Agreeing to agree

Rummaging the internet for something I could use in my recent Adjusting Debt for Inflation series, I found an old (2011) post by John T. Harvey: What Actually Causes Inflation (and who gains from it) at Forbes.

I was so impressed by his opening:

I made a post two weeks ago in which I explained that the popular view of inflation (wherein it is caused by money growth) depends critically on assumptions that do not hold in the real world. Money comes into existence when someone adds it to her portfolio of assets. This occurs either when she borrows money (which creates new cash from reserves) or sells securities to the Federal Reserve (which injects new cash into the system). Neither of these scenarios allows the central bank to increase the supply of money beyond demand, the story told by those in the money growth ==> inflation camp.

I don't know what a "portfolio" is, and I don't want to know. But I know that money comes into existence when someone borrows money or sells securities to the Federal Reserve, as Professor Harvey says.

What I never thought of, on my own, was that "Neither of these scenarios allows the central bank to increase the supply of money beyond demand, the story told by those in the money growth ==> inflation camp." It's nothing, really. It's "supply and demand" as opposed to just "supply". But it is how the economy works -- I don't even have to stop and think about that. And it's important because, as Harvey says, "money growth ==> inflation" is a story without demand.

At least, in the dumbed-down "printing money causes inflation" version, it is a story without demand. And I never noticed.

So, first impression, I was pretty well impressed by John T. Harvey.


That opening paragraph continues:

... Neither of these scenarios allows the central bank to increase the supply of money beyond demand, the story told by those in the money growth ==> inflation camp. Instead, inflation happens first. This then means that agents need more cash for transactions, leading them to borrow more or sell government securities to the Fed. Thus, the money growth accompanies inflation, but does not cause it.

I'm a little uncomfortable with "inflation happens first". But I'm okay with "there is a need for more money". Either way, the key is "accommodation". If the Fed doesn't accommodate the increased demand for money, then there isn't enough money to let prices increase. At least, that was Paul Volcker's plan. (Hey, I'm big on cost-push. If costs are driving prices up, then the failure to accommodate means there isn't enough money to let the economy function normally, and all sorts of problems arise. I don't think Volcker's plan was a good one. However, I do still think the lack of money pretty well prevents prices from rising.)

I'm okay with "the money growth accompanies inflation, but does not cause it." I think it often works that way. One thing I particularly like about John Harvey's wording is that it leaves the cause of inflation unspecified. It leaves open the door to inflation being cost-push. I need that door open.

But I don't think it always works as John Harvey describes. Note that his analysis omits fiscal actions. Money comes into existence, he says, because "she" borrows it. She is the private sector, as I read his paragraph. When the Great Depression enveloped us, it was Federal spending that went high. And Federal borrowing. Nobody was depending on private-sector demand to lift prices while the Fed sat there pushing on string.

And again, during World War Two, it was Federal spending and Federal borrowing that went high. It's not the same as private borrowing and spending. The aftermaths differ. Professor Harvey omits this different era from his analysis.

Graph #1: Real GDP Growth (blue) and the Rate of Inflation (red), 1930-1955

Demand -- largely government spending -- along with manipulation of gold and other FDR policy created Depression-era highs (centered on 1935) in economic growth and inflation. Then wartime spending (see 1940-1945 on the graph) created a higher high in economic growth. The increased demand created a higher high in inflation as well.

After the war (1945) economic growth fell and inflation went low. After a low point in 1946, economic growth and demand came back, weakly. The blue line couldn't reach the 5% level. Inflation, however, spiked to 20%. And again after the 1949 recession growth and demand returned, stronger this time, but again inflation climbed higher than economic growth.

These peaks, in the late 1940s and early 1950s, these peaks show demand coming back enough to permit inflation to occur. But they do not show demand coming back enough to cause the inflation. Five percent growth doesn't cause 20% inflation. What was the cause of the inflation when price controls ended? Too much money chasing too few goods.

Federal spending and economic policy during the Great Depression and the Second World War raised the quantity of money to a high level relative to GDP and whatever. After the war, when the economy was getting back to normal, even a relatively low level of demand was enough to create a high rate of inflation because the quantity of money was extraordinarily high. This was demand-pull inflation.

Sometimes the "popular view of inflation" does happen in the real world.

I happen to think that John Harvey's description of the cause of inflation is mostly right most of the time. I also happen to think that Milton Friedman was born at just the right moment to see what was happening with money and demand and prices during the Great Depression and the second great war. And I think Friedman's description is exactly right for those periods of our economic history.


There is plenty more I'd like to say about Mr. Harvey's article. Another time, perhaps. Just now I have to say there is a lot of disagreement between different schools of economic thought. But a lot of it doesn't need to be disagreement. A lot of those different views need to be put on a timeline, that's all.

It's not that the other guy's assumptions "do not hold in the real world". It's that they don't hold at the present time. Or they only hold in special circumstances. From a timeline we might discover interesting stuff, like the "zero bound" problem occurs only rarely, and if "printing money" is applied as a solution then we should expect that the inflation which follows, when it comes, will be "too much money chasing too few goods" inflation.

The timeline would help us see that it's not always a matter of right and wrong. It is sometimes a matter of right now or right at some other point in time. Fleshing out the timeline might help economists get along better. And it would help them, and all of us, understand the bigger picture.