Monday, April 12, 2010

In the Black Trunks weighing in at 3% is inflation

As a result of Mike's comment on my last post, I want to dig further into the issue of inflation. Some economists are very worried that the government will monetize its historically large deficits. Monetizing a deficit in the USA today means that the government does not borrow by issuing new bonds. Well -- it's a little more complicated than that. They actually do borrow but when the ensuing competition in the credit markets drives up interest rates, there is much pressure aimed at the Fed to bring them back down. How does the Fed do this? They buy government bonds in the market. Summary -- (1) government sells bonds to the public, (2) the Fed buys bonds (not necessarily the exact same bonds but it doesn't really matter), (3) bonds in the credit markets are replaced by money. While the government did not literally PRINT money to finance its debt, the result was the same.

Economists believe that money is the root of all evil -- just kidding -- money is the root of spending. Since money has no real interest associated with it -- its main purpose is for spending. Unless prices are falling it does not make a good saving device. In the long-run this money will eventually raise spending. A large injection of money will eventually increase spending at a much faster pace than supply can respond and the difference is inflation. Now this is getting to be as much fun as a colonoscopy. Right?

So it is appropriate to worry that today's government deficits could lead to higher long-term inflation. But many just shrug their shoulders. Why should we care so much about high and rising inflation? There are a lot of answers to this question but the one I want to focus on today is the bout between inflation (Black Trunks) and unemployment (White Trunks). Let's face it -- very few leaders are going to say openly and repeatedly that they want to focus on inflation stability when so many people are unemployed in the USA. Most of these leaders base this PREFERENCE on a so-called TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT. Any policy that would reduce inflation today, according to this trade-off, will reduce the growth of spending, reduce the rate of inflation and raise the number of people unemployed. So -- if you are worried about inflation and you activate a policy to reduce it, then you must "pay for it" with fewer jobs and employment. This is not the stuff of reelection.

Did this piece of trade-off economics come down from on high? Not really. In fact, while the trade-off might exist at times, there are also plenty of times in recent USA history when policy was able to reduce both the inflation and the unemployment rate. There have also been some times when both inflation and unemployment rose. Hmmmm -- so much for a reliable and predictable tradeoff.

What causes the inflation/unemployment tradeoff to vanish at times? Answer -- an active supply-side. The trade-off is totally spending or demand based. But surely the expectations and behaviors of firms matter as they decide how much to produce and at what price to sell. Of course expected demand for computers is important to Dell -- but also of importance to Dell and its competitors is the expected wage, the price of commodity inputs, the level of productivity, tax on healthcare, and many other supply-side factors. Notice that any factor -- policy induced or otherwise -- that will have the impact of increasing business productivity and confidence relative to their business costs will have the interesting effect of reducing the cost per unit produced -- allowing them to produce more without raising prices markedly. Viola. Supply can make the trade-off disappear.

Did you ever believe that an economist would say "you can have your cake and eat it too?" But that is the magic of supply-side economics and supply-side policy. Right now we are faced with policy choices with huge implications. Monetizing the government deficits will have a predictable trade-off that could lead to high and rising inflation. But we have other choices. We know that firms are the ones who create the jobs. It seems very sensible to me that part of our policy arsenal should be devoted to finding ways for them to be permanently more competitive, especially if this frees us from undesirable trade-offs and lets us have our cake and eat it too.

One more point about supply. Letting inflation rise in the next couple of years as we use demand remedies to increase demand and employment is a very risky policy. If the increases in ACTUAL inflation causes a rise in EXPECTED future inflation, then the result will be an adverse supply shift as business costs rise faster than productivity. That will lead to higher unemployment and inflation. The trade-off is a very tricky theory to use. There is a lot more to say on this topic but I think I will leave it right here for the time and see if you post any comments.


  1. Mr. LSD. I agree that U.S. policy should focus on making “businesses more and permanently competitive,” to which I add “both domestically and internationally” and “innovative.” Until the current administration (and future administrations) is replaced by right-thinking and fiscally conservative bodies (which presumes a like-minded electorate) “permanently competitive” and “innovative” will be as illusive “having your cake and eat it too.”
    Maybe to avoid all the hassle and bother of trying to reconfigure the controlling branches of government, of rolling the rock uphill to level the international trade field, and of eliminating rules/regs/taxes (especially) that hinder innovation and job creation, we should all become poets (“MacArthur’s Park is melting in the dark, all the sweet green icing flowing down, Someone left the cake out in the rain . . .”) and sell our IP (intellectual poetry) to the global demanding mass audience. And dance the light fandango with harmonizing castanets.
    Bottom line, I thought your blog was most informative and brought down to earth an erstwhile confounding subject. More . . . more . . . .

  2. Mr Tuna, it looks like we agree on a lot. Your comment reminds me of when we were in high school. None of us had an inkling of where our lives would take us and we often didn't care. We definitely didn't care about inflation/unemployment trade-offs. While you and I never reached the stage at which anyone would have called us hippies, it was hard to ignore the poetic and thoughtful messages we were hearing and reading. I hope it is not too late to balance our priorities. While I greatly enjoy talking macro -- I also love the opportunities to be with my old friends and share our thoughts about life.

  3. The classic definition of inflation is too many dollars chasing too few goods. But that was before the days of govts could do things like use central banks to steer the economy, and as a side line change the inflation/unempolyment rates.

