Economists in a bubble
I often see economists advocate inflation targeting because it is “readily understood by the public and thus highly transparent,” to quote from Mishkin’s money textbook. I’d like to argue exactly the opposite; that the public doesn’t have a clue as to what economists mean by the term “inflation,” and that NGDP targeting would be far more transparent.
Economists make the mistake of assuming that the average person looks at the world the way they do. Not so. I used to ask my students the following question:
If all wages rise by 10% and all prices rise by 10%, has the cost of living actually increased?
In every class almost everyone says “no,” even though the answer is obviously yes; the cost of living would have risen by 10%. Now Bentley students are way above the national average according to metrics like average SAT, so perhaps a more representative sample would answer differently, but I doubt it. I see all sorts of signs around me that the public interprets the term ‘inflation’ very differently from the way economists do.
1. The sort of inflation that seems to most upset the public is higher prices caused by supply shocks, such as a sharp rise in energy prices caused by reduced output. The public believes that their living standards are falling because prices are rising. But economists think that is totally wrong. Suppose a supply shock caused 5% CPI inflation in a year when incomes rose 3%. That means real income falls 2%. Economists would say the fundamental problem was falling RGDP, and that inflation had nothing to do with the public’s welfare loss. Indeed if the Fed had held inflation down to zero percent when oil prices soared, then real incomes would have fallen 2%, even if money was completely neutral in the short run. In practice, real income would have fallen even more sharply, as wages and prices are sticky. So to the extent that inflation affected consumer welfare, it raised it. What’s so transparent and easily understandable about that?
2. When discussing inflation with people I often point to the “good news” of plunging house prices. I point out that the government often misses those prices, but they do result in a lower actual rate of inflation, which is the price increase of goods and services consumed here. Admittedly people don’t buy a house every year, but that’s also true of cars, and I’ve never heard anyone argue that car prices aren’t part of the cost of living. And yet when I look in the eyes of the people I’m speaking to, they seem confused. How can plunging house prices mean lower inflation? After all, plunging house prices are bad, and lower inflation is good. People think of the cost of living in roughly the way economists think of the term “standard of living.” That’s why my students always got the question wrong.
3. Suppose inflation targeting at 2% really was “transparent, and easily understandable.” Then when inflation fell below 1%, the public would be thrilled to hear on Fox News that Ben Bernanke was going to start printing money to try to raise the cost of living of the average American. Instead they are mostly bewildered and angry when they hear the news. They read the story as Bernanke trying to lower their standard of living, even though economists view easy money as a policy that should (if it works) raise both the cost of living and the standard of living of the average American. Otherwise, why do it?
On the other hand NGDP is totally transparent. It’s easy to understand if Bernanake says he’s printing money so that American incomes can grow at a steady rate of roughly 4% per capita. If growth in average incomes has slowed due to recession, then it’s easy to understand why the Fed would think higher income growth would help the average American. Admittedly it’s a bit harder to tighten during a boom, but those are the periods where people are most content, and monetary policy is most uncontroversial.
An economist might argue that it doesn’t matter if the public is confused, what matters is financial markets. Unfortunately if the public is confused, the Fed will be trying to please two masters. They’ll be trying to boost growth to please the equity markets and unemployed workers, and they’ll be trying to hold down inflation to avoid becoming a lightning rod for public opinion. When they try to serve two masters, they’ll almost certainly end up pleasing neither. And isn’t that exactly what’s gone wrong over the past 3 1/2 years?
PS. Josh Hendrickson has post that made some related points, and some different ones as well. I love this line by Josh:
Rising prices aren’t a cost of inflation, they are the definition of inflation.
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9. March 2012 at 11:59
You need to be careful about framing, but discussing “NGDP” as “(nominal) income per capita” is indeed clearer than talking about changes in the CPI.
Believe me, if you started talking about nominal gross domestic product on national television, most people’s eyes would glaze over. Income, though, is an immediately familiar and understandable concept. Thankfully the two are the same thing!
9. March 2012 at 12:37
Total spending vs. productivity growth.
Spending is too low, it hasn’t kept up with productivity growth, the Fed needs to increae it.
Spending is outstripping productivity growth, the Fed needs to slow it.
