The things that you think CAUSE inflation are merely the symptoms of price stickiness

Some people liked my previous post, while some missed the point.  So let’s take another stab at it.

My island economy with 100,000 people and $1 billion dollars in Monopoly money does just fine for 273 years, with NGDP fluctuating above and below $8 billion as velocity moves around due to random minor shocks.  Then another crate of Monopoly money unexpectedly washes up on the beach, doubling the money supply to $2 billion.  The public is not stupid; they understand the implications of this monetary shock.  They know that prices will double in equilibrium, so they immediately start charging twice as much for the commodities they sell.

Is this “rational expectations” assumption realistic?  I think so.  I’m pretty sure than when the Mexican government does a 100 to 1 currency reform, an uneducated woman in Oaxaca selling strawberries to tourists will immediately cut the peso price of her strawberries by 99%, even though the Mexican government has no law requiring that lady to charge any particular price for strawberries.  (Someone correct me if I’m wrong.)

Now let’s say I am wrong about rational expectations and flexible prices.  Then what?  Let’s say the people who live in my island economy are a bit “slow” and don’t understand that the extra $1 billion in Monopoly money that washed up on the beach will soon cause the price level to double.  What then?  In that case you get an overheated economy, with excess demand.  The price level does not immediately double; rather it doubles over a period of weeks or months, as people eagerly spend their new wealth on goods and services.

Only an idiot (or a brilliant saltwater economist) would think that this excess demand is causing the inflation.  Indeed if there were no excess demand we’d be back in the currency reform case, where prices immediately double.  The excess demand resulting from sticky prices is actually slowing the upward adjustment in prices.  The inflation is clearly caused by a doubling of the money supply in both the rational expectations and the sticky price case, it’s just that with sticky prices it takes a bit longer to occur, and excess demand for goods is a side effect.  But it would be idiotic to claim that this excess demand causes the inflation.  It’s a symptom of price stickiness.

Now let’s add wage earners and sticky wages to our island economy.  After the crate washes up on the beach, firms eagerly produce more as demand for their goods rises and wages are temporarily fixed.  Hours worked increase.  But only an idiot (or a brilliant saltwater economist) would claim the tight labor market is causing the inflation.  If wages were not sticky and the labor market cleared then the inflation would actually happen even more rapidly, indeed it would happen immediately if both wages and prices were flexible and people had rational expectations.  Sticky wages slow the inflation process and lead to labor shortages.  Labor shortages are a symptom of sticky wages.

Now let’s add a financial market to the island economy.  After the crate of money washes up on the beach, the lucky islanders who first discover the crate have more money than they wish to hold.  They exchange this money for other assets, which depresses interest rates.  Of course eventually prices will double and then they really will be happy to hold twice as much cash as before.  Interest rates will return to normal.  But during the transition period the interest rate will fall, which depresses the velocity of circulation.  The reduced velocity slows inflation.  So money is not neutral in the short run.  But only an idiot (or a brilliant saltwater economist) would claim that the lower interest rates cause the inflation.  Indeed if interest rates did not decline and velocity stayed the same, then prices would rise much faster.  The tendency for interest rates and velocity to initially decline due to sticky prices actually slows the upward adjustment in prices.  It’s merely a symptom of price stickiness, not an underlying cause of inflation.  The inflation is caused by a doubling of the money supply. Lower interest rates are a symptom of sticky prices.

Look, I’m a market monetarist, not a new classical economist.  So obviously I think sticky wages and nominal debt contracts are really important.  But they are not important because they explain how money causes inflation—the flex-price classical model does just fine in that regard—they are important because they help us to understand all the nasty side effects from unstable money.  Those real world side effects are extremely important, far more important than the inflation itself.  (Hitler was a side effect of German tight money.)  But they are not the underlying cause of the inflation (or the NGDP growth), they are symptoms.  This makes excess demand/Phillips curve/interest rate theories of inflation doubly wrong.  Not only do these factors not cause inflation, to the extent they are important they actually slow the inflation process resulting from monetary shocks (shocks to the money supply or money demand).

PS.  People please read what I wrote, not what you think I wrote.  I never said saltwater economists were idiots, I said “idiot or a brilliant saltwater economist.”  These guys really are brilliant.  The word “or” has a very well defined meaning, please use the correct definition.

