation was a real (cost-push), and therefore non-monetary, phenomenon.

If Marcus didn't include "(cost-push)" there, I would not have known what that last sentence meant. But now I *do* know. And I like the concept of seeing "cost-push versus demand-pull" in terms of "real versus monetary". And I really like the way Marcus defines "real" by distinguishing it from "monetary". I think the clarity he provides can help answer questions like Why Does Y Equal Real GDP?

Marcus Nunes identifies the cost-push view of Arthur Burns as "Keynesian orthodoxy". (I could not have guessed that. No matter.) Anyway, he looks at the cost-push view and ties it back to the discrepancy that opened the door to his alternative analysis:

This “cost-push” view of inflation, together with an SAS perceived as horizontal when output is below potential, can explain the observed differences in the estimates of the parameter on inflation in the Taylor Rule during the Great Inflation and the Great Moderation.

"Under the cost-push 'doctrine'", Nunes writes, "forecast[s] of inflation based on the ... Phillips Curve" would be systematically under-estimated because "after the negative supply shock output is below potential and unemployment above the NAIRU."

The Phillips Curve identified a trade-off between inflation and unemployment. But then, "SAS perceived as horizontal" implied that output could be brought up again (by increasing Aggregate Demand) without causing inflation -- because the flat SAS curve predicted supply increasing while prices remain stable. But since this (horizontal SAS)* notion was flawed, inflation kept turning out worse than predicted.

*   Nunes explicitly identifies the Phillips curve as the flawed mechanism. Not the horizontal SAS. But I can only make sense of Nunes' remarks by assuming he misplaces the error.

Nunes concludes the thought by referring back to the discrepancy Orphanides observed:

The fact that inflation was systematically under forecast implies that estimates of the Federal Reserve reaction function as measured by the Taylor Rule using real time data [concur] that the Fed had a much stronger response to inflation than the response obtained using “final” data.

He then moves on to the next piece of his analysis:

So, if during the Great Inflation the Fed did not under react to inflation, given real time data – the error coming from a flawed forecasting mechanism – The Phillips Curve – how come the Great Moderation emerged? In other words, how did Fed “doctrine” change and why was this new “doctrine” consistent with reduced volatility in both inflation and real output growth?

"On becoming chairman of the Fed," Nunes writes, "Volker challenged the Keynesian orthodoxy":

Volker´s challenge placed inflation as the FOMC´s top priority. He also brought to the fore of policy discussions the ideas developed during the previous 12 years – since Friedman´s address to the 1967 AEA meetings – on the importance of inflation expectations.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.

Before the change in doctrine, policymakers thought they could increase Aggregate Demand to boost the economy, without contributing to inflation (because they thought inflation had other causes, cost-push causes).

After the change in doctrine, policymakers held that inflation is related to the quantity of money (or, to the growth of the quantity of money) and, excuses be damned, that they could control inflation by controlling the quantity of money. This brings us back to Roger Farmer's quote, from the opening of the post:

Volcker followed a policy of strict control of the money supply, as opposed to control of the interest rate. This policy rapidly reduced inflation at the cost of a period of high interest rates and a big spike in unemployment.

"Volker," Nunes writes, "believed that inflation was the result of excessive AD."

So nothing more natural than to assume that the Fed should increase its responsiveness to the growth in nominal spending. How would this change in “doctrine” (from regarding inflation as a “cost-push” to “demand-pull” phenomenon) show up in the data?

This is the best part of Nunes' post. He reminds us that

under the cost-push “doctrine” the Fed would react vigorously to negative output gaps making policy expansionary, so nominal spending would grow.

But under Volcker's "demand-pull" doctrine,

the Fed doesn´t react much to supply shocks ... but would react vigorously to AD or nominal spending shocks.

"Therefore," Nunes concludes, "under the new “doctrine”, policy would make AD growth stationary, in which case AD growth will not show a rising trend as under the cost-push “doctrine”. The chart illustrates."

And then Nunes displays the chart -- the chart that is the reason I'm still analyzing and evaluating his post, after more than a week:

 Source: M. Nunes, A last ditch defense of Inflation Targeting

"The main difference between the two 'doctrines', Nunes writes, "is not the change in the Fed´s responsiveness to inflation as argued by Taylor, Bernanke or Farmer, but the changed responsiveness to aggregate demand or nominal income growth." Moderation in inflation and output volatility, he says, would be a "collateral effect".

Finally, tying back to his post title, Nunes writes:

The Fed never explicitly targeted anything – inflation or nominal income (AD) growth – but implicitly you could say it targeted nominal AD along a 5.5% growth path growth after Volker.

#### 2. Summary of the Summary

Good economics is like good science fiction: The story doesn't have to be true, as long as it is interesting. One needs to suspend disbelief. That lets you take in the whole thing, and evaluate the whole. James Bullard's remarks from back in February, which I reviewed beginning here, is one example of this kind of good economics. Marcus Nunes' post is another.

In my day job I take drawings from customers and make drawings for the shop, so the shop can make what the customer wants. It's a good job. Sometimes it is difficult to figure out what the customer wants. So I will make a guess about what he shows me, and proceed on that basis. What I do then is look for discrepancies. If I made a bad guess, there will be discrepancies and I will know. If there are no discrepancies and things fall into place, then I can figure my guess was a good one.

Discrepancy analysis is a useful tool.

Marcus Nunes opens his post with a look at the "consensus view" of how the Great Moderation emerged. He points out a discrepancy in this view, regarding the Fed's "responsiveness" to inflation. Because of the discrepancy, Orphanides' discrepancy, Nunes says the consensus view (represented by Roger Farmer's statement) is a bad guess.

Nunes then makes a new guess. His guess is that "there was a change in the 'doctrine' of the Federal Reserve" -- a change from thinking in terms of cost-push, to thinking in terms of demand-pull. The old doctrine led to low-ball predictions of inflation, so that (based on what we know today) the Fed's policy responses seem weak when compared with "new doctrine" responses.