Of course, that doesn’t work perfectly when the goal is stable spending. Spending is growing with usual productivity growth, but problems in the oil market or what have you, and slowing productivity growth, and so we have inflation.
Spending growth is continuing at levels consisent with past growh in productivity, but unusually rapid productivity growth is leading to slower inflation or deflation (good news.)
Only when spending moves off trend do you haul out the spending is growing buying historical productivity trends, it needs to slow to avoid inflation.
And then, spending is far below historical trends on productivity growth, the Fed needs to get spending up.
All of this works better if you all give up on your planned 2% a year attack on the average persons standard of living…
9. March 2012 at 12:49
..and I posted a comment that apparently belonged here, but you didn’t have this post up when I started. People would really get it, if they knew targeting is also capable of highlighting specific income to consumption possibilities. Just call out the service sector on the discrepancy between what it wants to provide and what people actually want to buy. Not only might that set into motion a thousand regulation and zoning issues in a hurry, it is also potential growth management the public can really relate to.
9. March 2012 at 12:57
With a little amendment, this same statement easily applies to AD. Like you, Scott, I am completely bewildered by all the commentators and policymakers who ardently believe that you can and must simultaneously boost aggregate demand while holding down the CPI, prescribing loose fiscal policy and tight monetary policy.
9. March 2012 at 13:03
Here is what the Deputy Governor the Reserve Bank of Australia said in a recent speech:
This is the traditional argument for inflation targeting. I think you have tacked this before, but could you remind/refresh me of your response?
9. March 2012 at 13:15
Great post Scott.
Me too, when discussing inflation with people I often point to the “good news” of plunging house prices one shouted back at me I am not buying a house but I buy gasoline. He was convinced that the fed should do something about inflation.
Our monetary system requires the median voter to understand the monetary system and that is bad.
What would happen if we cut the Federal Reserve loose from government control made it a corporation and gave each American 100 shares and told Ben to run it as a for profit business? Also allowing currency from competitors.
9. March 2012 at 13:30
I’m 100% behind your basic point, but I disagree with your example of house prices. Houses are an asset, just like stocks. When we’re talking about inflation, what we care about is the price of housing services, which doesn’t have a tight relationship with the prices of the actual structures, since the discount rate for those services is very volatile. To the extent that housing services have actually gotten cheaper, that is “good” news from the point of view of people who dislike inflation, but mostly that’s not what has happened. What has mostly happened is that the discount rate for future housing services has risen (that is, the risk and liquidity premia involved have risen more than the interest rate has fallen). That’s good news for someone who wants to buy a house (assuming they can still get financing on comparable terms), just as a discount-rate-driven stock market crash would be good news for someone who wants to buy stock. But it doesn’t and shouldn’t figure in your measure of the cost of living.
You could perhaps make a case that the expected price of future housing services has fallen, and that that, rather than a change in the discount rate, has driven much of the housing crash, in which case this is “good news” about prospective inflation. But I don’t think I would find that case very convincing. Or I suppose you could argue that the discounted returns model is not a good model of house pricing, because there is a large bubble element. I have to say that’s not an argument I would expect Scott Sumner to make.
9. March 2012 at 13:43
What really happens?
all of America freaks out when public employees getting a raisespushes to inflation to 2.1% and the fed announces they will raise rates.
Transparency screws those who benefit from opaqueness now it does very little to make fox viewers want to have their money diluted.
9. March 2012 at 14:45
Two masters? Are the financial markets really smarter than average people? I don’t see any evidence of that.
9. March 2012 at 17:04
I agree.
The good news is that we’ve done a lot of “paying it forward” on inflation. We’ve incorporated a gasoline price that is unlikely to rise further barring an excise tax or nuclear war in the mid-east. We’re also incorporating higher rents, due to the lack of mortgage availability. But rent-own parity is starting to stretch in a way that favors home ownership. If rent, food and energy all flatten out, that’s about 50% of CPI. The Fed will have to work hard to avoid undershooting a 2% target, but no one (other than bond investors) seems to realize that. Personally I think rents will do a fair bit better than 0% and houses even better than rents, but what do I know?
