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Friday, April 9, 2010

Transcript: 369 Inflation? We should be so lucky... But there is a problem

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Today we continue with a look at the Sarkozy report on economic metrics, and we get a bit from Michael Greenberger on regulating derivatives, but first, we want to bring up a problem with inflation.

The dynamics of recovery from the Demand Side point of view involve inflation, because they involve investment. First, in the private sector, investment requires a financing structure built into the price. That is, people invest with the expectation of a return. The process is not so much different in the public sector, when investment spending has to be paid back. Both need to come from the stream of payments generated by the investment. That is, a new road must generate well-being sufficient to make it worthwhile. Cost-benefit.

But second, investment spending creates jobs in the production of non-consumer goods. When everyone is employed in the production of consumer goods, there is less demand pressure, and it becomes a simple trade of one for the other through the medium of money. When a portion of the population is employed in producing investment goods, they bid against the producers of consumer goods and may bid up the price. This is a danger in a fully employed economy, which is far from where we are today in our global economy.

Inflation is a messy thing, but it has the advantage, and we have benefited from this advantage in every post-war recovery up until now, that it reduces the real value of fixed debt contracts. It is a way of getting out from under onerous debt and getting the flow going again.

We note here that typically workers in the investment goods industries earn more than those in the consumer goods industries. Perhaps too general, but important if we want to again create living wage jobs.

We have introduced here at Demand Side the idea that government can invest. The infrastructure, education, technology changes that begin with government we think is exactly equivalent to the investment of the private sector. The only difference is that government produces public goods, and the private sector produces private goods. The difference, you will remember, is that private goods are excludable and depletable. One person or household's use of a private good by and large excludes another person or household from the use of that good. And to a greater or lesser extent, the food, clothing, technology, housing, etc., is depleted over time. Public goods, on the other hand, as described by a road, are not so excludable or depletable. The not being excludable gives rise to the free rider problem. The not being depletable means public goods are a very good deal. And the last point in this brief refresher. Taxes are the means of financing public goods. Nothing else. Taxes are not the siphoning off of the great energy of the private sector by a vampire government. Taxes are the means of creating the investment that underlies the economy's basic human and physical capital stock.

The fact that education and infrastructure, public safety and social security, underlie the rest of the economy is missed by the myopic. The leaves and branches do not grow and flourish without these roots. But let's leave that aside for today.

The point I want to make involves recovery. The dynamics of recovery involve inflation, as we said. We run a great risk when we finance the recovery spending of government by deficits, for one reason. A great part of the federal debt is short-term bonds. These will reset -- absent a coherent Federal Reserve -- at higher levels with inflation, and thus the debt service will increase. Our incoherent Fed is peopled with individuals who actually want the interest rate to rise as soon as possible to choke off inflation. We can leave that for future idiots of the week. Unfortunately the general ignorance is so loud, that when debt service increases as it will, there will be a cacophony of "I told you so's" and "Profligate government led us on the road to ruin."

Now remember, I am not talking about the current noise in the economic numbers. Many see these as a recovery, albeit a weak recovery. We see the business cycle as broken and any real recovery being delayed until we get off our butts and start investing in what we need. Then the inflation starts. Then the nonsense begins.

So, what if we were to magically be graced with an enlightened public policy? We would tax to finance the recovery. Now many, most, nearly all Keynesian voices will be heard to object. Taxation will reduce demand. I can hear it now. But this is not the case. Why? Because Keynesian stimulus relies on the multiplier. The general idea of the multiplier is that it operates on deficits and that tax cuts are as good as spending increases when it comes to stimulus.

This is not true. Government spending and investment by the private sector both involve creating jobs which create a full spectrum of spending.

Back up. The multiplier works by the logic that one person's spending is another person's income. The multiplier gets bigger when the second person spends his income. This is why we target the lower income levels. They will spend their income. This why we want to create jobs with spending. The workers will spend most of their income. Even if they save five percent it is a lot less than will be saved if there is a tax cut. That is marginal income that people will tend to save as much as possible.

The second and third steps in the pass-through of the stimulus spending are critical. Our society is so burdened with debt and so unequal in income, that before many steps go along the spending is drained off into debt payments or saved in some way by the wealthy and advantaged. Public sector spending has a very high multiplier because it is very much concentrated on jobs.

But, unfortunately, we are not graced with an enlightened public policy. Most recovery spending will come out of deficits, borrowing, and the prospect that any recovery will be choked off by hysterical responses to inflation is almost a sure thing.

We went on longer than we meant to. But we did not want to continue to advocate for inflation as an essential part of any recovery process without bringing out this very serious drawback. It's effect on the short-term debt of the federal government and on subsequent debt service payments.


Of course, the preceding discussion treats inflation in its demand-pull form, a form we haven't seen since the 1960s. Recent bouts have had to do mostly with oil prices and commodity speculation, cost-push. You'll remember the great commodity bubble of 2007-2008 culminating in $147 per barrel oil before it collapsed. That created heavy inflation. Right in the middle of the housing bust. And such is likely to be any future inflations.

When you have oil spiking, you have a siphoning away of demand as it goes to filling up the tank. At the same time, you have a Fed which cannot see inflation as anything other than demand pull, and a bias from the nabobs to raise interest rates. This is exactly what Alan Greenspan did in late 1999. He saw inflation. he ratcheted up interest rates. We had historically high rates and then the dot.com crash and historically low rates. In an earlier form, we at Demand Side predicted the end of the so-called New Economy based on that action from the Fed. That myopia.

To some extent, higher interest rates would help. It would reduce the backdoor bailout to the banks and force them into real lending. It would assist those who are trying to save and prevent some of the stock market enthusiasm.

But let's move on. Here is today's audio, again from the Roosevelt Institutes's Making Markets Be Markets symposium, which we are putting up over the next week or two on the blog. Today is a clip from Michael Greenberger's presentation on derivatives. All of these are up on the main feed at demandside one word. On the blog we have embedded the video in the post, in case you want to see the visuals. Since we have some extra bandwidth this month, we'll put some of them up on the two word demand side feed.

Michael Greenberger.

Now, to continue the discussion of the Sarkozy Report, and some resonance with what we were talking about earlier. We've taken up the shortcomings of GDP as a measure, since it is production, not income, and measures bads as well as goods. The averaging of income is not so good, we saw, in economies with high discrepancies in income. Today, what about the changes in price. Let's quote:

from the Commission on the Measurement of Economic Performance and Social Progress, chaired by Joseph Stiglitz, advised by Amartia Sen,

In all the measures we have calculated, we have taken into account changes in prices over time. We do not just measure money income. Statistical agencies calculate the increase in prices by looking at what it costs to purchase an average bundle of goods. The problem is that different people buy different bundles of goods. Poor people spend more on food, rich on entertainment. When all prices move together, different indices for different people my not make much difference. But recently, with soaring oil and food prices, these differences have become marked. Those at the bottom may have seen real incomes fall by 50% or more, while those at the top may have seen real incomes hardly affected. A price index for actual private consumption for major groups in society, differentiated by age, income, rural or urban, for example -- is necessary if we are to appraise their economic situation. Such indices are not readily available in most countries, but could be made available at moderate costs. Their development should constitute a medium-term research objective.

While the problems that are involved in constructing good indices are well understood, the rapid changes in relative prices and economic structures have meant that conventionally constructed price indices may be seriously flawed.

And it continues, noting the difficulties with assessing health care costs, the changes in quality of goods, and the problems arising when an increasing fraction of sales are done over the Internet or at discount stores.

A little dry today, but thank you for listening.

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