PPS.  Why did brilliant saltwater economists fall into the trap of confusing symptoms and causes?  First, because these symptoms often result from inflationary monetary shocks.  (Confusing correlation with causation).  And second, they are confusing demand shifts with “excess demand”.  Think about a microeconomic analogy.  If there is a shortage of bottled water in Florida after a hurricane, and water prices are gradually rising to equilibrium, the rising water prices are not caused by the shortage of water; indeed prices would be even higher if there were no excess demand.  The rising water prices are caused by more demand for water.

Similarly, inflation is caused by either more supply of money or less demand for money.  All the rest is symptoms.

Money/macro needs to go back to basics

Imagine an island with 100,000 people who are all self-employed. They produce 43 commodities, such as food, clothing and shelter, and exchange the commodities with each other. There is no financial system and obviously there is 0% unemployment—how could a self-employed person be unemployed? To avoid the inconvenience of barter, they adopt some form of money—it might be silver coins or it might be a crate of Monopoly money that washed up on the beach.

How do we model the price level? Certainly not with interest rates or a Phillips curve!  There are no interest rates and there is no unemployment.

It’s easiest to start with NGDP, and then work backwards to prices. Suppose people prefer to hold 12.5% of their annual output/income in the form of money balances. That 12.5% represents the inverse of velocity (i.e. 1/V). In that case, V will be 8 and NGDP will be 8 times the money supply. Thus if the money supply is $1 billion, then NGDP will be $8 billion, or $80,000 per person. Now let’s model the rate of inflation:

Inflation equals NGDP growth minus RGDP growth

NGDP growth will be growth in the money supply plus growth in velocity. RGDP growth is determined by non-monetary factors. There’s your basic model of inflation in the simple island economy.

Now let me immediately acknowledge that the real world is very complicated, and this makes it hard to model V. Workers are usually not self-employed–they work for companies and have sticky wages. Labor markets don’t always clear. There are also financial markets, and the nominal interest rate can have a big impact on velocity (especially at the zero bound). But no matter how important these extra factors, they are still basically epiphenomena—the core of monetary economics is all about shifts in the supply and demand for money—it has nothing to do with the Phillips Curve or the liquidity effect from interest rate changes. Call the supply and demand transmission mechanism in my simple model, “Mechanism X”. That’s still the core transmission mechanism in our modern economy; it doesn’t go away just because you add sticky wages and interest rates. It’s just harder to see.

Where did modern macro go wrong? Perhaps when they made these liquidity effect/Phillips curve epiphenomena into the center of their models of the transmission mechanism. We don’t need Phillips curves or interest rates to explain why more supply of peaches and/or less demand for peaches reduces the relative value of peaches, nor do we need Phillips Curves or interest rates to explain why more money supply and/or less money demand reduces the relative value of money. We need to go back to basics.

Matthew Klein has a good article in the FT, pointing to the fact that modern macroeconomists are floundering around, unable to explain recent trends in inflation. He begins by quoting Olivier Blanchard, who states the conventional New Keynesian view:

I have absolutely no doubt that if you keep interest rates very low for long enough the unemployment rate will go to 3.5, then 3, then 2.5, and I promise you at some point that you will have the rate of inflation that you want.

-Former International Monetary Fund Chief Economist Olivier Blanchard

Japan has kept rates very low for a very long time, and still has low inflation. Their unemployment rate is only 2.8%. Sorry, but interest rates and the Phillips curve are not reliable models of inflation.

Now of course these elite NKs are very smart guys, and they did not develop these models for no reason at all. In the short run an easy money policy often (not always) leads to lower short-term interest rates. But over longer periods of time it often leads to higher nominal interest rates. The point here is that it’s the easy money policy that matters, not the interest rates. An easy money policy will lead to higher inflation regardless of when whether it causes lower or higher interest rates. The easy money policy of 1965-81 led to both higher interest rates and higher inflation. Switzerland’s tight money policy of January 2015 led to lower inflation and lower interest rates–even in the short run. (Yes, the NeoFisherians are occasionally correct.)

The same is true of the Phillips curve. It worked OK for many years, especially under the gold standard.  The Phillips curve still “works” in places like Hong Kong. A low rate of unemployment is indeed often associated with higher inflation. But it did not work during the 1970s in America, when unemployment and inflation rose at the same time, or in the last few years when inflation has stayed low despite unemployment falling to 4.2%. And that’s because it’s not the core transmission mechanism for inflation, the core mechanism is the supply and demand for money. Changes in inflation may or may not be related to interest rates or unemployment, but they are always related to what’s going on with the supply and demand for money.

Unfortunately, this confusion has led Blanchard’s opponents to go even further off base:

Blanchard was prompted to recite his faith in the power of the Phillips Curve by former Fed governor Jeremy Stein, who wondered how central banks were supposed to raise their inflation target to 4 per cent when they are still undershooting the current target of 2 per cent. Blanchard seemed to think the answer was easy: keep rates low, unemployment will fall, and inflation will necessarily accelerate.

Larry Summers — Blanchard’s co-host at the conference and co-author of one of the papers — found this hopelessly inadequate. He pointed to Japan’s long experience with full employment, large government budget deficits, aggressive monetary expansion…and total price stability. If they haven’t managed to get inflation, how could anyone? Blanchard had no answer but to repeat his catechism.

This literally makes me want to pull my hair out. Indeed Stein’s argument is not even logical. Suppose someone were halfway between Baltimore and DC, driving south, and the passenger said “What makes you think you’d be capable of driving this car to New York, when you haven’t even reached Baltimore”. My response would be “Umm, I’m not trying to reach Baltimore. If I wanted to reach New York I’d turn around and drive north. I’m driving south.” My response to Stein would be to point out that if the Fed wanted higher inflation it would not be raising interest rates with the publicly expressed purpose of holding inflation down. Rightly or wrongly, the Fed believes that if it raises interest rates it will achieve 2% inflation, and if it does not raise them then inflation will overshoot 2%. They may be wrong, but this has nothing to do with monetary policy being impotent. It’s a question of whether they are steering in the right direction.

I could have also responded, “I have decades of experience driving cars, I’m pretty sure I’m capable of driving this car to New York.”

I’m not sure if people realize just how radical 2% trend inflation is. If you had told Keynes that central banks could target inflation at 2% in the long run he would have laughed—he would have regard you as a fool. Throughout almost all of human history the long-term trend rate of inflation was either near-zero (commodity money) or wildly gyrating (German hyperinflation, post-Bretton Woods “Great Inflation”, etc.) Then around 1990 the Fed started trying to stabilize inflation at about 2%. Since that time, inflation has averaged about 1.9%, amazingly close to 2%. This isn’t some sort of weird miracle; it’s happened because the Fed controls the long-term trend rate of inflation.

If the Fed wants 4% trend inflation, they’d go back to Volcker’s policy from 1982-90, when inflation averaged 4%. This is not rocket science; other countries have also been able to target inflation.

Japan can’t create inflation? Really? What if they devalued the yen from 112 to the dollar to 600 to the dollar? No inflation? Then what about 6000 yen to the dollar?

Inflation is always and everywhere a money supply and demand phenomenon.  (I prefer that to Friedman’s, “Persistent inflation is always and everywhere a money supply phenomenon.”  Which is basically what he meant in the quote often attributed to him)

HT:  Caroline Baum

Why John Taylor might be a good choice for Fed chair

I’ve done a few posts expressing opposition to Kevin Warsh being nominated to chair the Fed.  Now there are rumors that John Taylor’s stock is rising:

Stanford University economist John Taylor, a candidate for Federal Reserve chairman, made a favorable impression on President Donald Trump after an hour-long interview at the White House last week, several people familiar with the matter said.

Former Fed board governor Kevin Warsh has meanwhile seen his star fade within the White House, three of the people said. They would not say why but Warsh’s academic credentials are not as strong as other candidates, and his tenure on the Fed board has been criticized by a diverse group of economists ranging from . . . [obscure nobodies] . . . to Nobel laureate Paul Krugman.

I had several problems with Warsh.  He doesn’t have expertise on monetary economics, he didn’t do well during his stint at the Fed, and I worried that he might be more “political” than Bernanke and Yellen.

I have much less concern about Taylor.  I believe that Taylor (and most other conservatives) missed the boat during the Great Recession, and was excessively worried that QE would lead to high inflation.  But he is also extremely smart and well-qualified, and a person who is likely to keep the Fed out of politics.  While the Taylor Rule is not the specific policy I favor, he’s a strong advocate for a rules-based approach.

Here’s why I think Taylor might be a good choice, despite my reservations about the Taylor Rule:

1.  Fed chairs are generally not dictators, but work with a very well entrenched Fed establishment.  Thus I would not expect Taylor to come right in and install the Taylor Rule.

2.  Point one might seem like a weak argument in his favor, but I’m also thinking about the fact that the current Fed is not sufficiently rules-based.  If Taylor and the Fed met halfway, it might well be a policy I could support wholeheartedly. In other words, I see Taylor as someone who might nudge the Fed toward a more rules-based approach.

3.  The Fed has a 2% inflation target, and I’d expect Taylor to take that target quite seriously.  Thus I’m not all that concerned about whether policy is “hawkish” or “dovish”, I want a more stable monetary regime.  It’s not the end of the world if core inflation average 1.8% instead of 2% over the next 10 years (although I’d prefer they hit their targets), but it would be really bad if the core inflation rate became highly unstable, and also procyclical.

4.  If (as I expect) Taylor were not able to immediately install his preferred policy rule, I believe he’d look to make progress in other areas.  One obvious choice would be to adopt some of the accountability measures that I have advocated.  These would make policy more disciplined and rules-based, without going all the way to a rigid mechanical formula.  Policymakers would have to provide a clearer sense of what macroeconomic outcomes they are trying to achieve, and how they see their instrument setting enabling those outcomes.

5.  Another possibility is Bernanke’s modified price level targeting proposal, which would make policy more accountable and rules-based at the zero bound.  That sort of policy would have reassured conservatives who worried about the risk of high inflation back in 2010, while actually providing additional stimulus.  Under level targeting there is basically no long-term inflation risk. Also recall that Taylor said good things about NGDP targeting during the 1980s, so that’s another possible direction for reforms.

To summarize, rather than think about a new Fed chair in isolation, we should think about the outcome of the new chair interacting with the existing structure of the Fed.  In the post title I said Taylor “might” be a good choice.  In this sort of area one can never be certain, but my instincts tell me that he’d nudge the Fed a few degrees toward a rules-based policy approach, which is exactly what the Fed needs.

PS.  Don’t take this post as an endorsement of Taylor as my first choice, rather I’m responding to the perception that I would oppose Taylor.  Not true.

The crybabies who blamed economists for not predicting the financial crisis

Back in 2008, it seems like everyone from the Queen of England on down was blaming economists for not predicting the financial crisis.  I seem to recall that Bob Lucas pointed out that economic theory explains why economists cannot predict financial crises, so our failure to do so was a feather in the cap of modern economic theory.  I also seem to recall that lots of people rolled their eyes at his seemingly too clever excuse.

In the past I’ve argued that Lucas was exactly right, but in this post I’ll assume he was wrong.  I’ll assume the EMH is wrong.  Even in that case I’m going to argue the complaints were silly, just a bunch of crybabies.

So how do I respond to those people who are moaning that we didn’t warn them that a crisis was coming?  One answer is that some economists, such as Nouriel Roubini, did issue warnings.  But then the crybabies might respond, “But most economists didn’t warn us.  How were we to know that he was the one to listen to? The economics profession as a whole should have issued a warning, so that it was unambiguously clear to the public that a financial crisis was coming.”

To summarize, a few economists did warn the public, so the crybabies’ lament only makes sense if you assume that these people wanted the profession as a whole to offer a clear credible warning to the public.  Something that would be believed.

Were you the sort of person who believed in Santa Claus, and thought he would bring you a fairytale castle floating on a cloud, with unicorns prancing about in front?  If not, why would you make such a patently unrealistic demand of the economics profession?

You wanted us to warn you that a big financial crisis was coming so that you could sell all your stocks before they went down?  I ask this because a prediction of a severe financial crisis is implicitly also a prediction of a massive asset price collapse.  So the people complaining that economists didn’t predict the financial crisis are (whether they know this or not) effectively complaining that economists didn’t warn them that their 401k plan was about to lose a few hundred thousand dollars.

Let’s suppose we have a time machine and economists from October 2008 can go back 6 months in time, to April 2008.  They are told to warn the public that a massive financial crisis is coming in the fall.  They warn the public that Lehman won’t be bailed out, and its failure will trigger a rush for liquidity and a Great Recession.  What exactly would that warning have done, other than move those events up 6 months in time?  Then the crybabies would have asked why we didn’t warn them in October 2007 (assuming they didn’t lynch the economists for causing the crash.)

And as for those stocks you were going to sell if economists had warned you of the crash—just who did you plan to sell them to?  And at what price?

A better argument is that the economics profession didn’t warn the public that public policy was creating excessive lending, as Fannie and Freddie and FDIC and TBTF were creating moral hazard.  In fact, I did warn people I met about this problem (but I completely failed to forecast the financial crisis.)  Some other economists also warned about moral hazard, but not all.  But no one wants to listen to a bunch of killjoy economists on public policy questions.  It would be like blaming economists for tariffs, or rent controls.

When I explain to non-economist commenters what economic theory tells us about some public policy, they almost universally blow off my advice, unless it coincides with their pre-existing view on that particular public policy.  No one cares what economists think, so don’t blame us for areas where we have no control.  (Monetary policy is a different case; there the economics profession actually deserves far more blame than it’s gotten from the public.)

PS.  I see that Trump threw a temper tantrum when his aides told him that Iran had been adhering to the nuclear agreement.  We now have an administration with no ability to negotiate because no one trusts them to keep their word.  The focus of his top aides is not dealing with foreign crises but rather managing unnecessary crises created by an out of control and mentally ill president.  North Korea knows we’ll renege on any agreement we sign with them, and so a nuclear deterrent is their only option.  Meanwhile they show their population images of Trump threatening to destroy their country.

Meanwhile Trump has abandoned the utilitarian approach of the Obama administration and the slaughter of innocent civilians has been skyrocketing:

Airwars reports that under Obama’s leadership, the fight against ISIS led to approximately 2,300 to 3,400 civilian deaths. Through the first seven months of the Trump administration, they estimate that coalition air strikes have killed between 2,800 and 4,500 civilians.

Trump seems like excellent black comedy to me, but unfortunately there are lots of dead women and children for whom he is no joke.

PPS:  New Flash:  Americans horrified to discover Hollywood producer behaving like a President of the United States.  Hillary and Fox News particularly disgusted by this behavior.

PPPS:  Another gem:

Speaking over the phone, Mr Reich said he asked his friend whether other Republican senators were preparing to follow Senator Bob Corker and “call it quits with Trump”.

His source told him: “Others are thinking about doing what Bob did. Sounding the alarm. They think Trump’s nuts. Unfit. Dangerous.” . . .

“Tillerson would leave tomorrow if he wasn’t so worried Trump would go nuclear, literally,” he added.

“Who knows what’s in his head? But I can tell you this. He’s not listening to anyone. Not a soul.

“He’s got the nuclear codes and, well, it scares the hell out of me. It’s starting to scare all of them. That’s really why Bob spoke up.”

Trump ran for President as a crazy man, and we are shocked to discover he is governing as a crazy man?

No matter how cynical I get, I can’t keep up

Commenter Ben Cole likes to point out that the Wall Street Journal was dovish when Reagan was President, but then became hawkish under Democratic Presidents.  It looks like they are back to their old tricks:

But Mr. Trump is counting on tax reform and deregulation to boost growth to 3% a year from 2%. If that growth happens, the Yellen-Powell Fed may believe it has to raise rates rapidly, endangering faster growth. Guess whose policies will be blamed? Not the Fed’s.

This is why the old “hawk vs. dove” monetary debate isn’t all that relevant at the current moment. Outsiders like Messrs. Warsh and Taylor, or Columbia’s Glenn Hubbard, believe that tax reform and deregulation can increase the economy’s capacity to grow above 3%. They therefore might raise interest rates more slowly than the Yellen-Powell faction would.

Translation:  Now that we have a Republican President we need easy money to hide the fact that Trump’s “pro-growth” policies are likely to fail.

They are right about one thing, with a 2% inflation target the question of hawks and doves becomes far less important; it’s really about competence vs. incompetence.

PS.  I wonder what John Taylor thinks of the WSJ claim that he’d be more dovish than Yellen.