9. March 2012 at 17:13
That’s right Morgan. That’s why Ohioans defeated anti-union legislation in a popular referendum by a margin of 61 to 39 percent.
9. March 2012 at 17:18
Integral, Good point.
Bill, Better yet, just ignore productivity entirely, as no one knows how to measure it anyway. What is productivity growth in education? Health care? Finance? etc etc. those are our big industries today.
Becky, Morgan talks a lot about how if we stabilized income growth, the fight would be over boosting productivity.
Johnleemk, AD is a good analogy. And do you know what causes more AD? More C + I + G. And they laugh at M*V!
Rajat, In the right column of this blog is a link to “defense of NGDP targeting” a 15 page argument for the superiority of NGDP over inflation.
Or google National Affairs Scott Sumner.
Floccina, Thanks. I’m skeptical of privatization, as they’d be a monopoly. But if the government sets an NGDP target, I’m fine with having the private sector determine the base and interest rates.
Andy. You said;
“I’m 100% behind your basic point, but I disagree with your example of house prices. Houses are an asset, just like stocks. When we’re talking about inflation, what we care about is the price of housing services, which doesn’t have a tight relationship with the prices of the actual structures, since the discount rate for those services is very volatile.”
The government uses “rental equivalent” but that’s nonsense. Rental units are an entirely different market. If houses are more expensive then the cost of living is higher. Most people would consider San Francisco to have a higher cost of living that Kansas City, even if apartments were the same price. But if apartments were the same price, the BLS would say housing costs were the same. So it seems to me that the problem with your argument is that it assumes single family home ownership hasn’t gotten much cheaper, indeed 32% cheaper. But I can’t see any reason why it hasn’t.
My second comment is that we need to ask what the price index is for? If it’s for the Fed to use for the purpose of macroeconomic stabilization, then the price of a new house falling 32% is much more meaningful than the price of a rental unit rising 7.5% over the past 5 years. There are different price indices, none of which is the “right one.” Different indices serve different purposes. The public has this simplistic view that the price of new houses shouldn’t be in the CPI because falling prices don’t help them. But that’s based on the false premise that if the CPI was defined correctly, then a falling CPI would help the American public. But that’s obviously not true. They confuse cost of living with standard of living, two unrelated concepts.
And finally, even if you are right, I’m claiming the public would have the same attitude toward falling house prices if rental units were also falling in price.
Morgan, Good point.
D. Gibson, Touche.
9. March 2012 at 17:20
Steve, Good point.
Socialist, You don’t understand Morgan, he’s saying that NGDP targeting will stop those sorts of stupid votes, as voters will see who really has to pay the bill.
9. March 2012 at 17:34
Interesting theory. NGDP targeting will make people mad at a janitor getting a raise that doesn’t even keep up with inflation(never-mind productivity growth)but will be OK with Wall St. gamblers getting 8 figure bonuses? Doubtful.
9. March 2012 at 21:11
“has the cost of living actually increased?”
You your example:
For savers it has increased! For borrowers it has decreased!
“Rising prices aren’t a cost of inflation, they are the definition of inflation.”
Yes, decades ago, Keynesians redefined inflation to mean “increasing prices” instead of “increasing money supply” because they wanted to muddy the waters of the public debate. Now is it the standard definition.
9. March 2012 at 23:49
The cost of living will always increase just like the price of gas . The debate should be other energy sources !!
10. March 2012 at 04:37
Scott:
“Better yet, ignore productivity?”
Is your goal really to outlaw inflation statistics?
If so, that is a foolish goal. If not, then inflation will be observed and reported. My view, and I think it is the dominant market monetarist view, is that these statistics should not be the target of monetary policy.
By “productivity” I don’t really mean some measure of labor productivity or total factor productivity, but simply potential output. I grant that measures of potential output are doubtful. My view, and I think this is the dominant view amoung market monetarists, is that potential output, and output gaps, should not play a role in monetary policy.
But your post was about public perception. My comment was about framing policy. Keeping nominal GDP on a stable growth path is the policy I favor. But how is that explained, expecially relative to inflation?