The analysis explains the discrepancy Orphanides observed. This makes a strong introduction for the "alternative view", for the guess Nunes provides. At this point, Nunes asks: "So ... how come the Great Moderation emerged?"

The new doctrine challenged the old, Nunes says, and "implicitly" accepted that rising inflation is caused by demand-pull. Nunes writes:

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

Volker ... believed that inflation was the result of excessive AD.

The new doctrine assumed that control of the growth of money would enforce control upon inflation. And it proved true, if we may judge by the result. The result of the change in doctrine, Nunes says, is visible in the change in nominal spending growth, visible in the chart he provides.

Me, I love graphs, and logic, and when Nunes' logic led to that graph, well, I was flabbergasted. But there comes a time when the suspension of disbelief has to be terminated.

Marcus Nunes' whole argument, good as it is, is built upon on the change of doctrine, the change from thinking of inflation as cost-push to thinking of it as demand-pull.

And judging by the results, Volcker was apparently correct when he said "the inflation process is ultimately related to excessive growth in money and credit". Treating inflation as if it was demand-pull reduced inflation significantly.

But what if Arthur Burns was right? What if the inflation was in fact cost-push? Treating it a demand-pull, suppressing money, would hinder the rise of prices. But it would do nothing about cost-push pressures, those real (as opposed to monetary) pressures that were driving prices up.

With cost-push pressures ignored, they could fester for decades while economic performance deteriorated. Meanwhile, to circumvent that deterioration a whole new system of supply-side policies would have to be put in place. However, with cost-push pressures ignored, inflation would never really go away away.

#### 3. Unsolicited Afterthoughts

Arthur Burns was wrong. Oh -- not about inflation being cost-push. He was right about that. But according to Nunes, Burns identified the push as "pressure on costs arising from excessive wage increases". Wage-push inflation. Burns was wrong about that.

Hey, if wages were the driving force, then wages would have been gaining relative to other costs. Wage-earners would have been doing better, not worse. So there is no way wages were the driving force behind this inflation. And I can show it to you, too:

 Interest Costs Rise as Employee Compensation Falls
Wages -- the red line -- were not increasing as a portion of corporate costs. Wages were falling. It was interest costs that were rising. Financial costs. The blue line. That's what was pushing prices up. Not wages. And look what that got us, thirty-odd years later: wage-earners deep in debt, and a financial sector grown too big to fail.

// UPDATE 6 October 2015: Fixed a graph that was not displaying.

## Monday, May 28, 2012

### Wesley changed my life

I worked with a guy named Wesley years ago. He worked behind the counter in a steel warehouse. He dealt with customers. He dealt with demand.

Back then, I still thought of inflation in the demand-pull terms expressed by Milton Friedman and Anna Schwartz. Too much demand, I said, is the cause of inflation. Too much money chasing too few goods. You know.

Wesley said, "But prices go up because costs go up."

Related posts:
 The Cost-Push Economy ...20 Feb 2011 Indonesia Now ...11 Jan 2011 Ignorance is Bliss ...6 July 2010 The Long Decline ...17 June 2010 The Schwartz ...31 Oct 2009

## Sunday, May 27, 2012

### Don't we want to think about that?

Marcus Nunes' A last ditch defense of Inflation Targeting still has my attention. Tryin' to work through what he says, so I can summarize it before I say what I think. I got stuck where he says "the short-run AS (SAS) curve was perceived as horizontal when output is below potential".

I like to read Nunes because he will often add a parenthetical phrase that works, for me, to make sense of a technical concept. Didn't happen this time. Here: here is the whole paragraph:

When placed in the dynamic Aggregate Supply (AS)/Aggregate Demand (AD) framework, this “cost-push view” as advocated by policymakers in the 1970´s suggests that the short-run AS (SAS) curve was perceived as horizontal when output is below potential.

"AS" is Aggregate Supply. "Short run", I can imagine what that is. "Cost-push", this is what fascinates me most about the article, because we need to look more at cost push. And "output below potential", I get that. I get all of that. It's the Aggregate Supply curve that stopped me cold.

What are the axes? If the curve is "perceived as horizontal" then I need to know what's on the vertical axis. Supply is a curve that slopes one way, demand slopes the other, where they cross is the perfect price or something, I get all that. But I didn't memorize the supply curve axis labels. I have to stop and work that out.

It rolled around in the back of my head a few days, then suddenly made sense. Nunes says it was thought that prices would not go up due to increased demand, if supply was below potential.

In other words, SAS is horizontal -- no change in prices when demand increases -- if supply is below potential. Or so it was thought in the 1970s.

So, price is the vertical axis and supply is the horizontal. Google brings up some images; these all show price on the vertical axis. Got it.

Wikipedia (out of context):

At low levels of demand, there are large numbers of production processes that do not use their fixed capital equipment fully. Thus, production can be increased without much in the way of diminishing returns and the average price level need not rise much (if at all) to justify increased production. The AS curve is flat.

As Wikipedia has it, "At low levels of demand ... the AS curve is flat." As Nunes has it, when output is below potential the AS curve is horizontal. As I have it, if supply is below potential, increasing demand won't raise prices. So it was thought in the '70s.

Now, I guess, we know better: Prices go up all the time, regardless of the output gap, regardless of demand.

That's why cost-push fascinates me.

Now I have a question. According to Nunes -- and the world -- prices *do* go up when demand increases, even when supply is below potential. Inflation is due to aggregate demand, the world says.

But, even when demand is below potential? Before the crisis, in the Bush years, the economy was really slow. Prices went up anyway. That was a demand problem?

Once upon a time, prices went up and down (as the red line shows). Now, prices only go up. (The red line almost never goes below zero.)

And, by one measure at least, economic growth since the 1970s has been substantially below the average of the past 200 years. Growth was better, back when prices went up-and-down. These days growth is less, and prices only go up.

Now, Aggregate Demand (AD) is relatively low. Demand is not sufficient to pull prices up. But now -- for decades before the crisis, I mean -- prices only go up. Doesn't this support a view that Nunes and the world reject -- the view that inflation was cost-push in the 1970s? And maybe, that inflation has been cost-push for quite some time?

