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)

A bit more from Heilbroner and Silk

Another excerpt from Leonard Silk's 1976 discussion of Robert L. Heilbroner's Business Civilization In Decline:

... in the end this mighty industrial machine spews forth so much output that it depletes the earth's resources and pollutes its environment, jeopardizing human life.

Economic growth must cease; but growth was the daemon of capitalism, and capitalism cannot survive in a nogrowth world. Without continuously increasing real income with which to buy off and pacify the lower classes, the struggle over distribution of income and wealth will intensify, nationally and internationally.

 
I've been doing economics since the 1970s. Untutored, yeah, but since the 1970s. And in all that time, this is the first explanation that I have seen for why growth is necessary in the capitalist system. I've heard it said a million times that growth is necessary in the capitalist system. Now I've seen it explained, once.

And I've never yet seen a careful and thorough analysis of the "growth is necessary" concept. It is always assumed to be true, whether or not you get the explanation, but there is never an analysis. Same as you get with the argument for free trade. Long as I've been interested in understanding the economy, I have never seen an analysis, no less a convincing one.

"Capitalism cannot survive in a nogrowth world." So says Silk -- expressing Heilbroner's view, I suppose.

Why can it not survive? Because capitalism needs "to buy off and pacify the lower classes", the story goes. That's not economic analysis. It's rabble-rousing.


Why can capitalism not survive in a no-growth world? Because that's how we set it up. If we set it up differently, it would work differently. If we designed economic policy for a no-growth world, we could live in a no-growth world. You see it in economic models all the time.

We're almost there now, actually. We live in an almost-no-growth world, right? And yes, things are not very good. And even I have been calling for (or predicting, actually) better growth. However, things are not very good in our no-growth world because all our policies are designed for a world of "full speed ahead" growth. Just for the record, then, the fact that economic conditions have satisfied almost no one for the past decade is not evidence that we cannot live in a no-growth world.

I can't lay it out for you today. I'm not particularly a fan of the no-growth world. I don't see it as necessary. But that's just me.

But I can lay out a parallel situation. I can lay out a no-debt-growth world:

• 1. Use credit for growth as we did, say, in the 1950s and '60s.
• 2. Use new tax incentives to accelerate repayment of the debt generated by Step 1.
• 3. Step 2 is deflationary, so the Fed should buy up some government debt.

Step 1 grows the economy; step 2 repays the debt; step 3 expands the money supply. Together these steps allow us to keep both the money-to-GDP and the debt-to-GDP ratios stable as GDP expands.

It's not magic. But it recognizes that existing policy encourages the use of credit, so that debt accumulates at an unnaturally rapid rate and reaches an unnaturally large size. It offsets that effect of policy by encouraging an unnaturally rapid repayment of debt.

Economic growth under this system is supported by credit use. Say we grow three percent. We need credit enough for that three percent. We don't need credit enough for the whole economy. We don't need to use credit for everything. We do use credit for everything, and that's the problem; but we don't have to. Let the Fed issue that money. If the economy grows 3%, let the Fed issue 3% more money by expanding its holdings of government debt. The system is essentially unchanged under the plan I describe, except the normal growth of Federal Debt held by Federal Reserve Banks is faster than before, and anti-inflation policy gets some help from the tax code.

Remember, I'm talking about encouraging the private sector to pay down debt at an accelerated rate. This doesn't have to be a punitive plan. Shouldn't be, until we can average 4% RGDP growth for a decade. Oh, and this suppression of wages to fight inflation, that has to go.

A plan similar to this, more or less, could change policy enough to make a no-growth world a pretty decent place to live.

Any question about the definitions of money and credit, see here.

Excerpts from a book review

I remembered the phrase "business civilization" and looked it up.

First hit, The New York Times:

Business Civilization In Decline

Is capitalism dying? Robert L. Heilbroner is sure it is. He expects it to be gone within a century. Yet, although Heilbroner is himself a socialist, the impending demise of capitalism leaves him joyless; for he is full of apprehension about the conditions that are causing capitalism to rot and bringing statist regimes into being. And he fears that personal freedoms and parliamentary political institutions, which he reveres, may die with capitalism.

By Robert L. Heilbroner. 127 pp. New York: W. W. Norton & Co. Cloth, $6.95. Paper. $2.95.

 
Those prices seem right to you?

The article is from 1976. Yeah, the prices are about right.

Heilbroner writes: “Much as we now Inspect Chichdn Itzi, the Great Wall, the pyramids, Machu Picchu, so we may some day visit and marvel at the ruins of the great steel works at Sparrows Point, the atomic complex at Hanford, the computer centers at Houston.”

 
Turns out we didn't have to wait a century to "marvel at the ruins of the great steel works at Sparrows Point":

Source: This drone video shows the disheveled remains of Sparrows Point steel mill (2015)

"But the worst of all," the article continues,

But the worst of all, in the future we may long for the time when liberties were accorded to “artistic statements, social or sexual habits, political utterances.”

 
We didn't have to wait a century for that, either.