When nominal GDP is on target, and there are “supply shocks” which involve shifts in both inflation and potentential output, then the “blame” should be put on those supply side factors. If the problem persists, so that what has happened amounts to a productivity slowdown (if inflation is persistent) then the “answer” should be better supply side policies. At some point, an adjustmetn in the nominal GDP target should be considered, but the appropriate ones would likely be small and I think the implementation gradual.
If, on the other hand, the problem is nominal GDP is off target, then problem is no longer explaining inaction (why isn’t the Fed doing something about higher gas prices at the pump when my grocery bill is rising.) Now, the Fed is actually going to do something–raise nominal GDP back to target or slow it back down.
What it is doing isn’t “causing inflation,” but rather changing spending on output. And the reason it is doing so is bringing it back to a target. Why that target rather than another? Why 5% rather than 8% or 1%? It has to do with the trend growth rate of real GDP.
Yes, this does bring to ahead the absurdity of the 2% inflatoin target that some market monetarists want to intergrate into the nominal GDP target.
In my view, the only justification would be that now isn’t the time to have a planned disinflation to a target more consistent with the trend growth rate of the productive capacity of the economy.
Spending on output show match the growth of productivity capacity. The Fed’s job is to adjust the quantity of money to the demand to hold it so that spending on output grows with productive capacity.
But what happens when productive capacity changes, paritculary due to transitory changes in the supplies of particular goods, but also when there are periods where productive capacity slows or accelerates for periods of several years? The least bad option is to keep spending growth steady, based upone the trend growth of productivity and allow product prices to rise more slowly or more rapidly.
Adjusting spending “growth” to offset supply side changes in the price level is a disaster. Trying to adjust to changing trends in productivity capacity would be difficult, require adjustmetn in wage setting practices, the changing prices of products provide a perfectly proper signal of change in real incomes, (productivity is growing more rapidly, so lower product prices and in the reverse, higher productivity prices.)
None of this requires odd notions like “inflation is good.” I especially think the notion that supply side inflation is good because having the monetary authority stop it would be worse, is not sensible.
The first pass response to “supply side” inflation is not that that it is good, but rather that spending is on target, so monetary policy is doing all that it should. Responding to a problem of lower oil supply by reducing spending on everything should slightly reduce oil prices, but this would do more harm than good. It is a really bad idea.
On the other hand, if inflation has occured because spending was too high, or inflation occurs because spending wsa too low and it recovering, then the inflation was still never “good.” The problem was always spending.
I think the claim that the monetary authority is creating money to raise people’s income, while true in the sense that nominal expenditure generates a matching nominal income, is not the way to describe this. What the Fed _is_ trying to do is generate spending on output.
From a naive point of view, the way the Fed would increase income would be to print up money and give it to someone. It would be their income. That sort of something for nothing policy sounds dangerous to me.
On the other hand, more spending on output means people have to produce something or work to earn the money. Having spending match the growth of the productive capacity of the eonomy means that we are not trying to cause spending to rise beyond what can be produced.
10. March 2012 at 06:47
Doc Merlin, It’s a much better definition, although still a dubious concept. But people don’t even agree as to what money is, so if we started to use the term ‘inflation’ for money, no one would have any idea what the other person was discussing. At a minimum you’d have to say cash inflation, M1 inflation, MZM inflation, etc.
That may bet true of price inflation as well (CPI,PPI) but the differences are far smaller for prices.
Bill, You said;
“If so, that is a foolish goal. If not, then inflation will be observed and reported. My view, and I think it is the dominant market monetarist view, is that these statistics should not be the target of monetary policy.”
I mostly agree, and indeed mostly agree with your entire comment. But I wouldn’t say they “observe” inflation, there is nothing to observe. Rather they “invent” an inflation concept. They use various statistical techniques to try to separate thing like consulting services into P and Q. But there is no rigorous economic theory backing these techniques, they are simply ad hoc. Thus they might simply assume that an hour of consulting services is one unit of Q, even if the average level of education of consultants is rising. For the auto industry, they do not assume that one hour of output by a auto worker is one unit of Q. It’s all arbitrary hand-waving.
10. March 2012 at 07:26
You are speaking of economists “observing” inflation.
I am speaking of members of the general public observing both the inflation statistics (which are highly imperfect) and the prices of the things they buy.
What is the monetary authority trying to do? Keep spending on output growing with productive capacity. Since it is impossible to know exactly what productive capacity is, and especially to predict it on a quarter to quarter basis, the least bad option is for spending to grow with the past trend.
What happens when the general public observes inflation? This could be the statistics that the government generates, but also just casual observations of the prices that people pay?
If spending is on target, then….
If spending is away from target, then….
10. March 2012 at 07:46
If all wages rise by 10% and all prices rise by 10%, has the cost of living actually increased?
In every class almost everyone says “no,” even though the answer is obviously yes; the cost of living would have risen by 10%.
There is no obvious answer to this question because you’re not making it clear whether you are talking about nominal costs, or real costs, i.e. nominal costs adjusted for inflation.
Depending on what the listeners have in mind when you say “cost of living”, then their answer will be yes or no. If they have in mind “real cost of living”, then they are right to say “no.” If they have in mind “nominal cost of living”, then they are wrong to say “no.”
If you have in mind “nominal cost of living” when you ask the question as just “cost of living”, then of course you’re going to get answers that will make you think your students are wrong. If I was a visitor in the class, then I would have in mind “real cost of living” if you asked that question, and I would have agreed with everyone who said “no” as being correct.
The sort of inflation that seems to most upset the public is higher prices caused by supply shocks, such as a sharp rise in energy prices caused by reduced output. The public believes that their living standards are falling because prices are rising. But economists think that is totally wrong. Suppose a supply shock caused 5% CPI inflation in a year when incomes rose 3%. That means real income falls 2%. Economists would say the fundamental problem was falling RGDP, and that inflation had nothing to do with the public’s welfare loss.
You’re fallaciously assuming that inflation of the money supply and consequent rise in prices will affect everyone’s nominal incomes the same way. That isn’t true. Inflation of the money supply and consequent rise in nominal incomes does not enter everyone’s pockets at the same rate. There are people habitually at the “end of the line” in the path of new money creation when it comes to their incomes, and they are completely 100% fully justified in complaining about rising prices. Their standard of living is in fact reduced because of the inflation, and not because there is less being produced.
You’re making the mistake of believing that because your God called “NGDP” is a single aggregate concept that masks all the relative price differences within it, that somehow it is prudent to ignore the fact that inflation isn’t like rain that lands on everyone’s lawn at the same rate, but is more like water flowing down a flight of stairs, where each step has one person, where those higher up the steps gain higher incomes before everyone else, and thus raise the prices of the goods they buy, and before those lower down the stairs see any additional water, they have already been paying higher prices, and by the time they see additional water, there will have already been more water flowing from the top again, increasing some people’s incomes before theirs, in a never ending cycle.
This is the reason why real wages have stagnated since the early 1970s. It’s because of relentless inflation that has counter-acted the productivity gains that would have went to workers in the form of lower prices for the goods they buy, but because of you monetarist psychos, you’re literally enslaving workers in an inflation concentration camp that they cannot do anything to escape.
When discussing inflation with people I often point to the “good news” of plunging house prices. I point out that the government often misses those prices, but they do result in a lower actual rate of inflation, which is the price increase of goods and services consumed here. Admittedly people don’t buy a house every year, but that’s also true of cars, and I’ve never heard anyone argue that car prices aren’t part of the cost of living. And yet when I look in the eyes of the people I’m speaking to, they seem confused. How can plunging house prices mean lower inflation? After all, plunging house prices are bad, and lower inflation is good. People think of the cost of living in roughly the way economists think of the term “standard of living.” That’s why my students always got the question wrong.
This is why economics graduates are by and large a bunch of ignoramuses. It starts in their classes.
Suppose inflation targeting at 2% really was “transparent, and easily understandable.” Then when inflation fell below 1%, the public would be thrilled to hear on Fox News that Ben Bernanke was going to start printing money to try to raise the cost of living of the average American. Instead they are mostly bewildered and angry when they hear the news. They read the story as Bernanke trying to lower their standard of living, even though economists view easy money as a policy that should (if it works) raise both the cost of living and the standard of living of the average American. Otherwise, why do it?
Otherwise why do it? To aggrandize the Treasury, major banks and financial institutions at the expense of everyone else who receive the new money last, that’s why. The communicate to everyone that if they gain, then everyone else must gain too, “too big to fail”, etc, but that’s only true with free market trading, not communist central bank counterfeiting that raises prices for goods that people on fixed incomes buy.
On the other hand NGDP is totally transparent. It’s easy to understand if Bernanake says he’s printing money so that American incomes can grow at a steady rate of roughly 4% per capita. If growth in average incomes has slowed due to recession, then it’s easy to understand why the Fed would think higher income growth would help the average American. Admittedly it’s a bit harder to tighten during a boom, but those are the periods where people are most content, and monetary policy is most uncontroversial.
WAGE EARNERS DO NOT GET CHECKS FROM THE FED!!
You keep making it sound like the Fed can increase everyone’s nominal incomes at an equal 4% rate across the board. That is pie in the sky nonsense. The overwhelming majority of wage earners do not deal directly with the Fed. The Fed deals primarily with the Treasury, the primary dealers, and some non-primary dealer major financial institutions. That’s it. The Fed inflates money into their bank accounts first, and they have higher purchasing power, they raise the prices of the things they buy (typically assets, securities and to a smaller degree consumer goods with their bonuses). Everyone else pays higher prices. After the initial receivers spend the additional money, the receivers then turn around and spend, bidding up the prices of the things they buy. Everyone else pays higher prices. Then, after many months, even years, the new money FINALLY enters most wage earner’s nominal incomes, but by the time their nominal incomes have risen, prices have already risen and they have already been paying higher prices. Once their incomes rise, prices will already be increasing from further inflation from the Fed, again into the Treasury, primary dealer, and major financial institution coffers first.
American incomes won’t all grow at 4% equally with inflation. You’re lying to your readers, you’re lying to everyone who rightly questions inflation, and you’re lying to yourself. The general public isn’t confused. They know when they have to pay higher prices with unchanged nominal incomes. It’s you monetarist economics professors who are confused.
10. March 2012 at 08:21
1. Aren’t we forbidden from using the word inflation around here? I am joking, but only a little.
2. Spot on about housing prices. Often I am told that inflation is underestimated because gas and groceries are not included in the basket of goods. But I have long argued that housing is underrepresented in calculating inflation and home prices have sunk a lot over the last 5 years, so talk of large inflation seems silly. But consumers are most sensitive to gas and groceries because they buy them most frequently. In a way when we talk about inflation we are talking about several different things, which is why the term is misleading. Which brings me back to issue 1.
10. March 2012 at 13:20
I have a PhD in molecular biology
I can name at least 5 supreme court justices, and both of my US senators
I sort of understand what a linear regression is doing
I don’t understand the paragraph below *at all*
You seem to arbitrarily decide that if inflation >income, it is an income failure – why ?
From the perspective of an ordinary person, whoose income is relativly fixed in the year time span, if gas prices go up 5% , why is that a failure of income ? it makes no sensewhatsoever, or at least, I can’t see why it makes no sense.
If I had to guess, it has to do with prof economists worship of markets, a worship that always seems a bit silly to me.
quote
The sort of inflation that seems to most upset the public is higher prices caused by supply shocks, such as a sharp rise in energy prices caused by reduced output. The public believes that their living standards are falling because prices are rising. But economists think that is totally wrong. Suppose a supply shock caused 5% CPI inflation in a year when incomes rose 3%. That means real income falls 2%. Economists would say the fundamental problem was falling RGDP, and that inflation had nothing to do with the public’s welfare loss. Indeed if the Fed had held inflation down to zero percent when oil prices soared, then real incomes would have fallen 2%, even if money was completely neutral in the short run. In practice, real income would have fallen even more sharply, as wages and prices are sticky. So to the extent that inflation affected consumer welfare, it raised it. What’s so transparent and easily understandable about that?
10. March 2012 at 15:14
Scott,
If you had bought the average US single-family house in December 2010, lived in it for a year, and sold it in December 2011, I think the net ex post cost of that year of housing services would have been quite high. We can disagree about the ex ante cost, but I think it’s fair to say that homeowners today expect less appreciation than did homeowners prior to 2006. It’s unclear whether the difference is enough to offset the difference in the amortized cost of the house. So again I say, it’s not clear that there has been a decline in the price of housing services. (Differences in house prices are a critical determinant of cross-sectional variation in the cost of housing services, but it’s not at all clear that the same is true for time series variation, and I tend to doubt it.)
