Monday, December 24, 2012

Cost-Push Inflation: An Issue Resolved, or Simply Dismissed?


At The Everyday Economist some months back, Josh Hendrickson captured my attention with his Nominal Income and the Great Moderation. In that post, Hendrickson introduced a forthcoming paper and said:

As I argue in the paper, during the Great Inflation period of the 1970s, members of the FOMC regularly asserted that the process of inflation determination had changed. Relying on public statements and personal diary entries from Arthur Burns, I demonstrate that there is little evidence that the Federal Reserve was less concerned with inflation during the 1970s. Rather, the view of Burns and others was that inflation was largely a cost-push phenomenon. Burns thought that incomes policies were necessary to restore price stability and stated that “monetary and fiscal tools are inadequate for dealing with sources of price inflation that are plaguing us now.”

The shift in policy, beginning with Paul Volcker, was an explicit attempt to stabilize inflation expectations and this was done deliberately at first through monetary targeting and ultimately through the stabilization of nominal income growth. Gone were notions of cost-push versus demand-pull inflation.

I can see a natural progression there: from the thought that "incomes policies were necessary" to policies for "the stabilization of nominal income growth." Incomes policies means wage-and-price controls. The method is crude, but the objective of wage and price controls is precisely "the stabilization of nominal income growth."

Beside the point. What concerns me is "the view of Burns and others was that inflation was largely a cost-push phenomenon." That, and the apparent fact that this issue of cost-push was never resolved. It was simply dismissed.

"Gone were the notions"

At this writing there remain just six comments below Josh Hendrickson's post. Make that five comments and a pingback.

First, Nick Rowe quoted Hendrickson -- a piece of the excerpt above, actually:

Josh: “Rather, the view of Burns and others was that inflation was largely a cost-push phenomenon. Burns thought that incomes policies were necessary to restore price stability and stated that “monetary and fiscal tools are inadequate for dealing with sources of price inflation that are plaguing us now.””

And he remarked:

People forget (and maybe younger people never knew) just how common that view was in the 1970′s. It was common among economists as well as the general population. It was almost the orthodoxy of the time, IIRC. Tighter monetary policy would just raise interest rates, which would increase costs, and make inflation even worse.

It was a common view at the time, Nick says, that cost-push forces were at work. Noted. In the next comment, Josh Hendrickson agreed with Rowe, saying

Burns’ view is consistent with the orthodoxy of the time — as epitomized, for example, by Samuelson and Solow (1960).

"Consistent with the orthodoxy of the time." A common view.

In the third comment, Marcus Nunes agreed as well. He offered a post of his own, on the same topic. (I spent a lot of time with the post from Marcus.)

In the fourth comment, Bill Woolsey asked

There were really _economists_ who thought that “tighter money” would raise inflation through a cost-push mechanism?

Woolsey says he'd heard the argument, but always figured it expressed "special interest" concerns.

So let me ask a question now, about Woolsey's question: Why does he ask? Is it because the cost-push issue was so well resolved that it never arose in all of Bill Woolsey's experience? Or is it that the matter was carelessly dismissed, as opposed to actually being resolved? I don't have the knowledge to answer that question, but it sure feels like the matter was carelessly dismissed.

The last comment is mine. I quoted the economist Robert V. Roosa from the September 1971 Fortune magazine:

And yet another factor has been the undue reliance on restrictive monetary policy to limit demand, with the perverse result of making interest rates themselves a major cost-push force.

After the Roosa quote I said, "I’ll swap that for two or three hobbyist-level links explaining what’s wrong with the idea."

Ten months later, still no response. To me, the issue looks unresolved.

6 comments:

The Arthurian said...

In a related post that I reviewed here, Marcus Nunes wrote:

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.

That is an extremely important observation. (Marcus links to a 25-page PDF by Hetzel, "Arthur Burns and Inflation" here:

http://www.richmondfed.org/publications/research/economic_quarterly/1998/winter/pdf/hetzel.pdf

I can see I'm going to have to get into it.)

