Transcript: Inflation and Corruption

Today on the podcast, Inflation and Corruption

Here is the conventional conversation from Boomberg:

IRVING

That's William Irving of Fidelity Investments, with Bloomberg's Tom Keen and Michael McKee.

No, Inflation is not the problem. Inflation is rarely the problem. It can be the symptom of a problem, however, and this one is serious. Low inflation is a symptom of stagnation, decline and dropping incomes.

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Inflation is a rise in prices -- a general rise in prices. We often hear of specific sectors having inflation, health care inflation, house price inflation. Analysts across the globe get paid good money to tease out the different components of inflation.

For example, this month's drop quickly spawned the chart at the bottom of today's transcript which shows most of the drop due to energy prices, and a simultaneous bump in transportation costs -- probably airfares.

One useful thing to come out of the idea of inflation is the idea of "real" versus "nominal." "Real" means adjusted for price rises. So it is a relative term. Incomes are down for households relative to a basket of goods, for example. Or health care is up in "real terms." Bad example. Health care is way up in price terms, that is, relative to other goods and services. In GDP  it is measured in terms of inputs rather than outputs, and outcomes have not improved, arguably the rise in health care since the early 1990s is entirely inflation. A "Real" GDP would erode by, what, seven, eight percent?

Economic science is in Bavaria with Dr. Frankenstein creating a monster out of inanimate body parts when it comes to inflation. They have created an immense and destructive and demonic force and set it loose on the population when they give inflation a life of its own. Inflation is a general rise in prices. A price rise. Nothing will be captured and eaten or infected by inflation. Perhaps it feels like an evil conspiracy. Not when it is your own income that is rising, of course, but price rises need to be looked at directly, and price declines likewise. Where do they come from? Why are consumer prices falling? And so on. If we do not do this, and do not investigate honestly the price changes, and imagine there is a dragon of inflation to be slain, we will make mistakes. Paul Volcker proved that when in trying to kill inflation in the 1970's and early 1980's, he actually killed the economy. Or damaged it considerably, at least.

So long as incomes are not the price that is falling in relative terms, we are better off.

What is a healthy inflation? There IS such a thing. A healthy inflation is whatever it needs to be to accommodate full employment and rising real incomes.

A healthy inflation typically arises with investment, which employs workers in the investment goods sectors, building plant and equipment, structures, infrastructure, schools, and other non-consumer goods. Wages are bid up and demand for consumer goods is increased. Such inflations are short-term, although one may follow another with a new round of investment. Typically there are no wide swings. Short term, since production will expand to meet the new demand. Such healthy inflation has happened here in the U.S., but not since the end of the 1960's.

A deflation indicates no investment, no growth, declining employment. A deflation is one form of very unhealthy inflation. Existing debt contracts are more burdensome. All workers get concentrated in the consumer goods sectors. Wages decline.

There can be situations where the money itself loses its value because it is debased by the government and another money is used.

If we were to get investment, public or private, and with it, low unemployment, employers must often offer better deals to attract or retain the workers they need, sometimes substantially better deals. Incomes go up. If there is substantial investment, then there is a substantial number of workers not involved in producing consumer goods but getting incomes to bid for consumer goods. Price rises attract new entries or offerings, more investment, more wage pressure. Workers buy houses, more investment, more wage pressure. That is the nightmare scenario. Wouldn't it be nice?

If we ever get around to saving the planet for human habitation, part of the experience of paying for it will be a rise in relative prices for food and transportation. That would be healthy.

Of course, in an open economy the demand for consumer goods may be filled from outside the country. In such a case, in the standard theory, the extra demand would change the exchange rates so that trade was more or less balanced. That is, prices would rise just as in a closed economy. Not in the U.S., of course, which has run immense trade deficits for decades without materially changing the exchange rate. We've been net importers big time ever since the Reagan years. If the Saudis and the Chinese are going to take green paper for real stuff, we're going to let them. Keeps inflation down. Doesn't do much for employment, but hey, I have a job.