Prices don't go up-and-down. Prices only go up. Prices are going up even while demand is relatively low. Doesn't that sound like there must be something other than demand that is pushing prices up? Doesn't it sound like cost-push?

Don't we want to think about that?

Sure, you can suppress the quantity of money and thereby keep demand, and inflation, and growth, at a low level. But that does not mean it was demand-pull inflation.

If there are cost-push forces at work, suppressing demand will not solve the problem. It will reduce or "moderate" economic growth. It will reduce or "moderate" inflation. But cost-push forces will continue to eat away at profits and living standards.

So the question that must be asked is whether, in our experience, inflation is cost-push or demand-pull. The question is easily answered, because the two inflations are related to two different economic conditions. Under demand-pull, incomes are plump and the economy is good. Under cost-push, incomes are lean and the economy is not good.

Don't we want to think about that?

## Saturday, May 26, 2012

### Spring Fever

She rests upon my coffee table,
face up atop Discover,
the model Hollie Witchey.

### Explaining stagflation

The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve.
- Phillips curve, Wikipedia

The Phillips curve said there was a tradeoff between inflation and unemployment -- one went down when the other went up. But then in the 1970s, unemployment and inflation both went up. The Phillips curve was "confounded" and a new explanation was needed.

That's when Keynesian economics fell into disrepute, and economists invented new explanations like the NAIRU.

After 30 years of building upon such explanations, the economy tanked.

To explain the problems in our economy you cannot go back to the subprime crisis or to the 1990s or the 1980s when policy fixes were being put into place. To explain the problems you have to go back to when those problems first arose -- back to the "Great Inflation" beginning in the mid-1960s. You have to go back to what the problems and policies were, then.

## Friday, May 25, 2012

### Mom and who?

From my Rajan post:

Regulation is ineffective. The profit motive is an irresistible force. Regulation is not an immovable object.

The trick is to use taxation to make different things profitable. Use it to make some things more profitable, and other things less profitable.

For example, the existing business income tax favors bigness. So, if things go their way, a business can grow like crazy. That's how you get giants like Microsoft and Google and the too-big-to-fail banks.

And then we have anti-trust, because sometimes we seem to think some companies are too big. But it would be much more effective just to change the tax system. We could redesign the business tax to favor small business instead, for example. But it would be better to make the tax so it favors no one by size. Let Walmart compete on equal footing with Mom-and-Pop.

## Thursday, May 24, 2012

### Jobs? You think jobs is the problem??

Okay. But it's our problem. A problem for people. It's not a problem for the economy. If you want jobs from the economy, you have to give the economy what *it* wants.

Of course everybody thinks they know what the economy wants: to cut the growth of government spending.

That's not it.

And now, to ruin a perfectly good brief statement, let me explicitly point out that I am *not* saying we must expand the growth of government spending. I am not saying we should cut it, and I am not saying we should expand it. What I'm saying is, the size of government is not the problem. The spending of government is not the problem. The debt of government is not the problem. The government is not the problem.

I'm saying we should stop talking about the government, and focus on the problem.

Excessive private debt is the problem.

We need to wipe out that debt, private debt, before life as we know it ends like a game of Monopoly.

## Wednesday, May 23, 2012

### Holy crap

For your shuddering pleasure, glimpses into the logic and literacy of Gina Aveni at Conservative Daily News:

John Maynard Keynes is the author of Keynesian economics who was both an investor and economist of his time.

Keynesian Economics stemmed from ideas that have taken a toll on the American Economy.

Keynes was opposed to Say’s Law which states that supply creates demand. Keynes believed the opposite; output determined demand.

## Tuesday, May 22, 2012

### Gunnar Tomasson

From Gang8:
I have long been persuaded that we will ultimately run into a stonewall with our debt dilemma and how to handle it. The solution so far has been to let the less well placed individuals of society bear the burden. This is the austerity programs that are imposed. And it is getting us nowhere. We are cutting down the economies through austerity programs, we are cutting down the welfare system, we are cutting down health and education and so on. [...] This reduces and cuts out purchasing power from the economy, and the purchasing power is what keeps the wheels of industry going.

And this:
We have seen it playing out in Europe now where they have taken steps, one after another, and they basically have not identified the problem. And if you have not identified the problem - and you cannot do that with modern monetary economics - when you cannot identify your problem, you cannot design a solution for it. You must know what your are talking about, and they don't. You have a system overburdened with debt and the solution cannot be to add more debt to it.

## Monday, May 21, 2012

### Liquidity Trap

Found this by accident:

 Source: Introductory Microeconomics and Macroeconomics By TR Jain, VK Ohri
I can duplicate that graph.

Dunno about the interest rates, though.

## Sunday, May 20, 2012

### I want all of it

From The Role of Monetary Policy (17 page PDF) by Milton Friedman:

Accordingly, the authority increases the rate of monetary growth. This will be expansionary. By making nominal cash balances higher than people desire, it will tend initially to lower interest rates and in this and other ways to stimulate spending.

"cash balances higher than people desire"

Is that the problem, really? We have too much money and we don't like that, so we spend the money just to get rid of it? Really?

I don't see it.

## Saturday, May 19, 2012

### Interesting

Marcus Nunes' "alternative view" of Fed policy since the 1960s.

The main difference between the two “doctrines” is not the change in the Fed´s responsiveness to inflation as argued by Taylor, Bernanke or Farmer, but the changed responsiveness to aggregate demand or nominal income growth.

Strong argument, I think.

## Wednesday, May 16, 2012

### A FRED Browser

After you edit a FRED graph, in a row of text above the graph are some options, including LINK to the graph. No matter how complex your graph, the URL is always short, and the filename part is never in my experience more than three characters.

That three-character simplicity amazed me. I wrote to the FRED webmaster about it and Mr. Essig offered this brief explanation:

The short links are generated from a sequence with a base of 62 characters (i.e. a-z, A-Z, 0-9) instead of the normal 10 numeric characters (i.e. 0-9).