    The problem with "modern economics" as opposed to "classical economics" is that there is a whole lot more stuff that needs to be held constant for models to work. As you point out sometimes both inflation and unemployment increase, but sometimes they both decrease. Is this because there is no inverse relationship between inflation and unemployment, or is it possible some other factor has not been held constant.

    Given current govt expenditures compared to govt revenues and the projected increasing deficit because of this spread one would think inflation would be running wild. However inflation seems very modest given current economic data.

    This is but one example of why the Austrian School appeals to me, there just seems to be too much we can not explain. Too often there is a 800 pound gorilla in the room that renders theories irrelevant. I will leave you with this blurb, something Keynes might call a liquidity trap and Hayek a broken banking system, but my point of view it is something neither one of them would ever dream could or would happen. I leave you to speculate on how it affects inflation

    "Remember the liquidity trap, where money piles up in banks because people have lost their animal spirit? With bank reserves climbing from $10B in August of 2008 to over a $1T now, it sure looks like a classic liquidity trap.

    Except it isn’t. Banks are keeping huge and increasing sums of money in reserve because we’re paying them to!

    The Economic Stabilization Act of 2008 allowed, for the first time ever, the Fed to pay banks interest on reserve funds. That rate was set at .25% originally and was recently raised to .5%, an ample return during this “flight to quality”.

    In a time when small businesses are starving because of lack of credit, we’re paying banks to keep a trillion dollars on the shelf.

    The idea is to strengthen banks with new money and new reserves without actually letting that new money touch the real economy, where it could trigger inflation. It may work, but I don’t think Hayek would approve of this financial Rube Goldberg machine."

  4. Mike, The government deficit isn't enough alone to cause rising inflation now. Models of inflation focus on slack -- or the difference between national demand for goods and services and potential output. Recessions and recoveries are usually typified by excess capacity and therefore low inflation. But the slack can quickly disappear (read recent stories about Singapore and China). Worse, once slack is gone inflation expectations rear up and can causes inflation to rise even more. That's our challenge now. Bernanke sees slack and takes a big breath. But he needs to have his eye of the numbers and his hand on the oar or could soon be in deep doodoo (pardon my French).

  5. This may not be on topic, but I have some real issues with what I read about China. What ever one thinks about the economy in general and banking in particular in the US both are much more transparent here than almost anywhere else in the world. Not to say demand in China has not exploded recently (to make that country the largest consumer of autos in the world as an example) I just am not sure anyone in China really knows what the real numbers are, less yet has a steady hand on the oar.

    I am also not sure theories about inflation are as good as one might like. When the supply is out of whack to meet demand inflation can result. But it can also happen when a govt prints money 24/7 to pay for stuff like SS, Medicare, interest on debt and the like. Or more to the point when a govt just shifts a few accounting entries at the Fed and Treasury.

    I write a check for the monthly maintenance fee for my condo. But my lights, cable, and all the rest of my bills are paid electronically, and all my income is deposited electronically. I can get on the internet and shift funds from savings to checking for just in time money inventory.

    I often wonder how this switch from dollar bills to paper checks to plastic cards in my pocket changes my demand for goods and services; cuz if my personal demand (spread world wide) goes up and supply remains the same inflation should result.

    I am not sure how you judge that "the government deficit isn't enough alone to cause rising inflation now", but the rule of thumb seems to be if the yearly deficit is above 10% of GDP you lose the AAA bond rating; and we are suppose to be at 11-12% by the end of this year.

  6. Mike, the inflation model based on aggregate supply and demand includes the impacts of government deficits. Keep in mind that even with the large stimulus we have had lately, the net impact of the private sector demand and the government induced spending is not enough to generate rising inflation. But keep watching. As the private sector starts spending more, the government is going to have to withdraw its impact on demand or we will see much higher inflation in the near term.

    If a loss of government bond rating occurs, interest rates would increase. But that it not necessarily because of expected inflation. Remember that there is a risk premium in interest rates. If loss of rating increases risk then interest rates rise. If higher interest rates reduce capital and durable goods spending then it is possible that this would imply LOWER inflation.

    The conversion from paper to electronic money should reduce the cost of making transactions and could have a long-run impact on inflation. But I am guessing that basic attitudes about spending and saving will be more important. If people quickly go back to old spending habits -- that would not be a good sign for inflation.

  7. Not sure I agree with any of your three points. Consumer confidence has been going up for a few months, probably increasing demand. The "large stimulus we have had lately" is only 1/4 to 1/3 spent and conventional wisdom is the rest will be used pre-election to generate votes for the current administration instead of being used to help economic recovery. Spending this much money which has not been paid for by taxes would seem to result in inflation from "too many dollars chasing too few goods" and a devaluation of the dollar compared to other currencies. Given current dem pols stated intention to pass another stimulus bill I doubt the govt will "withdraw its impact on demand" whatever the private sector does with its spending.

    The problem with your argument that "higher interest rates reducing capital and durable goods spending" resulting in implied lower inflation is that IMHO the govt would simply increase, not withdraw, its impact on demand (via more stimulus bills and other govt action).

    I agree that converting from paper to electronic money has an upside; but it use to be there was a limit on how much money you could steal. Even a big strong football star like yourself would have a problem carrying a billion dollars. Now a small nerdy hacker can electronically transfer than amount with a couple of key strokes AND the right security intel.

    Bottom line is most big debtors (like the US govt) want more inflation so they can use cheap future dollars to pay back more expensive currently borrowed dollars; and the govt is in a position to create inflation.