Nunes again:
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”.

Clearly, stagflation is evidence that inflation is *NOT* the result of excessive demand. I would however agree with Volcker that the "Keynesian orthodoxy" didn't have it quite right.

Marcus then brings up "Friedman´s address to the 1967 AEA meetings – on the importance of inflation expectations." (His bold)

"Inflation expectations" is the key. It is the wrong turn economists took, many years ago. It is the shifting sand upon which the economics of the post-Keynesian era was built. It will have to be demolished, along with most of what came after. Meanwhile...

Marcus writes: "Volker... believed that inflation was the result of excessive AD": Excessive aggregate demand. But clearly, stagflation is evidence that inflation is *NOT* the result of excessive demand.

Nick Rowe said...

Arthur: I did this post recently, it's directly related to this old 1970's question, I think it resolves it, (and I'm rather proud of it):
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/12/does-monopoly-power-cause-inflation.html

The particular type of cost push that I use in the model is increased monopoly power by firms. But if could have been increased monopoly power by workers too.

The Arthurian said...

Nick,
Funny opening. Good post. I *always* have trouble with models such as you present. I think I will put yours into a spreadsheet.

Once inflation got rolling in the 1965-1980 period, it could easily become a wage-price spiral. But at the start I think there must have been some cost that was ultimately responsible: the prime cost-pusher, so to speak.

Your case for monopoly pricing is an example. I hold that the increasing financial costs of a growing financial sector are to blame. But be that as it may...

If monopoly power by workers was the driving force, I would expect to see living standards increase as labor gained on the other factors of production. I'm sure that didn't happen.

If monopoly power by firms was the driving force, I would expect to see profits gain on the other factors of production. I'm pretty sure that didn't happen.

If the growth of finance was the driving force, I would expect to see finance gain on wages and nonfinancial business profits. And that actually *did* happen.

Actually Nick, I am a firm believer in multiple causation in the economy. I will gladly adopt monopoly power as a contributing factor if you will likewise adopt excessive finance.
:)
Happy holidays.

Nick Rowe said...

Happy Holidays Arthur!

I'm not sure I buy the assumption that firms' monopoly power increased either. I was just taking that as given, because Paul Krugman suggested it, and worked out the implications for inflation.

Weirdly, whether greater monopoly power by workers pushes up real wages in a *macroeconomic* model is very different from whether it does so in a micro-model. You may get different answers in the two cases. In that particular model I built, if one firm's workers unionise they will get higher real wages, but if all firms' workers unionise real wages stay the same (and employment falls). (I could even rig the model so that real wages fall if all workers unionise). The inuition is that if one firm's workers unionise the firm raises its price, which reduces real wages for other workers.

You might be right about the costs of financial intermediation. It would take a more complex macro model than the simple one I did.

Joshua Wojnilower said...

Art,

Thanks for returning to this topic since it has been on my mind recently. I'm currently reading Michael Hudson's new book, The Bubble and Beyond. He tries to argue at various points that reliance on credit increases the costs of production due to compounding interest costs over time. Personally I find this perspective appealing and thought you might too.

Relating to private debt and interest expenses, it's interesting to note that most mainstream macro models don't account for those factors since they were believe to be of little consequence.

I think it's wise to take a multiple causation approach to inflation. Pursing cost-push through interest expenses seems like a beneficial route to pursue.

The Arthurian said...

Woj, this is always going to be key: "...most mainstream macro models don't account for those factors since they were believe to be of little consequence."

Those factors WERE of little consequence! But the economy changes faster than people can understand and describe it. I still think in terms of M1 and M2, for example. (I don't know when they came up with MZM but it certainly wasn't included in the Bicentennial Edition of the Historical Statistics!)

Nick Rowe catches himself ten years out of date here.

Most painful of all, Anna Schwartz here expresses ideas that were correct when she struggled to understand them in the years before 1963.