The article, by Leonard Silk, also includes this statement which I include here because it will be useful later:

Why should a society—which Daniel Bell calls a post‐industrial society—that is shifting from the production of goods to services become a more centralized system, rather than the reverse? Admittedly, the provision of some services, such as telephone communications, may have large economies of scale, but others, including education, medicine, the arts and sciences, do not. Even in massive existing corporations, the degree of vertical and horizontal monopoly in the United States today is less obviously a result of economies of scale than of market power, often reinforced by government, which carries its own political dangers.

 

Monopoly power in the United States today is less a result of economies of scale than of market power reinforced by government

See also: The power to change the world

Taking a knee today

"... a burst of renewed growth" -- Steven Kopits

The great unwind begins by James_Hamilton at EconBrowser, 20 Sept 2017:

The Federal Reserve announced today that it will begin reducing the size of its balance sheet next month in very modest and deliberate steps.

Hamilton takes a graph of the Fed's balance sheet since 2002, and uses details from the Fed's announcements to calculate what the balance sheet might look like over the next few years.

First he shows the asset side. Then he shows the liabilities side. The latter graph helps explain some of the assumptions Hamilton uses in his asset-side prediction.

Fascinating stuff. Recommended reading.


And something else. The comments on Hamilton's post include one from Steven Kopits. Following is the body of that comment:

Depressions show markedly different economic and social dynamics than ordinary recessions. For example, we see persistent low interest rates, low population growth, low productivity growth, and sluggish GDP recovery, for example.

On the social front, we see a rejection of the established political system, eg, Brexit, Trump and Macron, an exaggerated ideological polarization (fascists v communists fighting in the street), and active steps to deport illegals (also occurred in the 1930s).

One has to speculate as to what could cause such a prolonged malaise. Gavin Davies takes a crack at the issue:

“The graphs above show a simple version of the Taylor Rule, comparing the appropriate rate (red line) with the actual policy rate set by the central banks (black line). The graphs contain a simple but clear message: because of the constraint imposed by the zero lower bound, policy [rates] were much higher than the appropriate rate for the ECB from 2009-16, and for the Federal Reserve from 2009-14. Now, the rise in the appropriate rates has taken policy into slightly expansionary territory in both the ECB and the Fed, despite the rate rises introduced in the US.”

This interpretation suggests that real interests were too high in the aftermath of the Great Recession, and therefore investment, and perhaps productivity growth, were too low. With Taylor Rule interest rates now above target, the economy may begin to operate well again, with productivity growth rebounding and GDP growing nearer (or above) its historical range. Oil consumption growth — above 2 mbpd / year for the last two quarters — and strength in oil prices suggest this might be true.

We know from the Great Depression (for which I have not seen Taylor Rule analysis) that the US struggled through the 1930s, but doubled its GDP from 1941 to 1947, and did not fall back materially with the end of WWII (although there was a stiff post-war recession). We are now at a similar turning point, which would seem to either end in war or in a burst of renewed growth.

I would welcome your thoughts in a post.

https://www.ft.com/content/0c6cfd54-b4c4-345b-a530-ae2b25967746

I like the opening paragraphs. They describe the world as I see it. The state of the economy affects "social dynamics". Most people look at the world, complain about politics and the decline of society, and toss in a few complaints about the economy as an afterthought.

The economy is not the afterthought. The economy is the driver of the system. And now I lost almost everybody. 99% of six readers gone, anybody still here? No matter: I don't have to be right about this, but you have to think about it. Because if I'm right and you don't think about it, our problem will never be solved. Or you could say it this way: The problem will be solved by a dark age.

Or this way: "Civilization dies by suicide."

Anyhow, look at the Gavin Davies quote and Steven Kopits's evaluation of it. Good stuff. Based on the Taylor rule, the policy rate was too high until recently, they say. But recently the Taylor rate has gone up, so that the policy rate is relatively low and is therefore expansionary.

They say With Taylor Rule interest rates now above target, the economy may begin to operate well again, with productivity growth rebounding and GDP growing nearer (or above) its historical range. In other words, growth and productivity will be improving. Gavin Davies and Steven Kopits are predicting vigor.

Vigor. Sound familiar? See mine of March 3, 2016, April 7, 2016, August 7, 2016, and August 22, 2016.

Life's little ironies

Yglesias at VOX: The economy really is broken — but we know how to fix it

No, we don't know how to fix it. And thinking that we do is part of the problem.

Yglesias:

Census data released last week revealed that 2016 was a second straight strong year for median household income growth. Consequently, inflation-adjusted median household income is now at an all-time high, finally surpassing the previous record set in 1999...

Anyone who predicted in 1999 that median income would be lower in 2015 would have been regarded as ridiculously pessimistic, and nobody would have thought that quibbling over exactly how we calculate the inflation rate was the difference maker.

Something really is badly wrong.

The good news in the census report is that what’s wrong is fairly straightforward, easy to understand, and conceptually simple to fix. It requires a sense of political urgency that’s been lacking.

No. Ever since Martin L. Gross's 1993 book A Call for Revolution I hear that what's missing is the political urgency. Wrong. It's flat out wrong.