Well, after that it was obvious! The three-digit sequence is just a number. In other words, when you create one of those links to a FRED graph, FRED gives the thing a number and saves the info needed to create that same graph again, later.

The three-character sequence is just a number.

So, why can't I pick a number at random and look at that FRED graph?

Well, I can't, because I don't have the ability to write the code to make it happen. But my son Jerry can. I described the idea to him and before I knew it, he was back to me with a link to try, and this email:

I'm not totally sure what you had in mind in terms of integrating it with your site, but here you go ...

This is two HTML pages. One has the two frames on it. The other is the nav bar, which goes inside the top frame. It sets the page in the bottom frame to be some fred graph. All of the logic is in javascript (no php or anything), but it's a little confusing because of all of the frames and the javascript. We can talk more about it ... anyway, here it is!

Well, I spent a few days with it, off and on, trying to put something in the sidebar that would access the FRED Graph/NavBar combo. Then I went back to Jerry:

Okay I give up. I can't even keep up with the posting.

What I have in mind is this: The user clicks a button or something in my sidebar to activate your FRED browser. But the FIRST call from this button is to a graph at random.

Then with your PREV/NEXT options the user can look at that random area. I thought people might find this worth trying more than once.

Jerry got back to me just a few hours later with a new link that picks one of those "base 62" numbers at random, and opens up that FRED graph.

All that was left for me to do was stick the thing in the sidebar and write this post!

Not bad. I really like the idea of accessing that base-62 list of graphs that FRED users have created. It offers a peek at what other people have been working on. And it gives me a look at data series and data relationships I've not seen before.

So I want to thank my son for developing the FRED Browser. You can find the link on my sidebar under the title Random Eyes. Just click the text below that title to open up the NavBar and a FRED graph at random!

Oh, by the way... I want to repeat something Jerry said the other day:

One thing I wonder about (I don't know if it's a serious concern or not)... maybe a more prominent attribution to FRED (in the top bar) might be appropriate. I could change the "FRED" to "St. Louis Fed." or something...

Yeah. Thanks, Jerry. And thank you, FRED.

Enjoy.

## Tuesday, May 15, 2012

### There is a difference.

I think I heard on the news the other day that Obama wants to save people as much as \$3000 per year by refinancing their debt.

The thing of it is, refinancing postpones the payments but does not reduce the debt. That's why it is ineffective policy.

From NaturalNews.com...

#### Iceland forgives mortgage debt to save its economy

by: J. D. Heyes

It's probably not a concept that most U.S. banks and lawmakers want to think about, but the fact is, Iceland's economy has grown by leaps and bounds since the government there implemented widespread debt forgiveness for many of its citizens.

There is a difference between refinance and forgiveness.

### Real and Nominal Debt: Your Turn

In the May 9th post I introduced two different calculations for inflation adjustment of number series that are stocks rather than flows. I worked out the ART2 calc with an example on the 14th. But I had some problem with the ART1 calc.

The ART2 uses a "base year" just as the usual inflation adjustment does. I used the final year as the base year, but I could have picked any year.

The ART1 is different. It has a floating or "flying" base. Each year's number is properly adjusted for that year: The current addition to debt remains in current dollars, but the prior years' debt is adjusted and expressed in those same current dollars.

I don't mean to beat a dead horse. But the difference between the two calculations is significant. To create the inflation-adjusted numbers behind Graph #4 in yesterday's post, I used the ART2 adjustment on the numerator and the Surreal adjustment on the denominator.

I think I could create the same numbers using the ART1 adjustment on the numerator, and *NO* inflation adjustment on the denominator. I have not done it, and I could be wrong. But I'm pretty sure that's how it works. If anybody wants to give it a try...

See also -- DIY Econ: Debtors and Inflation, by Ohm at Bread and Butter. Ohm looks at the "big misconception out there that the problems of debt overhang can be solved by creating inflation" and "the myth that "inflation is always good for a debtor".

## Monday, May 14, 2012

### Real and Nominal Debt: An Example

In response to my The Inflation Adjustment of Debt, Clonal replied in part:

You may also want to look at Scott Fullwiler's presentation -
What Should Economists Have Learned from the Crisis?

which for some reason opens with a picture of a naked guy doing math at the blackboard.

Took me a few days to get to it -- that Debt and Inflation series really took a lot of time -- but I finally did. The presentation is done in "Prezi", a service I've not seen before. It was pretty easy to view the presentation, intuitive. Not bad, though there did seen to be a lot of zooming in and zooming out.

I even turned on my speakers so I could hear it as well as see it. But there was no audio to be heard. And since it's a presentation -- a sequence of images, not a body of text -- there was nothing to read and follow. So I'm not really sure what the point of the thing was.

I don't really think it had much to do with the inflation adjustment of debt. But I did find one graph in it, that brought me back to that topic:

 Source: Rob Parenteau via Scott Fullwiler

See that flat spot there, from 1965 to 1985? It corresponds pretty well with the "Great Inflation" of 1965-1984. Corresponds very well, actually. Thanks, Clonal.

I think the ratio of debt-to-income shown on that graph was influenced by the inflation of those years.

I think I can use my inflation-adjustment calculations, developed in the Debt and Inflation series, to see the extent of that influence.

First, duplicate the graph using FRED data for household debt as a percent of disposable income:

 Graph #2: Household Debt relative to Disposable Income

CMDEBT is Household Credit Market Debt Outstanding, and DPI is Disposable Personal Income. Graph #2 continues into 2012; Graph #1 stops about six years earlier, and lacks the tip of the peak and decline. Other than that, the two graphs show similar patterns: increase before the Great Inflation, flat during, and increase again after that inflationary era.

I thought I would use the "ART1" inflation adjustment from mine of May 9th for this post. But I got far enough with that to have second thoughts. I think the "ART1" has a flying base, not a single-year base. I don't think it is compatible with the Surreal inflation adjustment. So I'll use "ART2" instead, taking the most recent year as the base.

 Graph #3
To make this adjustment I need the debt numbers and a price series. I wasn't sure what price series to use, so I checked with FRED. Graph #3 compares their "Real Disposable Personal Income" (blue) to "Disposable Personal Income" divided by the deflator (red) and by the Consumer Price Index (green) adjusted to the 2005 base year that the other lines use. The deflator gives a better match. I'll use that.

