Friday, December 30, 2016

Paul Volcker went with option "b"

Following up on my last two posts...

I'm wondering why people even bother to teach cost-push inflation. I mean, the prevailing attitude is that there's no such thing: Prices go up because there's too much demand, period, end of story.

To me, that's plain ignorance. But that's easy for me to say, because I don't know anything. I had just one three-credit course in economics -- you know, ECON 101, the one economists use as an example when they make jokes about people not understanding economics. Yeah, that. From my vantage point, knowing so little, it's easy to see when people are brushing questions aside thoughtlessly.

Ignorance is an attitude.

Marcus Nunes on Paul Volcker

In an old post (but one that fascinates me more than ever) Marcus Nunes writes
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.

... This view is clearly illustrated by Burns who argued as early as 1970 that “monetary and fiscal tools are inadequate for dealing sources of inflation such as are plaguing us now – that is, pressure on costs arising from excessive wage increases”.

There follows an explanation of "a flawed forecasting mechanism" involving the Phillips curve -- again, absolutely fascinating.

Next, Marcus describes the policy change that a change in leadership brought to the Fed:
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.

Essentially, Paul Volcker said there's no such thing as cost-push inflation. And that was all there was to that.

Josh Hendrickson on Paul Volcker

In an even older post, Josh Hendrickson at The Everyday Economist writes
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...

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. The Fed simply assumed accountability as the creator of inflation.

The solution to the problem of cost-push inflation was to dismiss the whole idea of it. Essentially, Paul Volcker said there's no such thing as cost-push inflation, and that was all there was to that.

Among the comments on Hendrickson's post is one by Marcus Nunes, linking to an older version of his post quoted above.

In other comments there, Nick Rowe quoted Josh Hendrickson

Josh: “Rather, the view of Burns and others was that inflation was largely a cost-push phenomenon...”

and replied:

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.

Hendrickson replied to Nick Rowe:

Yes, you are correct. I make the point in the paper that Burns’ view is consistent with the orthodoxy of the time...

Bill Woolsey also replied to Nick:

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

There were such economists. Bill Woolsey is evidence of just how thoroughly cost-push as a legitimate economic concept has been purged from economic thought.

The cost-push problem was never solved. It was dismissed. It was purged from economic thought. If there is no such thing as cost-push inflation, that's okay. Otherwise it's a problem.

Me, I still remember Wesley.

Arthurian Theory

The factor cost of money was increased by persistently increasing the reliance on credit -- what most people call the growth of debt. The growing cost of finance hindered economic growth, such that the choices open to policy were:

a) reduce the hindrance by expanding the money, thus creating inflation, or
b) accept the hindrance and accept that economic growth would be slower going forward.

Arthur Burns followed option "a". Paul Volcker went with option "b".

I call for option "c": Reduce the reliance on credit.

Many people today call for 100% reserve banking. That's the extreme form of reducing the reliance on credit. Too extreme, I think.

Let us create tax incentives that encourage the repayment of debt, and use these incentives in place of the existing incentives that favor debt accumulation (like the tax deduction for interest expense). Today, the playing field is tilted toward increasing the accumulation of private debt. We must tilt it the other way, toward reducing the accumulation of private debt. Then, if we want, we can sit back, put our feet up, and wait.

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