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Wednesday, June 3, 2009

Inflation Narratives

The standard narrative about inflation runs something like the following:

Modern inflation began in the Guns and Butter days under Lyndon Johnson, when the Vietnam War and the Great Society competed for labor and drove prices up. This was not entirely unintentional, as Keynesian advisers to Ke
nnedy and Johnson, people like Arthur Okun and Paul Samuelson, convinced the presidents that by allowing a little bit of inflation, unemployment could be brought down. The standard narrative says that, with a modest assist from the oil shocks of 1973 and 1979, things just got out of control.

Riding to the rescue was Fed Chairman Paul Volcker, who with noble determination squeezed the quantity of money until the double dip recession of '80-'82 destroyed enough demand to bring down prices.

Since that time, the vigilant Fed has jacked up interest rates at the first sign of inflation and generated the so-called Great Moderation -- low inflation and steady growth.

The Great Moderation continued until the current crisis.

This trail of conventional wisdom then disappears into the tall grass of confusion over why prices rose between the onset of the recession late 2007 and the middle of 2008 and then collapsed. The confusion is minimized by ignoring the facts and emphasizing alarm over the financial collapse.

But it reappears in a general concern and even paranoia that immense monetary easing will sooner or later and probably sooner create a burst of inflation that will carry the country into the abyss. Meanwhile there is no real need to panic about deflation, since the Fed is doing so much, and after all it is mild and even more What's wrong with falling prices anyway?

So many points, so little time.

First of all, the Kennedy-Johnson inflation was the last demand-pull inflation. Johnson instituted a ten percent income tax surcharge to deal with it.

Separating that time from the present is the 1970's, first with Nixon's ill-conceived and disruptive wage-price freezes and cutting loose the currency from the Bretton-Woods scheme. Then by the two great oil shocks of 1973 and 1979.

The use of the interest rate, or in Volcker's case, the quantity of money, to dampen inflation runs into many practical problems, but it is well supported by academic and financial sector advocates. One problem is that inflation has more often accompanied recessions than booms since 1970, since the fact is that most inflations have been pushed by costs -- primarily oil costs -- not pulled by demand as in the 1960s. Another problem is that raising the cost of money, i.e., the interest rate, increases costs and hence puts upward pressure, not downward, in the short term. Another is the use of the CPI and so-called Core CPI to segregate prices. Some prices -- like those of assets -- housing and stocks -- escape inflation measures altogether.

A Tale of two impotences.

Paul Volcker in 1979 took Milton Friedman's theory of Monetarism and ran with it, constricting the money supply ruthlessly to wring inflation out of the economy. Interest rates climbed into double digits. Cocktail party chatter in the 1970s was not about houses, but about where to find the latest, best sixteen or twenty percent bonds. Savings and Loans -- the Thrifts -- were caught in the vise of low long and high short rates. Rather than deal with insolvencies, the response was to deregulate and hope the S&Ls could innovate a way out. The bailout of these institutions at the end of the 1980s showed the effectiveness of this strategy.

Earlier in the 1980s the Latin American debt crisis had brought the big banks as close to insolvency as they are today.

And while the determination of Volcker the general is praised by all to this day, it was the millions of unwilling draftees in unemployment lines around the country who actually won the war on inflation.

The second impotence is Ben Bernanke's. His response to the collapse of asset prices and incipient deflation has been historic monetary easing. Most observers suggest Bernanke was a bit slow out of the gate, but has been charging hard ever since. After twenty months, the big banks are zombies and a couple have gone under, even at the expense of unprecedented taxpayer bailouts. The economy is in negative growth territory.

This second impotence followed twenty years of speculation in stocks and then houses and by a general submersion of the society -- household, business and government -- into debt.

A collapse in asset prices destroyed trillions in paper wealth. We suggest the residential investment figures of the past six years be recalculated to reflect actual values. These trillions in paper wealth were the collateral for the debt balloon. The financial sector's fiasco has loaded onto this a credit crunch.

So the policy response from the Fed under Bernanke is precisely the opposite of that under Paul Volcker, but parenthetically the same as that under Alan Greenspan. Every effort is being made to expand the money supply in hopes this will bring down interest rates, create lending and borrowing, or just stimulate an inflation that will carry asset prices back upward. Simultaneously the Fed and Treasury are inventing new ways to float the banks off the rocks into which they steered themselves. Most of these involve swapping the bad decisions the banks made for taxpayer-backed bonds.