I went to FRED and gathered up a bunch of data, uploaded it to Google Docs, and combined it into a new workbook. The first time through, I gathered quarterly data, FRED's default. But when I plugged my adjustment formula into the spreadsheet, I ended up with one number every four rows, and N/A errors between. Because I had only one starting value transferred over from the unadjusted debt column. To make matters worse, when I graphed it, the line with the N/A errors didn't show up.

All in fun. Anyway, when I regathered data for the ART2 adjustment, I got annual data. I used ART2 on the debt; the method is as follows:
1. Adjust the first debt value to the base year; then for each subsequent year
2. Carry forward the previous year's adjusted value, and add to it the new debt after adjusting for inflation to the base year. (See the May 9 post for details.)

For inflation adjustment of Disposable Personal Income, a flow, I used the standard "surreal" calculation; refer to the May 8 post for more.

Because I am using two different inflation adjustment calculations, the adjustment is not lost when I divide the adjusted debt value by the adjusted income number.

Here is a peek at the spreadsheet:

Here's how my graph turned out:

 Graph #4: The "Erosion of Debt" Is Shown in Pink

The blue line shows debt relative to income, in current dollars (like Graph #2 above). The red line shows debt relative to income, in dollars of constant purchasing power, 2011 dollars. The pink area (above the blue line) shows the purchasing power eroded by inflation.

Note that the most rapid erosion occurred during the Great Inflation of 1965-1984. Let's make it twenty years, 1965-1985. That's the period where the unadjusted blue line shows no increase in debt, or what people think of as no increase in debt because the blue line runs "flat" for those years.

For the record, the GDP deflator (base year 2005) for 1965 has the value 19.934, and for 1985 has the value 61.624. In other words, prices more than tripled during that twenty-year period. That's what it took to erode enough debt to keep the blue line flat.

## Sunday, May 13, 2012

### Raghuram Rajan: True Lessons of the Recession

Modeled Behavior links to Raghuram Rajan's The True Lessons of the Recession (12-page PDF). Rajan's opening surprised me:

According to the conventional interpretation of the global economic recession, growth has ground to a halt in the West because demand has collapsed, a casualty of the massive amount of debt accumulated before the crisis.

Yes, exactly. But that's the conventional interpretation? I wouldn't have thought so.

The rest of Rajan's opening paragraph does sound more like the "conventional" story. Some of it sounds like what the Fed is doing:

Households and countries are not spending because they can’t borrow the funds to do so, and the best way to revive growth, the argument goes, is to find ways to get the money flowing again.

The rest of it sounds like what Paul Krugman is saying:

Governments that still can should run up even larger deficits, and central banks should push interest rates even lower to encourage thrifty households to buy rather than save. Leaders should worry about the accumulated debt later, once their economies have picked up again.

Myself, I don't see how the first sentence has anything to do with the rest. We boldly admit there is too much debt everywhere we turn. So the obvious solution is to reduce that debt. But nobody ever gets to that conclusion!

Instead, we want to "get the money flowing again". I think that means: get everybody borrowing more again. Does that make sense, when the problem is that there is too much debt?

Getting governments to "run up even larger deficits" is the opening salvo of the solution that wants everyone to run up even larger debts. And promising to worry about that debt later, well, that's plain hypocrisy. Can't fix the roof when it's raining, don't need to fix it when it's not.

... growth has ground to a halt in the West because demand has collapsed, a casualty of the massive amount of debt accumulated before the crisis.

Yes, everyone has said at one time or another that the massive accumulation of debt was the cause of our troubles. Then they move on to other things, all of 'em.

Rajan himself some two years before the crisis, according to the Wall St. Journal (2 January 2009) in August 2005 "chose that moment to deliver a paper called 'Has Financial Development Made the World Riskier?'"

"His answer: Yes", the article reports.

Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money, but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products with potentially big payoffs, which could on occasion fail spectacularly.

He pointed to "credit-default swaps," which act as insurance against bond defaults. He said insurers and others were generating big returns selling these swaps with the appearance of taking on little risk, even though the pain could be immense if defaults actually occurred.

Mr. Rajan also argued that because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk. Banks would lose confidence in one another, he said: "The interbank market could freeze up, and one could well have a full-blown financial crisis."

Two years later, that's essentially what happened.

So Raghuram Rajan himself has been among those pointing a passing finger of blame at finance, at our massive accumulation of debt. But now that is just a "conventional interpretation" that he rejects.

Today, Rajan's plan for the US consists of

educating or retraining the workers who are falling behind, encouraging entrepreneurship and innovation, and harnessing the power of the financial sector to do good while preventing it from going off track.

Education, deregulation, and finance, Rajan says. More and better finance.

More and better excessive debt? Really?

I assume Rajan still thinks excessive debt caused the crisis, caused the sudden collapse in demand. So why he doesn't go immediately to the conclusion that the solution is to reduce debt, mostly private debt, I do not know. But like everyone else, he does not.

Perhaps he is considering the "prospects for growth ahead", as the Grumpy Economist said. Perhaps Rajan remembers that the economy was not so good even before the crisis, and he is looking ahead, looking to fix that problem. To fix the problem we had when things were still "normal", before everything fell apart.

Okay. So then the problem is solved for Rajan by education and deregulation and expansion of finance; and the "massive amount of debt accumulated before the crisis" was just an anomaly and the crisis a one-time thing, an accident.

Except, how do you expand finance without increasing the accumulation of debt? I don't think you could do it, even if you were heavy-handed with regulation, like Haldane. Regulation is ineffective. The profit motive is an irresistible force. Regulation is not an immovable object.

Education is not a bad idea. If we live in a world where machines make everything, so that jobs are not plentiful, in that world we have to do something to make money, and we have to do something to spend money. Education fills the bill nicely: we can be teachers and students.