The argument is: We know how to fix the problem, but we lack the political will to do it. Bullshit. If they knew how to fix the problem, they'd fix the problem. Do you really think the Dems wanted to lose control to the Republicans? I don't think so. I think that if the Democrats knew how to fix the problem they'd have fixed it. That way they'd have been king of the hill for decades, like what happened after FDR.

Do you really think the Republicans wanted to lose control to Trump? I don't think so. If the Republicans knew how to fix the problem they'd have fixed it, instead of having to redistrict and restrict voter rights to gain king-of-the-hill status.

And if voters thought either of the parties knew how to fix the problem, they wouldn't have elected Trump. So no, it is not true that we know how to fix the problem and only lack the political will to do it. It's not true. And the evidence is: We elected Trump.

Yglesias:

In short, the country has gotten a lot richer on average, and yet the typical household hasn’t gotten richer at all...

What we need to do is tax the rich, spend the money on the poor, and prioritize fighting recessions as a core economic policy mission that’s more important than low inflation or high bank profits.

But what's "more important" depends on one's point of view, doesn't it. Meanwhile, the economy has degenerated into an "us versus them" struggle because we've failed to fix the problem. The wrong answer makes the problem worse as economic decline puts employer and employee at odds, making it seem that the solution must be to pick a side in the battle, and fight harder.

It won't work. The economy is not "us versus them". We're all in it together.

Yglesias:

Median household income has been essentially flat since 1999...

Reflecting this reality, the poverty rate is higher today than it was in 1999.

The solution to both facets of this problem is simple: taxes. Higher taxes on very high wages and higher taxes on investment income.

This is an "us" solution. "Them" won't go for it. And "them" have the money and power and influence.

I'm not saying Yglesias is wrong about raising taxes. But he is not presenting a fix for the economy. He is presenting a fix for one side only. He builds his argument on us-versus-them:

The rich, as it turns out, have a very different set of concerns than does the rest of the population. In particular, they don’t necessarily suffer during times of high unemployment...

Lucky them. But the rest of the country needs a government that’s fanatically committed to fighting recessions.

Fanatically committed?

You know about the Fed, right? The dual mandate? "The monetary policy goals of the Federal Reserve are to foster economic conditions that achieve both stable prices and maximum sustainable employment."

"Maximum sustainable employment" doesn't sound fanatical. But it does sound reasonable -- at least until you look at economic conditions, I know. I know. But I would argue that the reasonableness of the dual mandate is not the problem. I would say we don't know how to fix the economic problem. And thinking that we do, well, that's part of the problem.

One of life's little ironies: The Fed's "dual mandate" instructs the Fed to do the two things that are part of the trade-off known as the Phillips curve. Whichever one the Fed chooses to do will undermine the other.

These days, economists say "the Phillips curve is broken." You know why it's "broken"? The dual mandate.


This part is good. Yglesias says:

One problem is that the top 5 percent includes all the members of Congress and all of the donors and lobbyists and business leaders whom members of Congress speak to. It also includes all the Federal Reserve governors and regional bank presidents and all the business leaders whom they speak to. It includes the top editors of all the major media outlets and most of the star talent. For that matter, it also includes most of the leading economic experts at top universities.

All else being equal, of course, political elites prefer lower unemployment to higher. But it simply isn’t instinctively urgent in elite circles the way a financial market panic is.

We still do have the right to vote, but it doesn't seem to help. I think there's a reason for that.

The reason is that we don't know how to fix the economic problem. I think that if we fixed the economic problem most of the other problems would go away, and the rest would be easier to fix.

Since we don't know the right fix for the problem, we can't agree with each other on a solution. But the issues are immensely important, so we become "partisan". And it only gets worse from there.

Since all the people who disagree with each other think they know how to fix the problem, they can only conclude that the other guys are wrong.

Yglesias thinks Yellen is wrong:

Janet Yellen’s Federal Reserve is raising interest rates to slow job creation in order to head off the possibility of future inflation even though actual inflation remains below target.

Yglesias himself takes the other position:

For the economy to work for normal people, the federal government needs to be obsessed with avoiding recessions and making them as short as possible. If that means short bursts of inflation during supply-side shocks, or reduced bank profits due to restrictions on lending, or high deficits to stimulate the economy, we need to be willing to make those trade-offs.

I'm not saying Yglesias is wrong. For the economy to work for "normal people" we need work for normal people. But Yellen has work to do, too, and it's a job that has to be done. Don't make it us-and-them. Think of it more as a dual mandate for the nation. Not just for the Fed, but for the nation.

It is funny, though, when the guy arguing for more inflation takes the view that inflation will only come in "short bursts". That's not the kind of inflation that bothers the other side. But Yglesias isn't writing for those guys.


Just to tie up a loose end, recall Matt Yglesias saying

... the top 5 percent includes ... the top editors of all the major media outlets and most of the star talent.

I asked google is matt yglesias in the top 5% of income earners? and this turned up: Matt Yglesias' $1.2 Million House Stokes Class Envy in Conservatives.

Yglesias isn't writing for the top five percent. But he's part of it.

George Selgin

Selgin trashes Sumner's story:

... why hasn't the Fed achieved higher NGDP growth? To observe that it hasn't done so because it hasn't been directly targeting NGDP won't do. After all, a 2 percent inflation target implicitly calls for whatever NGDP growth rate it takes to achieve 2 percent inflation.

Thank you, George.

A Brief History of Microfoundations (plus afterthoughts)

Google the origin of microfoundations

Romain Plassard:

Robert W. Clower’s article “A Reconsideration of the Microfoundations of Monetary Theory” (1967) deeply influenced the course of modern monetary economics.

Wikipedia:

One particularly influential call for microfoundations was Robert Lucas, Jr.'s critique of traditional macroeconometric forecasting models.

Barney and Felin:

However, there is little consensus on what microfoundations are and what they are not.

J.E King (PDF):

It is widely believed by both mainstream and heterodox economists that macroeconomic theory must be based on microfoundations (MIFs). I argue that this belief is unfounded and potentially dangerous.

//

Afterthoughts...

Economic forecasting has always seemed odd to me. Different than my way of foretelling the economy.

Lucas I think said that when you change the rules, peoples' behavior will change, yadda yadda, and so you have to have microfoundations. Okay. And lately there is "behavioral" economics, I guess to account for the "peoples' behavior will change" part, and to relax the microfoundations.

I just look at monetary balances. Debt per dollar. Private debt relative to public debt. Things like that. If the ratios get out of whack, the economy gets out of whack. This has nothing to do with human behavior or changing it. Monetary balances over time.

If debt-per-dollar is too high, we have to lower it. My prediction is: After we lower it, the economy will improve. My prediction tells you what needs to be done.

Lucas says you have to do forecasting right or your prediction will be wrong. Behavioralists say yeah but doing it right is not the way Lucas said.

My opinion, these guys don't even know what needs to be done.

Why?

Bruegel: Europe’s fourfold union: Updating the 2012 vision

The depiction of the euro area/European Union (EU) as a ‘fourfold union’ (financial union, fiscal union, economic union, political union) emerged in the first half of 2012 at the height of the euro-area crisis. It was primarily shaped by the recognition of the bank-sovereign vicious circle and the need to break it to ensure the survival of Economic and Monetary Union (EMU).

The bank-sovereign vicious circle? Okay...

And the need to break it? Okay...

To ensure the survival of Economic and Monetary Union? Why?

This framing of EMU and EU integration is inevitably simplistic but its four-part categorisation remains relevant and useful when assessing current and future challenges to European integration.

Fuck European integration.

Political union, a more intangible notion, might have advanced further than many observers realise, even as national politics remain paramount for the vast majority of EU citizens.

Doubletalk.

A near-term agenda to strengthen EMU, for which decisions could be made in the course of 2018 and without any treaty change, should rest on a balance of further risk-sharing and enhanced market discipline, building on the significant risk reduction achieved over the last half-decade.

Without any treaty change.

And definitely without any participatory democracy.

Complementary initiatives should include, on the fiscal side, a reform of the accounting and auditing framework that applies to euro-area member states, and on the (structural) economic side, a new architecture of sector-specific EU authorities to enforce the single market in regulated industries.

Without any treaty change.

A more ambitious vision would have to include the European pooling of selected tax revenue streams to support an incipient fiscal union.

"Even as national politics remain paramount".


This whole thing is driven by wealth, praised by policymakers who can't solve their own nations' problems, and supported by a dying middle class desperate for economic recovery.

Economic problems demand economic solutions. You cannot solve economic problems with political solutions.


// See also: Delian League

Final definitions of Money and Credit

In an old PDF, Joe Salerno defines money: the final means of payment in all transactions.

At EconomicsHelp, Pettinger defines credit: any form of deferred payment.

These two definitions work. And they work together.

In case you don't get it...

David Beckworth, in The Knowledge Problem in Monetary Policy at Mercatus:

Inflation is caused by both supply and demand shocks. Monetary policy can only productively address the latter, but discerning which type of shock has caused inflation in a particular instance is almost impossible for Fed officials to do in real time.

In case you don't get it, Beckworth draws a picture:

See the two circles at the top of the picture? How do we know there are only two circles? It's an assumption. Maybe the picture should look like this:

What could be in that third circle? Here's a thought: policy. Maybe it's policy that's causing the inflation problem. And maybe the solution is not to tighten or loosen, but to try something else with the money. Something like keeping an eye on the ratio of credit to money.

Imagine that.

Beckworth gets it

Milton Friedman quoted JS Mill. I requote it often:

There cannot, in short, be intrinsically a more insignificant thing, in the economy of society, than money ... [Money] only exerts a distinct and independent influence of its own when it gets out of order.

Here's Friedman himself:

Money is so crucial an element in the economy, yet also largely an invisible one, that even what appear to be insignificant changes in the monetary structure can have far-reaching and unanticipated effects.

David Beckworth explains:

... money is the one asset that is a part of every transaction. Whether the transaction is the sale of a physical or financial asset, a good, or a service, money is always a part of the exchange. It reaches into every market. Consequently, destabilizing money destabilizes all markets.

"Money is the one asset that is a part of every transaction." Memorize that.

When a problem affects the whole economy, like inflation or unemployment for example, one of the first things to consider is the money: "Is there a problem with the money?" Always. Even if the problem appears quite certainly to be "peak oil" or "too much immigration" or "China".

Alt-Policy

You know about the Fed's 2% target for inflation. Since 2012 I think, that's been the official target.

Thomas Palley, in 1996, in The Atlantic, wrote:

most economists support policies of zero inflation achieved by high real interest rates

Myself, I'm no economist. But I think economists should be embarrassed to support any inflation other than zero. I think they should see the call for 2% as an admission of failure -- a failure of policy, and of the theory behind it.

Anyway, it occurs to me that using high real interest rates to achieve an inflation target has the unintended consequence of increasing aggregate financial costs to the economy. Let's say unintended.

Imagine an alternative way to fight inflation. If we design and implement tax policy to encourage the accelerated repayment of debt, we have a new way to limit aggregate demand. But the new policy includes the intentional consequence of reducing aggregate financial costs to the economy. It may not seem that way now, because private debt remains at such a high level. But as the new policy pushes down debt-to-everything-else ratios, the effect will soon become clear.

When Palley and Taylor agree...

I switched on a computer that had been off for six months, and found something I didn't remember putting on the desktop: The Forces Making for an Economic Collapse (subtitle: Why a depression could happen) by Thomas I. Palley in the July 1996 issue of The Atlantic.

That's July of 1996.

I was going to quote Palley where he says a new Great Depression has become possible -- 1996, remember -- because it shows remarkable foresight. Instead, I'll file that under Recommended Reading and move on.

Here, Palley describes policy shortly before the "Goldilocks years" of the mid-to-late 1990s were to become obvious in hindsight:

... the Fed now interprets any sign of wage increases as incipient inflation, and responds by raising interest rates. Since wage increases are the means by which labor shares in productivity growth, this policy is tantamount to helping corporate and financial capital to gang up on labor.

The Federal Reserve vividly illustrated its new stance in 1994, when it raised interest rates six times. Just as the long-awaited economic recovery was picking up steam, the Fed slowed employment growth. It claimed that its action was necessary to prevent inflation from accelerating, but never produced compelling evidence of the danger of inflation...

The story since December 2015 is similar.

Palley didn't know it in July of 1996, but the economy was strong enough then to withstand a series of interest rate hikes and move ahead with vigor nonetheless.

We don't know it yet, but the economy today is probably strong enough again to withstand a series of interest rate hikes and still move ahead with vigor. And strong enough for the same reasons.


One more quote from Palley to emphasize the similarity between the 1990 recession and recovery, and the 2009 recession and recovery. While the '90 recession was still fresh in his mind, Palley wrote:

Just as the causes of the 1990 recession have been poorly explained, so have its prolonged nature and the weakness of the subsequent recovery. Economists consider the recession to have ended in the first quarter of 1991, but substantive recovery did not really begin until the second half of 1993. Thus for almost three years the economy was effectively dead in the water.

Dead in the water. We know about that. For crying out loud, even John Taylor in 2016 was saying "In several key ways the US economy resembles an economy at the bottom of a recession, ready for a restart".

Credit is not the same as money (even if you can't see it)

David Glasner at Uneasy Money: Milton Friedman Says that the Rate of Interest Is NOT the Price of Money: Don’t Listen to Him!


In the days before the internet, I wrote to Milton Friedman three times. He wrote back every time. That was great.

Not only that, but I could tell from Friedman's answers that he read and understood what I said. That's a rare and precious thing. For this reason I will always think of Milton Friedman as a great economist, no matter how many problems I have with his economics.


David Glasner quotes Friedman, from the Friedman Heller debate:

... the interest rate is not the price of money... The interest rate is the price of credit. The price of money is how much goods and services you have to give up to get a dollar.

That's it. That's it exactly. I had written to Milton Friedman, and my explanation for what I was thinking was: the interest rate is the price of money. Friedman wrote back to me, saying the interest rate is not the price of money; the interest rate is the price of credit; the price of money is what you have to give to get the money.

I remember, because I had to think about it for years before it made sense to me. Literally, for years.

It made sense, finally, when I realized that credit is not the same as money. Here's how I see it: I can get money two ways. Either I work for it, or I borrow it. If I work, I help to build this civilization and the money is my reward. If I borrow it, I'm going to have to pay it back, with interest.

Credit is not the same as money. The idea came to me direct from Milton Friedman. Having embraced the idea, I can easily see people who have not taken that idea to heart. People like David Glasner, who writes:

What is wrong with Friedman’s argument? Simply this: any asset has two prices, a purchase price and a rental price. The purchase price is the price one pays (or receives) to buy (or to sell) the asset; the rental price is the price one pays to derive services from the asset for a fixed period of time. The purchase price of a unit of currency is what one has to give up in order to gain ownership of that unit. The purchasing price of money, as Friedman observed, can be expressed as the inverse of the price level, but because money is the medium of exchange, there will actually be a vector of distinct purchase prices of a unit of currency depending on what good or service is being exchanged for money.

But there is also a rental price for money, and that rental price represents what you have to give up in order to hold a unit of currency in your pocket or in your bank account. What you sacrifice is the interest you pay to the one who lends you the unit of currency, or if you already own the unit of currency, it is the interest you forego by not lending that unit of currency to someone else who would be willing to pay to have that additional unit of currency in his pocket or in his bank account instead of in yours.

I have a problem with that. Glasner says there is always a rental price for holding money. If it's money you borrowed, he says, the rental price is the interest you pay on the loan. If it's money you earned, money you "own" as Glasner says, there is still an opportunity cost for holding it, and this is its "rental price".

But if the dollar in my pocket is borrowed, I can still choose to lend it out and collect interest on it. If I fail to do that, then by David Glasner's logic I am paying the rental price twice for that dollar, once for interest, and again for the lost opportunity.

So, looking at it Glasner's way, if the dollar in my pocket is my own, I am paying the rental price which is an opportunity cost. But if the dollar in my pocket is borrowed, the rental price I pay is opportunity cost plus interest cost. The cost (or "rental price") of a borrowed dollar is different from that of a dollar I own. Therefore, a borrowed dollar is different from an earned dollar.

An earned dollar is "money". A borrowed dollar is "credit". The opportunity cost for holding money applies to both money and credit. The interest cost applies only to credit.

Milton Friedman was right: The interest rate is the price of credit. David Glasner cannot see it, because he has not embraced the idea that credit is not the same as money.


One more point. I want to leave out the "opportunity cost" part and look at the rest. Glasner says:

But there is also a rental price for money, and that rental price represents what you have to give up in order to hold a unit of currency in your pocket or in your bank account. What you sacrifice is the interest you pay to the one who lends you the unit of currency ...

Glasner says that in order to hold a borrowed dollar, I have to pay interest to the lender. That's incorrect. I don't have to pay the interest because I'm holding the dollar. I have to pay the interest because I borrowed the dollar! Look what happens when I finally spend that dollar: The fellow who receives that dollar does not have to pay interest on it even if he holds that money. The interest obligation stays with the borrower.

The interest obligation is part of the same loan agreement that created the credit you could spend. That's what credit is: a "medium of exchange" dollar that moves through the economy, and a dollar of debt that stays with the borrower.

When you borrow a dollar you receive a dollar of money and a dollar of debt sandwiched together. When you spend it, you peel off the money layer, spend that part, and keep the rest. The borrower retains the debt. But the borrowed dollar, once spent, is freed of the debt obligation and is thereby transformed from credit to money.

New Borrowing, minus Interest Paid (adjusted for inflation)

... changes in borrowing behavior have played a smaller role in the growth of household leverage than is widely believed. Rather, most of the increase can be explained in terms of “Fisher dynamics” — the mechanical result of higher interest rates and lower inflation after 1980.

JW Mason

The year-to-year change in household debt is a measure of the money households borrow into existence and spend into circulation. An increase in household debt is an injection of funds into the money used as a medium of exchange.

But, to state the obvious, an addition to debt adds to debt. And debt must be repaid with interest. Interest is a cost that takes money and moves it from the productive sector to the financial sector. While it remains in the financial sector, the money is not used as a medium of exchange -- not, at least, in the productive sector.

So we can say that an addition to debt increases the money available for spending, and interest payments reduce the money available for spending. If we take one year's addition to debt and subtract from it the payment of interest for that same year, we can calculate a "net change" in money available for spending due to household credit use. Figure it for a number of years, and we can make a graph showing the history of the net change over time.

But the values on such a graph will be influenced by the rate of inflation. The graph will be malformed because the rate of inflation varies. As we are thinking about growth, we must remove the inflation. We can remove it by the same calculation used to remove inflation from "nominal" GDP.

However, I want to use the CPI as the measure of inflation, rather than the Deflator, because we're looking at household debt and household interest costs.

All of this can be done at FRED with a minimum of fuss:

Graph #1: Net Change in the Medium of Exchange due to Household Debt

The description of the calculation (in the upper blue border of the graph) has been cut short by a devious and disappointing FRED. The full description is "(Households and Nonprofit Organizations; Credit Market Instruments; Liability, Level-Monetary interest paid: Households and nonprofit institutions)*(100/Consumer Price Index for All Urban Consumers: All Items)"

The plotted line shows the increase in debt, minus interest paid. The difference has been adjusted for inflation. Where the line is above zero, borrowing is greater than interest cost. Where the line is below zero, borrowing is less than interest cost.

Before 1980, the line is mostly above zero, indicating a net increase in the circulating medium, a boost for spending and growth.

Between 1980 and 2000 the line is mostly below zero, indicating a net decline in the circulating medium due to the cost of interest.

The graph supports JW Mason's statement.

It's not a coincidence

At Bloomberg: Act or Wait? Fed Debate Heats Up After Inflation Misses Target by Matthew Boesler, 13 Sept 2017.

The opening words:

Former Federal Reserve Chairman Alan Greenspan, in year nine of a U.S. economic expansion, conceded in 1999 that patience was sometimes a better policy than his doctrine of preemptive interest-rate moves because “the future at times can be too opaque to penetrate.”

For some Fed officials, these days look like one of those times to wait for clarity.

And this:

“The conventional wisdom did not work in the 1990s and it is not working now,” said Allen Sinai, chief executive officer of Decision Economics in New York.

The 1990s and now. It's not a coincidence.

The butterfly non-effect

The butterfly effect is a concept that states "small causes can have larger effects".

Wikipedia

Macro events (in big economies) don't have micro causes

Scott Sumner

Scott Sumner has a tendency to say things clearly. For example:

I see the business cycle as being (in Fisher's words) a "dance of the dollar". Unstable monetary policy shows up as unstable NGDP. Since wages are sticky, employment tends to move with NGDP in the short run, and unemployment is countercyclical. Recessions occur when a sharp decline in NGDP growth leads to a rise in unemployment ...

In other words:

Monetary Policy --> NGDP Growth --> Employment Growth --> Recession

There's no place for butterflies there.

Like Sumner, I see monetary policy as causal. We differ because, for me, monetary policy should include not only money but also credit; and the credit-to-money ratio is of the utmost importance. But we agree that monetary policy is causal.

I also agree with Sumner (or, say Okun) on the relation of GDP growth and employment growth; and certainly recession may follow from changes in GDP and employment.

But where Sumner has NGDP Growth, I would instead put Spending Growth:

Monetary Policy --> Spending Growth --> Employment Growth --> Recession

I would have a second arrow coming out of Spending Growth, pointing to NGDP Growth on a different line. Other things would be pointing to NGDP Growth as well. Butterflies included.

Does not contradict my prediction of booming RGDP

Capacity Utilization is going up again:

Graph #1

(Does contradict those who expect recession within the next two years.)

Imagine the improvement possible if Capacity Utilization were to rise from 75% to 85 or 90 percent. Look at the size of the increases after the 1970 and '74 recessions. Such things are possible. Such things were possible, I should say. For us, too much, too soon.

Okay, so look at the increase after the 1991 recession: five percentage points. That would get us to 80% and (for those whose memories go back as far as 2008) that would seem pretty good. But 80% is still low: Look at the graph. We should expect to approach 85%, as in the 1980s and '90s.

And, because recent patterns of debt and debt service are comparable to those of the 1990s, we should expect a sustained high in capacity utilization and in economic growth, as in the '90s. Maybe longer, as the fall of debt was deeper and people are more cautious now about adding to their debt.

This would be the perfect time for policymakers to create tax incentives designed to accelerate the repayment of private debt.

"Don't Look Now," Bloomberg says, "But Productivity Is Finally Rising"

At Bloomberg: Don't Look Now, But Productivity Is Finally Rising.

I told you so.


The Bloomberg post is date 7 September 2017.

On 17 November 2016 I explained Why Labor Productivity is Low, and said

We are in a transition now that will soon give way to a more vigorous economy. Debt Service is beginning to increase, and productivity will soon be on the rise.

On 21 August 2016 I looked at productivity (real output per hour) for 22 data items (five years plus) beginning in 2011Q1. The linear trend ran low (near 0.5 percent growth) and flat.

I looked also at the nine quarters from 1993Q1 thru 1995Q1. The linear trend ran low (near 0.5 percent growth) and flat. But during the nine quarters from 1995Q1 thru 1997Q1, the trend increased from 0.5 percent to nearly 3%. "You never know," I said.

"To my way of thinking," I wrote,

Graph #1 (our time) is very much the same as Graph #2 (the early 1990s). But I think we are at the end of Graph #2 and ready to start Graph #3 [productivity improvement]. That makes all the difference.

"Oh come on," you are saying. "Graph #2 shows only a couple years. Graph #1 shows almost six years. There's no comparison. The slump is endless this time."

It's not endless. That's the point. The quiet time before the vigor is longer this time -- about 2½ times as long, my guess. I'm telling you we are at the end of the quiet period. Soon we will see productivity start to climb, just as on Graph #3.

On 7 April 2016 -- almost a year and a half ago -- I said

I predict a boom of "golden age" vigor, beginning in 2016 and lasting eight to ten years. It has already begun. In two years everyone will be predicting it.

And on 3 March 2016, in We are at the bottom now, ready to go up, I said

This is not going to be your typical anemic recovery. This is going to be the full tilt, rapid output growth, rapid productivity growth, high performance boom.

I can't promise you it'll last long, because the level of debt is already very high. But it'll be a good one while it lasts.

On 7 September 2017, Conor Sen of Bloomberg said Don't Look Now, But Productivity Is Finally Rising.

Remember Alan Greenspan in 1995, talking about anecdotal evidence?

In the last year or two we've seen a lot of improvement in jobs and employment, and economists were confounded by it because inflation didn't accelerate. And now they talk about how the Phillips Curve is "broken". They refuse to consider the possibility that the kind of good economy we had in the latter 1990s could return.


Tim Duy at Economist's View, quoting Cleveland Federal Reserve President Loretta Mester:

... my current assessment is that inflation will remain below our goal for somewhat longer but that the conditions remain in place for inflation to gradually return over the next year or so to our symmetric goal of 2 percent on a sustained basis. These conditions include growth that’s expected to be at or slightly above trend ...

... the 70 percent confidence range for forecasts of PCE inflation one year ahead is plus or minus 1 percentage point, and a significant portion of the variation in inflation rates comes from idiosyncratic factors that can’t be forecasted. Indeed...

FORECASTED.

...forecasted. Indeed, since the 1990s, assuming that inflation will return to 2 percent over the next one to two years has been one of the most accurate forecasts.

Tim Duy responds:

Since 1990, a 2 percent forecast has worked more than not, so lets just stick with that as the baseline for policy? By that logic, since the great recession, a 1.75% forecast has worked more than not, a testament to the Fed's one-sided inflation target and falling inflation expectations. I am not buying into her inflation forecast story yet.

He's a pretty good read.

As Duy points out, the more recent inflation numbers have been lower. Thinking in terms of averages, if the average since 1990 is 2% and the average since 2009 is 1.75%, then the average for 1990-2009 must be higher than 2%. Thinking in terms of year-on-year results, this appears to be the case:

Graph #1: Core PCE Inflation (the Fed's measure of choice) since 1990

Looking at that graph, I just want to remind you that the latter 1990s were pretty good for employment and income and real GDP growth, not just for price stability. Economists consider that a fluke, though. They refuse to consider that it could happen again. In the last year or two we've seen a lot of improvement in jobs and employment, and economists were confounded by it because inflation didn't pick up as well. And now they talk about how the Phillips Curve is "broken". But they refuse to consider the possibility that the kind of good economy we had in the latter 1990s could come back.

Duy quotes New York Federal Reserve President William Dudley:

Overall, the economy remains on a trajectory of slightly above-trend growth, which is gradually tightening the U.S. labor market. Over time, this should support a rise in wage growth. When combined with [other] factors, that causes me to expect inflation will rise ...

See? Dudley cannot imagine that inflation will remain calm as the economy improves -- broken Phillips Curve or not. A repeat of the latter 1990s is inconceivable to him.

(President Dudley says he expects inflation to rise just to the Fed's target and stop there (at 2%) but doesn't say why. Not by natural causes, certainly. By aggressive rate hikes, should inflation attempt to exceed its target. Typical Fedspeak. Dudley isn't predicting inflation. He's threatening to act against it.)


Duy further quotes William Dudley:

But, the upward trajectory of the policy rate path should continue to be shallow, in part because the level of short-term interest rates consistent with keeping the economy on a sustainable long-run growth path is likely to be considerably lower than it was in prior business cycles.

NO COMMA AFTER "BUT"

Duy quotes more:

If it turns out that structural changes have played a significant role, I would generally view this as a positive, rather than negative, development. It would imply that the U.S. economy could operate at a higher level of labor resource utilization without generating a troublesome large rise in inflation. More people could be put to work on a sustainable basis, enabling them to gain opportunities not just to earn greater income, but also to develop their skills and grow their human capital.

And Duy says this suggests

a downward revision of estimates of the natural rate of unemployment.

Tim Duy is right.

Notice that Dudley mentions "structural changes" (but fails to identify the changes or their causes), says it's a good thing (ooh, ooh, maybe he can imagine that inflation will remain calm as the economy improves! Nah, it's probably just words). And the rest of the paragraph just gets giddy. Rather than explaining the fall of the natural rate of unemployment, he gives us the happy ending.


Duy again:

Separately, on the data front, we get this from Commerce, via Reuters:

The U.S. economy probably grew faster than reported in the second quarter, with data on Thursday suggesting stronger consumer spending than previously estimated.

The quarterly services survey, or QSS, from the Commerce Department implied consumer spending increased more briskly than the 3.3 percent annualized rate reported last week in its second estimate of gross domestic product.

The Fed forecasts are based on more modest growth numbers. Stronger growth numbers will tilt them toward further rate hikes.

Yup: If growth improves, policymakers expect inflation. They simply refuse to consider the possibility that the economy might actually be good for a few years.

Nobody remembers the Alan Greenspan of 1995, talking about anecdotal evidence and refusing to raise rates as the economy improved.

I'm with Menzie

From Demystifying the trade balance: Why a trade balance deficit isn't necessarily a sign of a poor economy at the FRED Blog:

Is it bad to have a trade account deficit? If this means that your economy is booming and local production cannot keep up with demand, then no. If it implies that there is a current account deficit and, hence, foreigners are investing in your country, then also no. If this means that you can have more investment without having to save more, because the rest of the world is picking up the slack, no again. If you are worried that in the future dividends will flow abroad, then yes. But that will happen only if your economy is in good shape in the first place and will be able to afford paying such dividends.

From US Withdrawal from KORUS Free Trade Agreement?

This is not to argue we couldn’t have more aggregate demand redistributed to the US — in my recent paper on global imbalances I argue that in fact it would be desirable for the US to have a smaller current account deficit.

Menzie Chinn

Paying down debt is a better way to fight inflation than raising interest rates

Why is paying down debt a better way to fight inflation than raising interest rates?


Paying down debt takes money out of circulation. Raising interest rates doesn't.

Paying down debt reduces financial costs. Raising interest rates increases them.

Paying down debt affects those who have borrowed. Raising rates affects everyone.


Paying down debt to fight inflation also reduces debt.

Reducing debt encourages growth. Raising rates discourages growth.

Paying down debt is a better way to fight inflation than raising interest rates.