Debt and Inflation (1): How Is Inflation Removed?

I want to look at the growth of debt, and the "erosion" of debt due to inflation during the Great Inflation. I want to use zero inflation as a conceptual yardstick.

People these days think zero inflation is not realistic. I don't want to argue about that but I need to look at debt with inflation stripped away. I have been confused by it.


Suppose we start with a look at "real" GDP, inflation-adjusted GDP. Compared to "nominal" GDP, which is based on actual prices.

Inflation means prices are going up. So when you take the inflation out of a number set, the numbers go up slower. So we see the blue line -- GDP with inflation removed -- goes up slower than the red line, which is GDP with nothing removed:

Graph #1: Inflation-Adjusted GDP (blue) and Actual-Price GDP (red)

After you adjust for inflation, you still have to express the numbers in dollar values. The red line on Graph #1 uses dollar-values that change. The blue line uses dollar-values that are "fixed" and unchanging. The two lines cross at the year 2005 because in that one year, both lines use dollar-values from 2005.

Where the lines cross is not significant. The numbers cross at the "base year". We could force the lines to cross at any year we want by using the desired year as the base year. On the graph we have, the base year happens to be 2005. The lines cross that year because the value of the dollar on both lines is the same for that year.


How is inflation removed from a number set? Basically, it is divided out.

Typing price index into the search box at FRED returns 5514 results. Top three among these are the Consumer Price Index (twice) and the GDP Deflator. It seems the deflator is the relevant choice when looking at GDP, so I'll go with that.

The deflator is a sequence of numbers that go up as time goes by. So dividing by the deflator will give results that get smaller as time goes by. Smaller, as compared to the numbers you start with.

I took the red line from Graph #1 and divided it by the deflator. What happened then was the red line looked like a flat line down near the bottom of the graph. (The "base year" 2005 value of the deflator was 100. So in 2005 where the red and blue lines are supposed to be the same, the red line was low by a factor of 100.)

To correct for this, I multiplied all the red values by 100. Now the red line follows exactly the same path as the blue line:

Graph #2: Calculating Inflation-Adjusted GDP

I stopped the red line two years short at each end so you can actually see that there is a blue line on the graph, and that the red line follows exactly the same path.


Now let's do the same arithmetic with Total Debt instead of GDP. I don't know whether the CPI or the deflator is more appropriate. I'll use the deflator to be consistent with what I've done above.

Look at the second line of text in the top blue border on Graph #3 below, and compare it with the second line on the top border of Graph #2 above. The calculations are the same. Only the original numbersets differ. The one is TCMDO; the other is GDP.

Graph #3: TCMDO debt (blue) and Inflation-Adjusted TCMDO (red)

I'm not sure that inflation-adjusted debt is a meaningful calculation, by the way.

Oops. On Graph #1 the blue line has the inflation adjustment. On Graph #3, the red line has the inflation adjustment. But in both cases, the inflation-adjusted line goes up more slowly than the unadjusted line. The unadjusted lines go up faster. The unadjusted numbers start out lower and end up higher than the adjusted numbers, because prices have been going up.

So that's the arithmetic of it.

++"Wealth Shock"

Krugman has an interesting take on James Bullard's "Wealth Shock" idea:

Maybe the idea is that the burst bubble reduces demand, and hence leads to lower production.

Yeah, that's how I took it, though I had to wait for Krugman to make it clear. But what else can it be, if a "wealth shock" leads to lower GDP? It's not that we're suddenly able to produce less. It's that we're suddenly buying less. That follows from the wealth effect.

I don't buy the "wealth effect" story, myself. I'm with Jazz on that:

given empirical data that closely links consumption to income, how can consumption depend "primarily on wealth rather than income?"

But falling demand due to a "wealth shock" and its wealth effects, was the only way I could make sense of Bullard's rather direct words: "The negative wealth shock lowers consumption and output."

Krugman, again:

Maybe the idea is that the burst bubble reduces demand, and hence leads to lower production. But at that point you’re into a Keynesian world of deficient demand, and you should be talking about ways to close the gap, not accepting it as a fact of life.

I thought that was clever, rubbing Bullard's nose in his own Keynesian poo.

...you should be talking about ways to close the gap, not accepting it as a fact of life.

I'm with Krugman on that. Here's mine:

If [Andolfatto] 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.

We do expect better. However, Krugman tells only one side of a story. Yes, demand is inadequate. The other side of the story is that demand must be excessive. According to Bullard, remember, inflation is already above our new explicit 2% target level. He wouldn't tell us that unless he thought it time to start pushing interest rates up again, to curtail demand. So demand must be excessive in Bullard's view.

Only two percent? Yeah. And if I thought Bullard's "wealth shock" analysis was right, I'd support him at two percent. Other people think we ought to push the inflation target higher, up to four percent maybe. If I thought that would solve the problem, I would support it. But the problem is certainly not that prices are going up too slowly. That's not the problem at all.

The problem, as Krugman said, is that we're in a world of deficient demand. But it's an inflationary world of deficient demand. So, wait: Let's not talk about ways to close the gap. Let's talk about how we got into this mess. Because this world of simultaneously insufficient and excessive demand is a result of the problem that needs to be fixed.

We got into this mess when everybody started deleveraging. Paying down debt. Rather than borrowing more and spending more, we started borrowing less and paying off more. So the reduced borrowing is spending that we're not doing, and the paying off is more spending that we're not doing. A double-whammy on spending.

So, paying down debt is the problem? No. Paying down debt is our solution to the problem. The problem is that we had so much debt in the first place. Private debt.


I left Bullard hanging.

Bullard is concerned about inflation. Now I know, a lot of people just want to dismiss that concern, because we have bigger problems. But you can't just dismiss arguments you don't like. You have to deal with them and show them wrong, or accept them.

Or bide your time and don't jump to any conclusions. That's always a good rule.

So, the inflation. I don't think inflation is a crisis. But I don't like a two percent target. I like a zero target (even if I can only fail to achieve my target). And I really don't like the doublespeak that says "a constant price level" when it means "a constant inflation rate". Bill Mitchell recently pointed out an example of that:

In that Press Release, the ECB said it main role was to achieve “price stability” (that is, stable inflation)

Anyway, Bullard. He says if we overestimate potential output and set policy by it, we will encourage excessive demand and we will get inflation like we got in the 1970s. (And, he says, inflation is already above target.)

Everybody else says the economy is not growing enough, and we don't have jobs enough, and unemployment is too high, and demand is insufficient, not excessive.

How can there be such a difference in views? I think the trouble arises from the way we explain inflation. Here's Mitchell again:

Inflation is driven by nominal aggregate demand growth that exceeds the capacity of the economy to respond in real terms – that is, to increase output.

Too much money chasing too few goods. For Billy, as for Milton and Anna, inflation is caused by excessive demand -- by demand "that exceeds the capacity of the economy to respond". Demand being excessive relative to potential output is the cause of inflation, they say. Exactly what Jim Bullard says.

If you think of inflation along those lines, and you admit we're getting inflation already, then you end up thinking that "the capacity of the economy to respond" must somehow have been crippled. You end up thinking that there must have been a sudden drop in potential output. Exactly what Jim Bullard says.


But all we need -- if we wish to undermine Jim Bullard's argument -- is to realize that demand-pull isn't the only inflation story there is. There is also a cost-push inflation.

Economists seem always to pooh-pooh and ha-ha the concept of cost push inflation. But it makes perfect sense to me.

There is a nice short Wikipedia article on cost-push inflation and if I take two parts of it and put them in reverse order, I get what seems to me an excellent explanation of cost-push inflation:

Monetarist economists such as Milton Friedman argue against the concept of cost-push inflation because increases in the cost of goods and services do not lead to inflation without the government and its central bank cooperating in increasing the money supply.

Keynesians argue that in a modern industrial economy ... a supply shock would cause a recession, i.e., rising unemployment and falling gross domestic product. It is the costs of such a recession that likely causes governments and central banks to allow a supply shock to result in inflation.

I accept both sides of that disagreement. It doesn't even seem to be a disagreement, with the order reversed like that. Here's what I see:

Yeah, it is demand that affects prices. More demand pulls prices up more. Less demand pulls prices up less. And demand expresses itself as spending. And spending is done for the most part with money -- money and credit. With things that work like money.

So, the quantity of money has to have an influence on prices. The quantity of stuff that works like money. I accept that. (I accept it even though I do not accept the graphs Milton Friedman offered to convince us of the truth of it.)

But if something happens -- a "shock" call it, pathetic as that explanation is -- and it drives costs up, then the existing quantity of money has to stretch to cover the higher prices that accompany increasing costs. And if the money doesn't stretch enough, then the spending has to shrink. And if the spending shrinks enough, you get a recession.

And if the central bank has a "dual mandate" to keep prices stable and to keep the economy growing, getting a recession means it has failed to meet its mandate.

And if the central bank decides to take a safe, "middle of the road" position, it ends up compromising between recession and inflation, and getting some of each.

And the inflation we get in such circumstances arises (as monetarists argue) because the quantity of money was allowed to expand. But actually, the prices had to go up anyway, because the costs were going up; and the central bank opted to allow some of that cost-push inflation to continue rather than creating another recession.

That's what it was like in the 1970s. That's the future Jim Bullard sees. The alternative is to figure out why we have cost-push, and to fix that problem.

At the root of cost-push you will find the ever-increasing cost of accumulating debt.

[ Part 1 ]	This is Part Two	[ Part 3 ]

Factors (2)

A little more from Adam Smith on the factors of production:

But the whole price of any commodity must still finally resolve itself into some one or other, or all three of those parts; as whatever part of it remains after paying the rent of the land, and the price of the whole labour employed in raising, manufacturing, and bringing it to market, must necessarily be profit to somebody.

So there are three factors by definition. I find that interesting.

Regarding the cost of interest, Smith writes:

Wages, profit, and rent, are the three original sources of all revenue as well as of all exchangeable value. All other revenue is ultimately derived from some one or other of these.

The interest of money is always a derivative revenue, which, if it is not paid from the profit which is made by the use of the money, must be paid from some other source of revenue...

Smith's use of the word "derivative" does not, of course, refer to modern derivatives, but simply to the fact that the money to pay interest originates in and must be pulled from one or more of his three factor incomes -- profit, wages, and rent.

Understatement of the Millennium

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

"Such turmoil is a sign that debt is not the instant solution it was made out to be."

I wonder: Did The Economist ever make such a bold statement before the financial crisis hit? In that earlier time, the special report says, "Those who cautioned against rising debt levels were dismissed as doom-mongers." Was The Economist cautioning its readers back then, or dismissing the doom-mongers?

(Observe the use of the passive voice in the phrases "it was made out to be" and "were dismissed." Who made it out to be, and who did the dismissing, are carefully hidden.)

It is easy, now, to speak wisely of the dangers of debt. Now the dangers are obvious. But the reasons there are dangers remain much less clear. If The Economist was unable to see those dangers beforehand, then surely it did not understand those reasons then, and very likely it does not understand those reasons now.