If you just limit your education to things that interest you, there's still so much available that there need be no end to it, and we can keep each other employed forever, basically, with a low requirement for natural resource use besides. And, to be known throughout the universe as an education-based society is not the worst thing that could happen.

So I like the education idea. But I still have a problem with Raghuram Rajan's analysis. Based on what I think he must hold true:
1. He knows the economy was not doing well even before the crisis.
2. He knows that the crisis was caused by excessive debt or "finance".
3. But by some magic, he seems to think that excessive debt is not really the problem, and that we can expand finance again as soon as we get out of the doldrums. Obviously, he is a man who has never contemplated the Debt-per-Dollar graph.

Has he never considered that the persistence and gradual worsening of our economic troubles is in any way related to persistent increase in debt? There were problems before the crisis, and then there was the crisis. And the crisis was brought on by excessive debt, excessive finance. At least that is what Rajan said some two years before the crisis.

But somehow, Rajan does not seem to see any connection between our growing debt and the problems we had before the crisis. For him it is as if the crisis was anomaly, the excessive debt as a problem was anomaly, and the anomaly soon vanished. This is the emptiest of arguments.

My god, man, the debt has been a problem since the 1960s. Think of it in those terms, analyze it in those terms. It explains everything.

## Friday, May 11, 2012

### Andrew Haldane: Financial arms races

Happy birthday, Aaron.

One thing I know for sure from my DPD graph is that the ratio varies: the amount of debt there is, per dollar of circulating money, varies. Since I first became convinced of the significance of that graph, I have been expecting to see policymakers turn things around and bring the ratio down.

Well, since the crisis the ratio has been coming down. But policymakers had nothing to do with that.

No, that's not entirely true. Policymakers did create the crisis, after all.

In an anonymous comment some days back (while I was up to my eyeballs writing the 'debt and inflation' posts) Nonny wrote:

OT , but since we were discussing Phillipon's papers on our bloated financial sector a while back , I thought you guys might like this related paper by Andrew Haldane :

http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech565.pdf

It covers the same ground as in his recent INET presentation ( i.e. the futility and resulting destruction of the "arms race" in finance ) , and he's as good a writer as he is a speaker.

Well I must say Nonny is right: Haldane is an excellent writer.

Maybe too good. I'd put him in a class with Krugman. With both of them, I worry that I'll be convinced by the good writing when what I really need is good economics.

Setting aside the quality of writing, there is still much of value in Haldane's paper, I think.

Page 4:
By any historical metric, the pre-crisis period was an extra-ordinary one for the financial sector. This is no better illustrated than in the returns to financial sector labour and capital. Between 1989 and 2007, the nominal gross value added of UK financial intermediaries rose more than threefold, or by about 8% on average per year. Over the same period, value-added of the non-financial corporate sector rose by about 5½% per year.

Assuming they start out equal and grow at the rates Haldane reports for the 1989-2007 period, finance grows from 100 to 400 while the productive sector grows from 100 to 262.

Finance increased 52% more than the productive sector, by Haldane's numbers.

Page 5:
Measures of executive compensation rose even more dramatically...

In 1980, a similarly-skilled individual earned about the same in investment banking as in the non-financial sector. By 2005, that same person would be benefitting from a salary four times that of their non-financial sector counterpart.

What explains this extra-ordinary period of high returns in finance? Arithmetically, the answer is simple – leverage.

Leverage. Debt and more debt. But the simple answer is not good enough for Andrew Haldane.

"But what drove those behaviours in the first place?" he asks. Competition, he answers. Competition for "high returns on equity". Competition "in financial sector pay".

As wages and equity returns ascended, the races in pay and returns joined forces. That spiral defined the pre-crisis arms race in financial returns. It generated an equilibrium of synchronously high returns and pay, as banks unilaterally militarised as defence against their competitors.

The result, Haldane says, was "sub-optimally risky".

Sure. But is Andrew Haldane suggesting that the problem is in our competitive spirit? That the problem is human nature? One must wonder then why it becomes a crisis only occasionally.

And if Andrew Haldane has doubts about competition, then we may have doubts about Andrew Haldane.

But I don't see it. There was competition in the non-financial sector too, without the extreme effect it had in finance. What finance did have, that nobody else did, was demand for the product. Demand for loans.

There is more. Then Haldane offers some interesting conclusions:

What public policy lessons might be drawn from these financial arms races? First, because they generate sub-optimal outcomes, policy intervention can be justified.

Second, to be effective this intervention needs to constrain behaviour across the financial system as a whole...

Third, what tools might such agencies bring to bear in tackling financial arms races in return, speed and safety? With hindsight, it is not difficult to identify instruments which might have slowed the pre-crisis race for excessive returns in banking. The most direct and effective would have been to place tighter constraints on banks’ leverage. This would have defused the return on equity race at source.

Yes, very nice. But how would you design the constraints on bank leverage? How would you design those constraints to withstand the continuous pressures driving financial expansion? What are those pressures, and why does Haldane not address them?

I say we can constrain bank leverage by cutting demand in half. Cut the demand for loans in half. Cut the borrowing in half. Undermine the source of financial profits.

Yes. But if it is so easy, why haven't we done it?

Good question. We haven't done it because it requires changes in the assumptions that underlie policy. But I'm getting ahead of myself.

What we need to do, in order to reduce the demand for loans, is to move away from credit-use, and move toward increased reliance on the dollar. We have to provide the economy with a lot more money that gets turned into a lot less debt. No, not "we". Policy has to provide the economy with a lot more money that gets turned into a lot less debt. Only policy can do it.

And that's where the changes to our assumptions come into play.

The Federal Reserve seems to think that a dollar of credit-in-use is just as good as a dollar of money in circulation. It isn't just as good. It's better (for the lender) and worse (for the borrower) because of the cost of interest that applies to credit but not to money.

Better for the lender and worse for the borrower. Doesn't that explain the growth of finance? Doesn't it explain the laggard performance of the economy?

We need to take income out of the non-productive sector and put income into the productive sector again, where it was when our economy was good.