The housing asset has not stabilized, and continues to fall, although bailouts have specifically stabilized the housing-backed securities. Stocks appear to have stabilized, although money has to go somewhere, and the great infusion of liquidity will seek a rising asset.

The Fed's money creation continues apace.

Let's go over this territory one more time.

The inflation of the 1970s and 1980s began with the Guns and Butter demand pull inflation of the Johnson years, but erupted under Nixon and then Carter. Long after demand-pull was over, inflation continued because of the oil shocks of 1973 and 1979. The remedy for inflation did not change. Raise interest rates and the cost of money. The solution to inflation was income suppression under harsh monetary restrictions. The trend level of growth of the society as a whole came out of the 1970s at half the pace it went in. Real median income growth per capita stagnated. Income disparity began to rise. Borrowing and financial games replaced real economy production. It is also no accident and is a direct result of the high dollar that the U.S. was de-industrialized during the 1980s.

Let's leave for another day the arcane B.S. that has grown up over inflation, such as the Phillips curve, the Non-Accelerating Inflation Rate of Unemployment -- NAIRU -- sometimes referred to as the natural rate of unemployment, Core Inflation v. Headline Inflation and so on and so on.

Let's just take a direct look at the inflation experience on its own terms. What is inflation? It is a generalized rise in the price level. Energy costs or upward pressure on wages from tight labor markets can push a broad range of prices up. Nothing is so effective in being universal, of course, across goods and services as the price of money -- the interest rate.

Leaving aside its effectiveness in curbing demand or any other consideration, you have to admit that increasing interest rates increases the costs of doing business. If costs are translated into prices -- as we at Demand Side suggest they often are -- then the Fed's tool for fighting inflation only exacerbates it, at least in the short run.

Other than those for energy, labor and money, it is hard to think of other prices which cause generalized inflation. Health care? Perhaps. But the experience of inflations has often been the experience of a single price rising and dragging others up. Like energy.

And as we mentioned, some prices escape notice by the CPI entirely. The great price rises in assets of the stock and housing bubbles are not suppressed by the Fed, but encouraged. Stocks and Housing led to enormous financial suffering, but the rise in their prices was hailed as wealth, prior to the crashes.

If those assets were included in the CPI, you can bet the Fed would have jacked up interest rates long before anything go out of hand. And we suspect it would have been effective in forestalling economic problems. As it happened, however, easy money stayed in place right through the bubbles and fueled the expansions. Likewise, the Fed's cheap money policy was right at hand for the Commodities Bubble.

Perhaps we should suggest this to Bernanke and Greenspan as an early warning system for bubbles. Both have expressed their inability to sense them in real time.

Other prices, like those for health care, have risen strongly and consistently and are included in inflation measures. But they are not -- or have not been until recently -- taken on their own terms. Instead, so long as wages and other costs can be squashed enough to make room, they are accepted.

And what of the price of labor? Once upon a time wages rose at levels above inflation. Inflation was simply calculated as wage increases minus productivity increases. This led to, of course, prosperity and strong growth. As demand side economics direct it to.

Now wages lag inflation, and productivity increases are collected in profits or pay other costs. Growth suffers and prosperity is absent.

So at a minimum, when you see the word inflation or deflation, think of prices. Do not think of a phenomenon that is consistent. The post-war inflation was caused by pent-up demand and lagging capacity. The guns and butter inflation was caused by full employment. The stagflation was caused by energy shocks in the real economy, as was the short-lived inflation of Bush I. The inflation of 2007-08 was a broad-based commodity price rise generated in financial markets.

What is ahead. Alarmists are pointing to inflation expectations grown by the Fed's aggressive easing. That is, the number of dollars is being multiplied so the dollars per good will increase. We point to the destruction of money by deleveraging, to the absence of empirical evidence, and to the likelihood that the financial sector will take the liquidity as it has in the past and play games in the markets.

It is a good thing that the much-maligned politicians are giving the real economy a little love with stimulus spending.

That's the inflation narrative, or more than one.

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