Inflation. Does it spiral out of control? No. It does not. Not investment led wage pressure inflation. Again, things get problematic when exchange rates get into the picture. PRICE RISES NEED TO BE LOOKED AT DIRECTLY AND INDIVIDUALLY.

Productivity, as we have pointed out, rises when employment is tight, mitigating wage pressure, as workers are shifted to the most productive activities, plants are used to capacity, innovation spreads, new tools -- capital -- is substituted for labor.

But as I said, we haven't had a healthy inflation for a long, long time, since the turn of the 1970's.

What have we had?

Two oil shocks in the 1970's, one under Nixon and one under Carter -- with the Iran oil embargo. OPEC set quotas, prices rose, other forms of energy -- electricity, natural gas, coal -- followed the oil price up. This mimicked the demand side inflation pretty well, since energy is the most ubiquitous economic commodity aside from labor. Let's call this energy price rise cost-push inflation.

As prices rose from the energy price spikes, workers demanded more in wages to compensate. This became known as the wage-price spiral. Workers were excoriated for their greed. Those without bargaining power saw their real incomes drop. The heavy guns were called in.

Early on, Richard Nixon established the wage-price freeze. A success in wartime, under Nixon in peacetime it was a failure. Long lines and short tempers at gas stations were broadcast by the yet-to-be-domesticated media as images of scarcity and desperation. The wages and prices that were successfully frozen simply waited until the freeze was lifted and shot up at once. Few of his advisers saw it as a success, and fewer still were on board for the second, and even less successful freeze. Inflation became the dragon, a powerful and evil force. Not just the impact of oil and energy prices that needed to be absorbed or somehow reduced.

The high energy prices hit producers, too, along with the bite out of consumer demand. The way some found to curb labor demands was to lay off workers. Meanwhile the uncertainty made people cautious. Rather than rush to the store before their money lost its value, people saved. In the face of the inflation goblin, the savings rate throughout the 70s rarely dropped below 10 percent. See the chart online.

Of course, savings were attracted to sweet interest rates offered by banks who needed the money, as well. Long-term financing at low rates was suddenly a loser. Banks scrambled to get short-term funding to retool. The financial community was up in arms. Then Paul Volcker listened to Milton Friedman and put the clamps on the money supply. "Inflation is always and everywhere a monetary phenomenon," said Friedman. To heck with this trying to deal with specific prices. Just reduce the quantity of money. Now long-term financing at low rates was REALLY a loser because interest rates took off for another level. Cocktail parties divided into clatches to twitter where the latest best certificate of deposit could be found. 16%? 20%? Not out of reach. Unemployment moved higher, Latin America defaulted, a ragged horde of homeless finally took the field and defeated inflation.

Which is to say, Volcker's interest rates dampened demand enough that oil prices backed off. When prices fell, more production came on line to keep up revenues to oil producers. Prices fell further. Interestingly, the Fed's control of the money supply fell victim to the credit card. Also, interestingly, the wave of deregulation began during this period, when Jimmy Carter's efforts to attack inflation proceeded along the theory that increased competition would drive down prices. Alfred Kahn, his inflation czar, sold the deregulation of airlines, and essentially raised the banner that would be taken up by Ronald Reagan and subsequent anti-government champions.

This period marked an inflection point in the growth trend, which bent to half its previous slope, as well as real household incomes. Personal income stagnated. Although Volcker was let go -- not re-hired -- by Reagan for his unwillingness to get with the program, and deregulator extraordinaire Alan Greenspan taken on, the Fed was always at the ready to raise interest rates should any inflation take off.

Looking back, we can see that raising interest rates into higher oil prices is not a recipe for killing inflation, but for killing the economy. Nevertheless, Greenspan repeated the exercise in late 1999 and early 2000. The failure to understand cost-push inflation, when cost shocks need to be absorbed, from demand pull inflation is one error that continues to plague economists today, with crippling consequences. Another is to think that inflation is a monetary phenomenon, in spite of the rude experience of the Volcker Monetarist experiment and the more recent absence of reaction to Fed easy money for the past five years.