To policymakers I say this:

• We need to stop assuming that credit is as good as money.
• We need to stop encouraging the use of credit to stimulate growth.
• We need to stop taking money out if circulation to fight inflation.
• We need to accelerate the repayment of debt to fight inflation.

We need to assure that there is enough money in circulation to sustain the existing level of economic activity, and then use credit for growth. Then, when the economy grows, we need to pay down that debt and counterbalance the deflationary effect by increasing the quantity of money in circulation.

#### Haldane's Recommendations

In the last few pages of his PDF, Haldane offers several parts of a solution. He wants "tighter constraints on banks’ leverage." He wants "to require banks to adopt [better] performance metrics". He wants banks to avoid "linking remuneration to return on equity targets". He wants to restrict "cash distributions by banks to shareholders and staff".

He wants "to set remuneration codes... for example, maximum ratios of cash distribution and minimum periods of pay deferral." He wants to reconsider "the instruments used for remuneration." He wants "to place direct restrictions on excessive message traffic". He wants "to strengthen market-making commitments." He wants to strengthen "circuit-breakers across exchanges". And he wants "greater transparency".

Andrew Haldane thinks like a banker. He looks for ways to minimize the problems arising from the excessive expansion of finance, but he fails to consider simply reducing the size of finance and reducing the role of credit.

I don't object to Haldane's recommendations. Heck, I don't even know what most of them are. But let's say Haldane is right. Let's say the crisis arose because we didn't have his recommended policies in place.

If we didn't have those policies in place, it is because of policymakers' faulty assumptions about money and credit.

And if you have any doubt about policymakers' assumptions, ask yourself why, at the onset of the crisis, we had \$3.50 of credit in use for every dollar's worth of GDP, but only 10 cents of spending money.

## Thursday, May 10, 2012

### Private Debt 2012 (19): Relative to GDP

The red line shows the gross Federal debt, the big one, relative to GDP.

The blue line shows everybody else's debt.

## Wednesday, May 9, 2012

### Debt and Inflation (4): Recalculating

Far as I know, it is GDP that is most often expressed as 'real' values. The conversion takes GDP values for a number of years, strips away the inflating prices from each value, and replaces it with the price-level of some "base" year.

FRED's GDP Deflator uses a base year of 2005.

FRED's Consumer Price Index uses a base period of 1982-84 -- a base that, remarkably, must be older than some economists!

The 1982-83 edition of the Statistical Abstract -- back when we were still using GNP instead of GDP -- used 1972 as a base year for the deflator, and 1967 as a base year for the CPI.

The Bicentennial Edition of the Historical Statistics used 1967 for the CPI and 1958 for the deflator.

But you can use any year for a base year, if you have the data. Pick the year you want to be the base year. Then divide each year's GDP by that same year's deflator, and multiply by the deflator for the year you picked. That's it. The year you picked is the base year for your results.

The blue line on Graph #1 below is the gross Federal debt. The other three lines show inflation-adjusted Federal debt, using three different base years. The red line uses the default 2005 base year, and maybe you can see the red and blue lines cross just at 2005 on the graph.

 Graph #1: The Gross Fededal Debt (blue) and Three Surreal Adjustments

The gold line shows the same Federal debt and uses the same calculation for inflation adjustment as the red line, but with a base year of 2010. The whole gold line is scaled up a little from the red one, because prices went up a little between 2005 and 2010. And the gold and blue lines cross in 2010.

You can see that the red and gold lines are similar, and that both show the trademark flatness before Reagan came to office (as noted in an earlier part of this series). The unadjusted blue line lacks that flatness through the 1970s, the worst of the inflation.

The green line shows the flatness in the years before Reagan. Like the red and gold, the green line shows the same inflation-adjusted debt data with a different base year. This time the base year is 1947; this means the green and blue lines cross at 1947.

Basically, the green line is a scaled-down version of the red and gold.

All three versions of inflation-adjusted debt rely on the same calculation that is commonly used when the inflation adjustment is made to GDP. This is the calculation I've been calling surreal, the one that I say produces erroneous results when used for inflation adjusting debt.

Graph #2 presents two improved calculations of the inflation adjustment of debt, the green and gold lines.

 Graph #2: Alternatives to the Surreal Calculation

First off, the blue line is the gross Federal debt, unadjusted.

The red line is inflation-adjusted -- by the surreal calculation -- with a base year of 2010, meaning the lines cross in 2010. But here's the thing: If inflation erodes debt, then they shouldn't meet in 2010. The red line should be higher in 2010. The 60-plus years of erosion by inflation should have made "the debt we owe today" less than "the debt we would have owed if there was no inflation."

The standard calculation used for inflation adjustment, the surreal calculation, tells us that there has been no erosion of debt. More precisely, it tells us that there has been no erosion in the base year, but that there *has* been erosion in other years. The surreal calculation cannot possibly be valid for inflation-adjustment of a stock like debt, that carries over from year to year.

Again: When we use the most recent year as the base year, the surreal calculates out the same as nominal debt in that year. This cannot be correct. It means there was no inflation adjustment. But the original purchasing power borrowed must have been greater than the outstanding debt today, if there was a loss to inflation.

Certainly, a different calculation is needed.

The gold line presents the result of one such calculation. It begins with the 1947 value, unadjusted. (Thus, the gold line has 1947 as base year.) For the next year, 1948, I adjusted the 1947 total for one year's inflation, and to it added the new debt for 1948, unadjusted.

For 1949 I take the total from 1948 and adjust it for one year's inflation, then add to that the new debt of 1949. I followed these steps repeatedly for each year, all the way through. At the end, in 2010, the inflation-adjusted value for gross Federal debt came to \$20,152.3. That is half again as much as the unadjusted Federal debt.

In other words, this calculation shows that there has been erosion of debt by inflation.

The green line shows another alternative to the surreal calculation of debt. Here, we begin by adjusting the 1947 value using 2010 as the base year. (This makes the green line start at exactly the same level as the surreal calculation's red line, by the way.) For the next year, I carry forward the previous year's adjusted value and add to it the new debt for 1948, after adjusting the new debt for inflation through 2010.

