The Inflation Adjustment of Debt

The typical inflation-adjustment of GDP takes the total dollar value of one year's output and converts it to the dollar value of another year. For example, if a basket of goods used to cost $80 but now costs $125, you take GDP now, multiply by 80, and divide by 125 to convert the current value to the value of that other time.

If for another year the basket cost $115, well, multiply that year's GDP by 80 and divide by 115. (Basically, the arithmetic un-distorts output by one year's price level and re-distorts it by a different year's price level. When all the years are distorted by the same price level, economists call that "real" output.)

Using this method, GDP for any set of years can be evaluated as if prices had not changed. That lets you distinguish changes in prices from changes in the amount of stuff we produce, to get a more accurate picture of how output has grown over time.

The GDP Deflator is a series of numbers that are conversion values for a whole series of years. That's where you find values like my examples 80 and 115 and 125, but actual numbers for all the years. So that works.

The thing is, when you look at GDP you're looking at the value of one year's output. It makes sense to use the deflator number for that year when you do the calculation.

But when you look at debt and try to make the same conversion of values, there is a problem. Debt is typically created and accumulated over a number of years rather than a single year. If you look at the debt you have today and this year's deflator number is 125, that's probably not the right number to use for all your debt. Maybe you took on some of that debt last year or the year before that, or the year that the deflator value was 115, or maybe even the year the deflator value was 80. This complicates the calculation.

With GDP, the number is the total value of stuff created on one year. So the standard conversion works fine. But with debt, which accumulates over many years, the standard calculation must give a wrong answer.


In my next few posts, I will consider the inflation adjustment of debt.

Bleak Apologists

Federal Reserve economist David Andolfatto says maybe there is no output gap.

The output gap is the gap between where we are and where we ought to be. People who see an output gap think we ought to be on the same GDP path we were on before the crisis. But, Andolfatto says, maybe potential output has collapsed. Maybe "where we ought to be" has collapsed, and maybe where we are today is as good as it gets. Andolfatto, and his boss James Bullard, and their friends Cochrane and Taylor.

Bullard writes:

For those who take the “large output gap” view, the expectation is for real GDP to grow rapidly after the recession comes to an end, as the economy catches up to its potential. It is like a rubber band, there is supposed to be a bounce back period of rapid growth. In fact, most analysts have been looking for exactly this effect since the summer of 2009. It has not happened. This has led to a lot of analysis concerning special factors and headwinds that might be inhibiting the “bounce back” effect.

The wealth shock view puts a different expectation in play. The negative wealth shock lowers consumption and output. But after the recession ends, the economy simply grows from that point at an ordinary rate, neither faster nor slower than in ordinary times. It is more like an earthquake which has left one part of the land higher than another part. There is no expectation of a “bounce back” to a higher level of output after the recession ends. This is closer to what has actually happened since mid-2009.

Taylor's graphs show both circumstances:

Large Output Gap, and Bounce-Back after the 1981 Recession

Wealth Shock, and NO Bounce-Back after the 2008 Recession

Bullard seems to be saying that it's potential output that is wrong, that a realistic evaluation would have us push the red line down to meet the blue, rather than expecting the blue line to bounce back up and meet the red.

Talk about lowering expectations!

What Bullard's "Wealth Shock" view means, if true, is less income all around -- "perhaps 5.5 percent" less, he says. Or, if the proceeds of growth are not evenly distributed, more that 5.5 percent less, for most of us.


Andolfatto writes:

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock... The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed's current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the "bubble period" as the economy being at, and not above, potential).

Fair enough. If we think of the housing bubble years as "normal" we are probably overestimating potential output now. And if that's the case, our overestimate does not apply only to the years after the recession.

The housing bubble years. Bubble years are good years -- unsustainable, but good. So the housing bubble years should have been better than normal I should think. After all, housing is the backbone of the U.S. economy. A magnificent boom in housing should have made the whole economy magnificent. And yet Robert Brenner observes

the business cycle that just ended, from 2001 through 2007, was -- by far -- the weakest of the postwar period...

Despite the major stimulus provided by a bubble in housing, the performance of the economy was weak. Weak, when it should have been better than normal.

David Andolfatto wants us to think that our expectations were too great. He is concerned that we'll get policy wrong if we think of the economy in those years as normal rather than bubbly -- "if conventional measures treat the 'bubble period' as the economy being at, and not above, potential." And weak as the economy was in those years, Andolfatto wants us to think of 2001-2007 as above potential.


If DA didn't stop there, I might agree with him. If he was trying to explain why GDP was slumping and why potential GDP was slumping -- because of excessive private debt, for example -- I would have some use for his analysis. But like Bullard, he brushes aside any concern with "special factors and headwinds". David Andolfatto seems to be saying only that things are bleak and we ought not expect anything better.

And Bullard? Good god, Bullard is ready to create another recession right now. In the opening statement of his 6 Feb 2012 paper, he says

At the January meeting, the Federal Open Market Committee (FOMC) took an important step forward by naming an explicit, numerical inflation target for the U.S. of 2 percent, as measured by the personal consumption expenditures (PCE) price index.

We now have an official inflation target of two percent. Next, Bullard says

In a targeting context, inflation means headline inflation... By the headline PCE measure, U.S. inflation is running somewhat above target right now, at 2.4 percent...

We are now ABOVE our official inflation target of two percent. It is time, Bullard implies, time to jack up interest rates and tamp out growth.

This is Part One	[ Part 2 ]	[ Part 3 ]

Factors

NOT LONG AGO I POSTED AN EXCERPT FROM THE MARC BLOCH BOOK FEUDAL SOCIETY.. IT DIDN'T WORK.. I COULDN'T READ IT, MYSELF.. ON PAPER, IT WAS GREAT.. AND TYPING IT ALL IN HELPED ME SEE EVEN MORE IN HIS WORDS.. BUT ON THE COMPUTER SCREEN, IT JUST DIDN'T WORK.

I HAVE TO POST AN EXCERPT HERE FROM ADAM SMITH.. IT IS UNQUESTIONABLY ONE OF THE BEST PARTS OF THE WEALTH OF NATIONS.. BUT I WILL TWEAK IT AS NEEDED, TO TRY TO MAKE IT READABLE.. (FORGIVE ME.)

I change spelling (LABOUR) and punctuation, and paragraph breaks.
I hesitate to change the words of Adam Smith. I omit some words, and change an occasional word.
When you see the words "the profits of stock" think: The profits of capital.

IF ALL ELSE FAILS, AND YOU DON'T HAVE A COPY OF THE BOOK, YOU CAN (1) CLICK THE POST TITLE TO GET THE POST ON A PAGE BY ITSELF, AND (2) PRINT THE THING OUT.

We live in a fast-paced world. I recommend reading Adam Smith slowly, and savoring his words. If it helps, remember that he lived at the peak of the cycle of civilization, and we live amid accelerating decline.

The Wealth of Nations

by Adam Smith
(1776)
Book One, Chapter VI

Of the Component Parts of the Price of Commodities

In that early and rude state of society which precedes both the accumulation of stock and the appropriation of land, the proportion between quantities of labor necessary for acquiring different objects seems to be the only circumstance which can afford any rule for exchanging them.

If among a nation of hunters, for example, it usually costs twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for, or be worth two deer.

In this state of things, the whole produce of labor belongs to the laborer; and the quantity of labor commonly employed in acquiring or producing a commodity is the only circumstance which can regulate the quantity of labor which it ought commonly to exchange for.

As soon as stock has accumulated in the hands of particular persons, some of them will naturally employ it in setting to work industrious people, whom they will supply with materials and subsistence, in order to make a profit by the sale of their work, or by what their labor adds to the value of the materials.

In exchanging the complete manufacture, over and above what may be sufficient to pay the price of the materials, and the wages of the workmen, something must be given for the profits of the undertaker of the work who hazards his stock in this venture. The value which the workmen add to the materials, therefore, resolves itself in this case into two parts, one of which pays their wages, the other the profits of their employer...

In this state of things, the whole produce of labor does not always belong to the laborer. He must in most cases share it with the owner of the stock which employs him.

As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce. The wood of the forest, the grass of the field, and all the natural fruits of the earth, which, when land was in common, cost the laborer only the trouble of gathering them, come to have an additional price fixed upon them.

This portion, or the price of this portion, constitutes the rent of land, and in the price of the greater part of commodities makes a third component part.

In every society the price of every commodity finally resolves itself into some one or other, or all of these three parts; and in every improved society, all the three enter more or less, as component parts, into the price of the far greater part of commodities.

The revenue derived from from labor is called wages. That derived from stock, by the person who manages or employs it, is called profit. The revenue which proceeds altogether from land is called rent, and belongs to the landlord. All taxes, and all the revenue which is founded upon them, all salaries, pensions, and annuities of every kind, are ultimately derived from some one or other of those three original sources of revenue.


A brief summary of a very important concept. And a great pleasure to read.

The Solution Is the Problem

2 SEPT -- REVIEWING MY CONTEXT POST.. THIS IS AN IMPORTANT GRAPH, THE ECONOMIST'S IT'S A DRAG GRAPH THAT I BORROWED.. IT SHOWS "GROWTH PER DOLLAR OF DEBT" FALLING TO ABOUT 10 CENTS.. IT SAYS ONLY 10 CENTS OF INCOME IS GENERATED FROM EVERY NEW DOLLAR OF DEBT.. IT CONFIRMS THE VIEW THAT CREDIT EFFICIENCY IS VERY LOW.. IT SUGGESTS THAT DEBT IS A PROBLEM BECAUSE OF THE COST OF IT.. I HAD TO GO BACK TO THE SPECIAL REPORT ON DEBT AND READ IT AGAIN..

READING IT RAISED SEVERAL ADDITIONAL POSTABLE THOUGHTS.. ..


From A special report on debt: Repent at leisure, The Economist, 24 Jun 2010

The answer to all problems seemed to be more debt... When the European Union countries met in May to deal with the Greek crisis, they proposed a €750 billion ($900 billion) rescue programme largely consisting of even more borrowed money.

I have the same complaint. When the problem is debt, the only solution our leaders can think of is more debt.

Well, at least that answers the question How did we get into this mess?