That famous stagflation was used to evict Keynesian influence from public policy, except as expressed by Congressional Democrats. Inflation had not been accompanied by economic expansion and this was outside the norm and supposedly outside Keynesian thought. Thus ended the liberal period of economics, which had lasted from the New Deal. Alfred Kahn described himself as a liberal. Most economists did. Probably not the case today.  Another interesting note. Unions at the time negotiated the COLA, cost of living adjustment, which is still around, if in a dormant state. Business assured the nation that cost of living clauses would embed high inflation into the economy, essentially institutionalize the wage-price spiral. Didn't happen. Actually, such clauses soon became widespread in many other kinds of contracts as well. Apparently distracted by other things, Inflation receded.

Another effect of stagflation and the Volcker-Reagan recession: the rise of the two-earner household. What do you do when your incomes are being held down as prices are going up. You add another income.

So that was one episode. There are others, many of them connected to oil prices. Bill Clinton enjoyed strong economic growth with low inflation partly on account of LOW oil prices, thus low energy prices. Before market manipulation on the grand scale we see today, with the Goldman Sachs traders, you saw all energy prices moving together. Now oil stays up, or actually fluctuates, as it is milked by futures market manipulators.

The point is here ...

Well, we should mention the most dramatic post-war inflation, which was just after the war. The wage and price controls that were in place during the war came off. American producers had huge markets in Europe for their products, agricultural products, in particular. A farmer could make ten percent by simply holding his produce off the market for a month. Inflation ran to 30 percent for almost a year, if I am not mistaken. The call went out to shut down the economy. Truman and his chief economist Leon Keyserling declined the invitation. At that time, the Fed and Treasury operated together, so you didn't have the Fed going off by itself as with Volcker. In any event, the speculation broke. Prices came down. Production went up. The economy was off and running. The effective rate on government and other debt was cut, as well, by this inflation.

Be aware that when you see inflation -- so-called -- from the influence of oil prices, the influence is upside down from labor tightness inflation. Not only do energy price rises take a bite out of people's discretionary incomes, when high employment increases incomes, but high oil prices actually push wages down. That is, since everything is made from energy and labor, to keep prices stable, one must go down if the other goes up. Add to this the fact that energy production is a low-employment resource extraction industry, and much investment is high employment construction, and you have the recipe for stagnation.

(I know we're all supposed to applaud the North American energy boom as a jobs producer, but that is basically bull. Many of these jobs are short term, and when they leave, the industry is among the very lowest in labor income. Fewer jobs per dollar. The clean-up, I suppose, as with the nuclear industry in Eastern Washington, will produce jobs on the public's dime. Hmmm. Maybe flammable tap water is not such a high price to pay.)

In any event, the inflation story is a jumble of meaningless words the way it is being told. You have inflation hysterics out even now shaking their fists at the Fed. Although stock and bond prices are high and higher, proceeding from the enormous debt the Fed is producing out of nothing on its balance sheet, those financial assets will not show up in consumer prices because -- most obviously -- the average American never sees a benefit from rising stock prices. But also, it will never show up because healthy inflation is not a monetary phenomenon today any more than it was under Volcker.

Healthy inflation? What a concept. Investment. Higher wages and household incomes.

One more story, about healthy inflation. Or at least more healthy inflation. Under John F. Kennedy the economy was chugging along, but steel prices were rising. The US steelmakers had a monopoly on production and we actually made things here in the US. The Steelworkers union was basically splitting the monopoly profits. Kind of like if Oil had a significant workforce, oil workers could split the profits and Oil could blame its labor for the high prices. Anyway, the price of steel was going up and getting embedded all over manufacturers. The steelmakers blamed labor. Kennedy negotiated directly with Labor and with the Big Seven steelmakers. If labor mitigated their demands, then Steel agreed it would keep the price steady. Labor agreed. Big Steel reneged and announced a price rise above the target.

It occasioned one of the earliest open mic moments when Kennedy was reported to have said, "My father always told me businessmen were SOB's. I didn't believe him till now." The federal response was furious and forceful, led by Attorney General Robert Kennedy. Every federal agency from the FBI and Justice Department to Commerce and down the line was doing investigations. All federal contracts were cancelled except with the one of the Big Seven -- Republic Steel -- which had held to the target. The water got very, very hot. Big Steel capitulated. Inflation pressures eased.

A lot to be said there. I hope I haven't said too much. Inflation is not a looming danger, a dragon. It is like body temperature. It can go up because you are exercising or working hard. Or it can go up because you are sick, or because you are being poisoned. It is a price rise, not a free-standing entity that has an always and everywhere character. It is always and everywhere better to treat the cause, not the symptom.

Now, we have to comment on Tim Geithner moving into collect. Not that Tim is alone. And that is the problem. Never having worked on Wall Street, officially, the former Treasury Secretary and New York Fed president has found the nest properly feathered at leveraged buyout firm Warburg Pincus.

Carried Interest

While buyout firms such as Warburg Pincus suffered when the financial crisis froze credit markets and the value of holdings plunged, they didn’t require bailouts like banks that had used their balance sheets to load up on mortgage securities. The industry has largely avoided tighter regulation, even as taxation of the firms’ share of investment profits, known as carried interest, came under scrutiny when Mitt Romney, the former CEO of Bain Capital LLC, sought the presidency last year.

Private-equity firms pool money from investors to buy companies within about five to six years, then sell them and return the funds with a profit after about 10 years. The firms use debt to finance the deals and amplify returns. They typically charge an annual management fee of 1.5 percent to 2 percent of committed funds and keep 20 percent of profit from investments as a carried interest. Carried interest is treated as capital gains in the U.S. and taxed at a lower rate than ordinary income.

‘Restore Fairness’

Throughout his tenure as Treasury secretary, Geithner called on Congress to “restore fairness to the tax code” by passing Obama’s proposed budgets, under which carry would be treated as ordinary income. Among the tax reform principles of the administration’s budget proposals was “eliminating the carried interest loophole that allows some to pay capital gains tax rates on what is essentially compensation for services,” Geithner told the Senate’s budget committee on Feb. 16, 2012, according to a transcript.

Arthur Levitt had this to say about that:

LEVITT

A priest or rabbi? A teacher? Heaven forbid. That is not the corrupt American way. With two kids at Stanford, you could hardly expect the good Secretary to do anything but collect. That is the American way. And Arthur Levitt:

Arthur Levitt is former Chairman of the Securities and Exchange Commission, a Bloomberg LP board member, a senior advisor to the Carlyle Group and a policy adviser to Goldman Sachs.

Oh. It IS the American way. The totally corrupt American way. Completely corrupt. That Geithner should be getting mega-bucks from the industry he supposedly regulated, after having run the New York Fed and shoveled money at Goldman Sachs through AIG, and the rest. I wouldn't mind if there was an 80 or 90 percent marginal tax rate on incomes over $2 million, including all that carried interest. Maybe then teaching wouldn't look so bad. But this is the payoff. The same under Obama as before. Peter Orzag. And don't forget Max Baucus and his staff on the Senate Health Committee moving on into the executive suites of the private health insurers. Completely corrupt. The system is corrupt. Everybody does it. So maybe that's why we've got what we've got.

Our question is, What About Alan Greenspan? All you private equity guys, you big banks. He has to live on his pension, I guess, and whatever few cents he can scare up writing bad books. Where is his nest? Here is the guy who fronted for you for so long. The guy who took the chainsaw to regulation when others just posed. Here's the guy who let mortgages find whatever mutation was most lucrative and as the banks' chief regulator saw nothing valuable in regulation. Bad forecasts, bad advice. Keeping his credibility by taking credit and shifting blame. My guess is he is the scapegoat. I wonder if he still gets in to the "A" list parties with Tim and Peter?

Needless to say, if Timothy had done his job at Treasury, he wouldn't be finding that fine feathered nest.