For 1949 and after, this process is repeated, so that the inflation-adjusted total always reflects base-year 2010 values. At the end, in 2010, the inflation-adjusted value for the gross Federal debt comes to \$20,152.3 -- exactly the same as for the gold line.

You know when I knew for sure I was onto something with this? When I saw Graph #2. Four lines, four different sets of numbers, but only two starting points, and only two end points.

The source data for this post is from FRED.

The worksheet I used to generate Graph #1 is in this Google Docs file.

The worksheet I used to generate Graph #2 is in this Google Docs file.

## Tuesday, May 8, 2012

### Debt and Inflation (3): Nomenclature

Suppose I borrow a dollar when the price index is 80. If I pay it off when the price index is 125, the erosion of debt by inflation is easy to figure. We can do it two ways.

We can multiply the debt by 80 and divide by 125. That tells us how much the dollar is worth, that we are paying back: It is worth 64 cents of the dollar we borrowed.

Or we can multiply the debt by 125 and divide by 80, This tells us how much we would have to pay, to pay back equivalent purchasing power: In this case, about \$1.56.

But suppose I borrowed a dollar when the price index was 80, and borrowed another dollar when the price index was 115, and I pay it all off when the price index is 125. Now the calculation is not so simple.

Or suppose I borrowed a dollar at price index 80 and started paying it back the next year. And maybe I had it half paid off some years later when the price index was 115 but at that point I borrowed another dollar. And I've been making payments every year since. And now, when the price index is 125, I want to see where I stand.

Now the calculation is even more complicated. To be accurate, the calculation must use price indexes from all the years, because there were transactions in all the years.

Consider any particular year. The new debt created that year should be adjusted the same way GDP is adjusted for that year.

The problem is that the total debt number for that year includes both the new debt from that year and a lot of older debt, and we should really separate out the new debt before making an inflation-adjustment on it.

I want to do this for all the years that I know about, adjusting each year's new debt and adding it to the previous year's total. This leaves me with just one problem: the first year of the series. Since this is the first number I have, I cannot separate out the prior years' debt. So the first inflation adjustment is a fudge.

However, debt has increased a lot (as we know) so the first year's debt is a relatively small number. So, maybe the fudge will be insignificant.

And anyway, the calculation I want to do for the first year is the standard calculation used to make inflation adjustments. So my adjusted numbers will begin with exactly the same value that the "standard usage" calculation starts with. Only the subsequent numbers will differ.

I made up some numbers and went over the calculation a few times in Excel, and it's simpler than I thought. Actually, I use the same standard calculation as everybody else, except I separate new debt from existing, and apply each year's price level only to that year's addition to debt.

I did struggle with that, a bit. What happens if you borrowed some money some years ago, then later you paid off half of it but also borrowed some more?

It's less complicated than I thought. If I pay off some debt and borrow more that same year, both of those transactions will use the price index for that year. Yes, I paid back some debt with inflated dollars. But I also borrowed more of the same inflated dollars. Since we (crudely) figure the price level is the same for the whole year, the payback and the new borrowing is a wash. Only the net difference, only the change in total debt will affect my calculation of inflation-adjusted debt.

So again, I will take only the new debt for that year, and apply that year's price index to it. And I will add that adjusted number to the previous year's adjusted total to get the new adjusted total.

It's easier to do in a spreadsheet than in words.

I want to create some terminology we can use to distinguish my inflation-adjustment calculation from the one that is standard usage.

My calculation adjusts each year's debt separately, translating the "nominal" values into "real" values. So I will call this the "Annual Real Translation" (ART) calculation. The standard calc I will refer to as the "Standard Usage Recalculation for Real" (SURReal) adjustment.

Next, we will look at some spreadsheets.

## Monday, May 7, 2012

### Debt and Inflation (2): Background

I want to look at the "productivity" of debt, and at eroding the real value of debt by inflation during the Great Inflation. But first I want to evaluate the notion of the real value of debt and the inflation-adjustment of debt.

I looked at inflation-adjusted debt a while back, in Iffy, Piffy:

 Graph #1: Inflation-Adjusted Gross Federal Debt

At the time, I said this:

This graph shows that before about 1981 the growth of the Federal debt kept pace with inflation, and since that time the growth of the Federal debt has far exceeded inflation. The change is surprisingly distinct.

Okay. However, in that post I also expressed this conclusion:

If the Federal debt only keeps up with inflation, then the debt is not excessive. By this measure, until 1981 the Federal debt was certainly not excessive.

Today, I am not certain of that.

I went looking for other examples of inflation-adjusted debt graphs.

Mark Wieczorek looks at the national debt, adjusted for inflation, and writes:

In 1950's dollars, our debt is currently \$887,445,036,515.72 or 887 billion dollars, which is 3.45 times the size of the debt in 1950. Here's just the inflation-adjusted debt from 1950 - 2003. This graph paints a very interesting picture about the past few administrations.

At Technorati, Steve Kosoris provided graphs of the U.S. National Debt, also adjusted for inflation. And at Bearwatch, Sackerson looked at US public debt since 1945 - inflation-adjusted. Sackerson writes:

For a long time, US public debt increased no faster than consumer price inflation, then under Reagan it appears to have started its steep rise. The causes are presumably complex...

And the Supporting Evidence site looks at the Federal debt, showing both current and inflation-adjusted values:

 Source: Supporting Evidence

Oddly, all of the inflation-adjusted debt graphs I found were for the government debt. None showing total debt. Not even mine.

I still wonder what can and cannot fairly be said about these graphs and about the inflation-adjustment of debt. My first thought was: Wow, Reagan really increased government spending! But that's not right -- or, at least, it isn't what the graphs show.

If increased government spending was the cause of the change in trend, it would show up in current spending. It would show up in the deficits immediately. But it would appear in accumulated debt only after a lag. Cumulative numbers change slowly.

So if increased government spending caused that distinct change in the debt graph, we should look for the increase not in the years after 1981, but in the years before. And we should look not at the accumulated debt, but in the annual deficits, the additions to accumulated debt. Mark Wieczorek, quoted above, shows the additions to debt: