Saturday, September 30, 2017

So much for the study of cost-push inflation

Roger Farmer, September 21, 2017:
In the 1960s, the U.S. government borrowed to pay for the Vietnam war, and rather than raise politically unpopular taxes, it paid for new military expenditures by printing money. Milton Friedman pointed out correctly, that printing money would eventually lead to inflation.

Roger Farmer brings back memories. Evans and Novak's memories, not mine. In Atlantic Monthly, July 1971, Rowland Evans and Robert Novak remembered early 1968: Lyndon Johnson was President; Richard Nixon was on the campaign trail; and former President Eisenhower was considering the options open to his protege Nixon. Evans and Novak wrote:
For the old General there was no higher imperative for a new Republican President than to curb the torrent of inflation that had been loosed on the economy since full US intervention in the Vietnam war in 1965.

That is what happened: War-related spending increased, and inflation went up. And Milton Friedman is remembered as having predicted the inflation. "Cause and effect" was thus inviolably established. And every day since, one monetarist twit or another, his mind closed tight as his sphincter, has been predicting inflation. Generally, like the famous stopped clock, such predictions are only occasionally accurate.

Sure, I know: The value of the dollar continues to fall. I'm not saying there's no inflation. I'm saying the predictions are junk. Remember Janet Yellen saying we don't know the cause of inflation? If you don't know the cause, you can only make an accurate prediction by dumb luck. Dumb luck.

I even accept the bumper-sticker logic that says printing money causes inflation. What I cannot accept is that no additional logic applies. Even Friedman distinguished between "money supplied" and "money demanded", as Peter N. Ireland points out. It ain't just printing money that matters. The logic of demand matters, too.

Yes, it seems Friedman also said the demand for money is constant and it's only the supply that varies. And okay, I can see that in a normal economy the demand for money may be quite constant, probably more constant than the supply. So maybe in the normal economy the predictions of inflation are pretty good after all. Okay, fine. But why were people still making the same predictions after the economy went all abnormal? Echolalia?

Time magazine, December 31 1965:
The economic policies of 1966 will be determined most of all by one factor: the war in Viet Nam. Barring an unexpected truce, defense spending will soar so high—by at least an additional $7 billion—that it will impose a severe demand upon the nation's productive capacity and give body to the specter of inflation.

And there it is again. Inflation -- specifically, the Great Inflation -- was created by Lyndon Johnson's spending on the Vietnam war. They said it in 1965. They thought it in 1968 and wrote it in 1971. And apparently we still think it in 2017. But as Roger Farmer would say: Where's the beef?

Where's the analysis that shows the mid-1960s wartime spending was the cause, the sole cause, or even the primary cause, of the inflation that arose in that moment? Coincidence? You relying on coincidence as an argument? What about lags, then, the long and variable lags.

Your coincidence is not evidence if there are lags.

We thought and still think the Great Inflation was created in 1965 by the "guns and butter" spending of Lyndon Baines Johnson. This we have taken for true since the very first day of the Great Inflation.

It's odd, though. In 1960, Samuelson and Solow did a study in which they considered the source of the 1955-58 inflation in the US economy. They wrote:
... just by the time that cost-push was becoming discredited as a theory of inflation, we ran into the rather puzzling phenomenon of the 1955-58 upward creep of prices, which seemed to take place in the last part of the period despite growing overcapacity, slack labor markets, slow real growth, and no apparent great buoyancy in over-all demand.

It is no wonder then that economists have been debating the possible causations involved in inflation: demand-pull versus cost-push; wage-push versus more general Lerner "seller's inflation"; and the new Charles Schultze theory of "demand-shift" inflation.

Samuelson and Solow thought there was a good chance the inflation of the latter 1950s was cost-push in origin. That's interesting because, if it was, then there is also a good chance that when inflation returned in the mid-1960s, it was the return of cost-push inflation. Mixed, perhaps, with demand-pull brought on by Vietnam war spending.

Samuelson and Solow in 1960 were leaning toward "mixed":
We have concluded that it is not possible on the basis of a priori reasoning to reject either the demand-pull or cost-push hypothesis ...

What was needed, obviously, was additional work on the cost-push question. But things didn't go that way. Instead, their paper was read as a call for tradeoff: more inflation and less unemployment.

The inflation/unemployment tradeoff was a story Milton Friedman could shoot down, and Edmund Phelps, and they did.

Then Milton Friedman rejected cost-push, saying inflation is always and everywhere a monetary phenomenon. Right behind him, Paul Volcker rejected cost-push when he said the inflation process is ultimately related to excessive growth in money and credit.

By then, the concept of cost-push was in the throes of death. Today, I can't even find a link to the Samuelson and Solow paper. But I can find a sharp guy like Nick Rowe observing that Arthur Burns -- Chairman of the Fed through most of the 1970s and thus through most of the Great Inflation -- observing that Burns thought inflation was largely a cost-push phenomenon; then Rowe adds:

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.

Nick is much too nice a guy to put it into words, but to my ear what he's saying is that "cost-push" is a ridiculous idea, not worthy of economic analysis. That was in 2012.

And now, in 2017, you've got Roger Farmer (in the opening salvo of a post titled "Where's the Inflation? Where's the Beef?") dismissing the possibility of cost-push when he says "the U.S. government borrowed to pay for the Vietnam war, and ... paid for new military expenditures by printing money".

So much for the study of cost-push inflation.

To my mind, the growing cost of finance was the cost that initiated the cost-push inflation that became the Great Inflation of 1965-1984 -- and is chiefly responsible for the inflation since that time as well. Finance takes from non-financial business, directly increasing the costs of production. Finance takes from consumers, directly depressing demand. Finance returns its monies to the circular flow at interest, further increasing production costs and further depressing demand. And that is the story since Volcker. Since before Volcker.

Convince me I'm wrong, or stop assuming there is no cost-push inflation.

Related links:

Anna Schwartz on the buoyant economy (here)

The inflation/unemployment tradeoff (Kevin D. Hoover)

Williamson's history of the time (here)

An overview of confusion (Mainly Macro)

The Forder connection (Robert Waldmann at Economist's View)


The Arthurian said...

Scott Sumner (not in response to me):

At times it seems we've gone back to the 1970s, as completely discredited theories of cost-push inflation are being revived ...

Then Sumner quotes one source, and responds. To my mind, both the quote and the response are irrelevant.

Then Sumner quotes somebody who "gets it":

This is one of those myths that never dies: cost-push inflation.

It's the "completely discredited" argument, all over again. But it's not an argument at all, really. It's just an announcement: Cost-push is a "myth"; end of story.

From that same source:

Wage and price increases are a reflection of inflation, not a cause of it.

and Sumner himself:

It's kind of scary when top Fed officials have forgotten that inflation is a monetary phenomenon.

Okay, stop right there. Without even getting into causality, I am willing to agree that if prices are going up, then spending must be going up and probably the Q of M is going up as well.

Add causality to that, and you get the Sumner quote and the other. HOWEVER, cost-push has one feature that demand-pull does not, which Sumner and the other are ignoring:

When cost is the driving force, the failure to increase the Q of M will lead to a failure of growth.

With demand-pull, prices go up because they CAN. With cost-push, prices go up because they MUST.

With demand-pull, prices go up because there's more money. With cost-push, prices go up because there's more money because otherwise the economy will decline. These are two different circumstances. If you focus only on the Q of M you will never see it.

The Arthurian said...

"Today, I can't even find a link to the Samuelson and Solow paper."

Even Amazon doesn't have it!

But you could try this link: