The Consequences of Denial

From mine of 13 Feb 2012:

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.

Not Sure About That

Near the end of Natural Born Recovery Killers Paul Krugman writes

Let me just add that White and others seem in addition to be victims of the fallacy of immaculate inflation. As Karl Smith said in the linked piece,

Inflation must proceed through market processes. Demand for some product must rise or supply must fall.

Any attempt to tell a story about inflationary risks that does not explain where excess demand for goods comes in is, necessarily, monetary mumbo-jumbo.

Karl Smith asserts and Paul Krugman repeats the assertion that inflation "must" "necessarily" be demand-pull inflation.

Not sure about that. Leave aside that PK reduces Karl Smith's demand must rise or supply must fall to the one-dimensional "excess demand for goods". Admit that a fall in supply (relative to demand) *IS* a version of the excess demand for goods.

Is the excess demand for goods the only cause of inflation? I think not.


Inflation was once thought to be driven by "cost-push" forces:

Under Fed chairman Arthur Burns in the 1970s, inflation was seen as cost-push, arising from forces beyond the Fed's control. But Volcker challenged that, seeing inflation as demand-pull. According to Volcker, "the inflation process is ultimately related to excessive growth in money and credit”.

Paul Volcker made the decision that inflation was always the result of excess demand for goods. See, that's where I have a problem. This is not how the economy works. We cannot just make decisions about how the economy works. We have to understand it.

Oh sure, it simplifies everything to say 'inflation is always and everywhere a monetary phenomenon'. Unless it's not true.

Meanwhile, these days, the notion of cost-push inflation is dismissed without a thought. See, for example, the comments following this post.


So, what could possibly cause inflation, other than excessive growth in money and credit? How about expectations?

Economists are big on expectations, as a way to explain everything. Everything other than inflation, that is.


Not what I think. I think expectations as an explanation is a joke. I think Arthur Burns was onto something with cost-push.

Suppose there was an unidentified factor X that was increasing costs for both the supply side and the demand side. On the demand side, X would push living standards down. On the supply side, X would raise costs and reduce profit. The result would be very much like the world in which we actually live.

X is the cost of finance.

The Cost-Push Economy

One of the quirky aspects of MMT is that people like Billy Mitchell always talk of taxes as a way to limit private-sector spending in order to prevent inflation. It could work that way, I admit. But that's not the point. The point is, people react badly to the idea.

People still think inflation is a problem. So Billy makes his argument and people are left thinking: They want to raise taxes MORE??? And people shake their heads, and nobody wants to listen to Billy the Wise.

But that's not why I'm writing today. I'm writing because Billy said something about inflation. Something I think is wrong. Something that tells me Billy still thinks in terms of demand-pull inflation.

Here's what Billy said: "I agree that taking a dollar from a private citizen reduces their capacity of spend that dollar. That is the very important function of taxation – to ensure that the state can manage total spending and keep it in line with what is required for full employment but not push nominal growth beyond the inflation barrier."

He's talking about a way to manage total spending and keep it in line to avoid breaking through the inflation barrier. This is the same sort of thing Milton Friedman used to say, except Friedman wanted the Federal Reserve to control inflation, and Bill Mitchell wants the IRS to control it. Their methods differ, sure. But their objective -- removing money from circulation -- is the same.

Stop thinking about taxes. This post ain't about taxes. I don't want to talk about how we control the quantity of money. The differences between Fed policy and Bill's MMT approach are not relevant to this post. I want to talk about the point of similarity.

I want to talk about the idea that it is the quantity of money that causes inflation. Of course it is, you know. I don't argue the point. However...

Milton Friedman asked a question: Why the excessive monetary growth?

The answer Friedman provides, which I find totally inadequate, includes three points:
1. the rapid growth of government spending,
2. full-employment policy, and
3. mistakes by the Federal Reserve.

My answer is different. I say conditions changed, and left monetary policy between a rock and a hard place. In the 1950s, when Milton Friedman was honing his ideas to perfection, there was too much money in the economy. You know: "Too much money chasing too few goods." It was a consequence of wartime spending and such.

Prices were going up because there was too much money in circulation. Friedman said we should restrict the quantity of money, and he was right. And we did restrict the quantity of money, and it worked. By 1960, inflation was pretty much at an end. Then we had a few good years. "Camelot," it has been called. Whatever.

Anyway, pretty soon inflation started coming back, what with the war in Viet Nam and all. And if you ask economists today, they still say that in the 1960s and '70s the excessive money growth was the cause of that inflation. Maybe. But "too much money in circulation" was not the driving force.

When inflation came back in the 1960s, it was cost-push inflation. By the 1970s it was obvious. We were getting stagflation. Prices were going up even when demand was going down. There was no more "demand-pull" to cause inflation.

It's easy to tell the difference. In demand-pull inflation, prices go up because we have more money than we know what to do with. In cost-push inflation, prices go up because we either increase income, or we go under. In times of demand-pull inflation, people have money to burn. In times of cost-push inflation, people have to stretch every dollar.

Demand-pull inflation is associated with good times; cost-push inflation, with hard times. By the mid-1970s, the "golden age of post-war capitalism" had reached an end. Times have been hard ever since.

The inflation since that time has been driven by rising costs. People have to have more income, just to stay even. So the choices open to policymakers at the Federal Reserve are to accept inflation, or to have recession. There is no middle ground any more. Just the rock and the hard place: Inflation, or decline.

Yes, we have inflation because of the quantity of money. But there are reasons we have an inflationary quantity of money. Reasons that developed after Milton Friedman had formulated his ideas and written his 1963 book with Anna Schwartz. Reasons Friedman and Schwartz never understood.

Anna Schwartz continues to explain inflation in demand-pull terms.


The question that must be asked is: What is the source of the rising costs that drive cost-push inflation? The answer is clear: The factor cost of money is the source.

In the 1980s, at the Federal Reserve they continued to restrict the quantity of money to fight inflation. In Congress, they came up with all sorts of ways to boost economic growth.

The thing is, if you boost growth you boost spending, and it's spending that causes inflation. But that's not the half of it. What we spend, matters. If we spend money, there's no associated interest cost and we don't have to pay the money back. If we spend credit, we have the cost of interest to deal with. And the repayment of principal.

Our economic policies took money out of circulation and encouraged the reliance on credit. "What we spend" became more costly. The factor cost of money increased.

A factor cost is something like wages or profit, or something that competes with wages and profit. The cost of interest is a factor cost that competes with wages and profit.

The cost of interest is an "extra" cost, a largely unnecessary cost in our economy. Yes of course we need to use credit. But we don't need to use credit for everything. But we do. So, we have this extra cost to deal with, the factor cost of money. And it creates cost-push conditions. And cost-push conditions cause inflation. Inflation, or decline.

In the '90s and the Naughts we have the Federal Reserve letting money grow enough to prevent decline, and still thinking it has to fight inflation by restricting the quantity of money. But it isn't even money that's causing inflation. It's credit-use and the cost of this substitute-for-money that are causing inflation. But nobody sees it. Nobody at the Fed says Hey, wait a minute!

At the Fed, they think they have to restrict the quantity of money even more. And of course Congress is happy to do more to encourage spending and the use of credit, to stimulate growth.

And, yeah, they did. But the economy wasn't working very well, so of course Congress had to do even more to boost credit-use. And then one day we had so little money and so much debt that we couldn't afford our debt anymore. Then we had a financial crisis.

And, somehow, the crisis seemed to catch everyone by surprise.


Meanwhile, Billy Mitchell, like Milton Friedman and Anna Schwartz, writes of taking dollars from people, to manage total spending, so that we may prevent inflation.

It's all wrong. It's just all wrong. It isn't even money that causes inflation anymore. It is credit-use that causes inflation. And it is the cost of credit-use that causes cost-push inflation.

The Schwartz

The name Anna Schwartz should ring a bell. She wrote a very great book (which I never read) with Milton Friedman, who was a very great man. Schwartz has some thoughts on the money supply, here. I have just a few remarks.

The Wrong War

Back in the early 1990s I was all gung-ho for Milton Friedman: Prices go up because the quantity of money goes up, always and everywhere. Amen.

And then I got a new job with a small steel warehouse. The counter man -- Wesley, his name was -- once said something I never forgot. He said, "We have to raise our prices, because our costs are going up."

This wasn't Milton Friedman's explanation. It was something else. As I look back now, it is clear to me that "always and everywhere" is not the same as "only." Friedman said prices go up when the quantity of money goes up, always and everywhere. He didn't say that was the only reason prices go up.

When you raise your prices because your customers have "too much money," your good profit gets better. When you raise your prices because you have to, it's because your profit is being squeezed. These two worlds are totally unlike one another.

Milton Friedman explained demand-pull inflation. Wesley introduced me to cost-push. Everybody today is familiar with Wesley's problem. Our costs are going up. Health care costs. Gasoline and heating oil. Candy bars and coffee. Costs are going up and it's tough to make ends meet. We have met the enemy and it is cost-push inflation.