If the Fed’s objective is to stabilize the cost of living, it’s clear that what should be in the index is something representing the flow cost of housing services, not the stock value of houses. Now I don’t happen to think that stabilizing the cost of living per se is a good objective for the Fed, but the consensus (both of economists and of lay persons) appears to disagree with me on that point.
Major_Freedom,
Have you ever heard of a labor demand curve? If all this price inflation has been happening and workers have fallen so far behind just because their wage increases come so much later in the chain, then hiring US workers must be a huge bargain by now. Hey, you’re paying them wages that have barely increased, and you get to sell your products for today’s inflated prices. Wow, businesses must be really excited about hiring US workers! Why, I bet our unemployment rate is way down from where it was in the early 70’s. Oh, wait, it’s more than double what it was then? Hmm, something’s wrong here….
10. March 2012 at 19:29
Major Freedom,
I don’t think you addressed supply-side inflation. What happens to the prices of things we buy when a hurricane wipes out the oil rigs and refineries in the gulf? What does this have to do with the Fed, and what should the Fed do about it, if anything?
This is an important point that I haven’t heard any Austrian address in any specific way, which is sad because it’s something that would have to be rationalized before we could even take steps toward trying to manage (which probably isn’t the best word choice) our national economy according to that prescription. It’s much better to do it now than wait until we get to that point, scratching our heads, wondering what we should do next.
I hate to say this, but the Austrian outlook isn’t going to work with the amount of government intervention in the economy at present, not just having to do with money and banking – because it has sort of the same kinds of outcomes at times, as a hurricane, on the supply side of everything. It would be a very painful experience that would happen quite frequently. Even if I agree that it shouldn’t be doing those things that need a central bank-enabler, it probably isn’t the right course of action to screw down the fed while the government is still hog-wild on the supply-side. Why should Joe Average who is just trying to work and get by have to go through that?
11. March 2012 at 00:51
I have one computer in my network that “is” and is not connected to my network. If anyone knows of a solution I am interested.
11. March 2012 at 01:09
Oviously I would prefer to reattach this computer. If not I will purchase another computer and attach it to my network.
This is an enourmous waste of resources and I guess that is the point. Why would anyone be compelled to depreciate my personal computing abilities?
11. March 2012 at 01:21
I still have two fully functioning computers. I have another on the way. You will not shut me up.
11. March 2012 at 01:33
All of this effort to shut me up only innervates me more. I will invest all of my free resources into expressing my opinion. You are idiots.
11. March 2012 at 02:04
I will be the shadows in the dark.
“Whenever they’s a fight so hungry people can eat, I’ll be there. Whenever they’s a cop beatin’ up a guy, I’ll be there… I’ll be in the way guys yell when they’re mad an’-I’ll be in the way kids laugh when they’re hungry an’ they know supper’s ready. An’ when our folks eat the stuff they raise an’ live in the houses they build-why, I’ll be there.”
Tom Joad
11. March 2012 at 02:19
Tom Joad totally beat up John Galt and I’m happy.
11. March 2012 at 02:49
@mf
The price of labor is determined by marginal supply and demand not inflation. Because of sticky wages, the only thing stable prices do is cause businesses to more quickly lay off existing workers and replace them with cheaper workers, machines, technology, or foreign production.
Bankers are overpaid because banks make excess profits from the implicit TBTF government guarantee.
Executives get overpaid because some people have the idea that corporate boards should be made up of public figures, do-gooders, educators, ex-politicans, etc., instead of major shareholders. If you passed a law requiring every director to have a significant share of their net worth invested in the company, executive compensation would be much more reasonable. Ditto for the executives themselves.
And…you really don’t understand how the Fed and primary dealers work. In most cases, the dealers are just acting as brokers (i.e. intermediaries) who sometimes make a little money on the trade. The ultimate counter-parties are institutional investors (think pension funds, insurance companies, money market fund managers, etc) and central banks in countries that have current account surpluses with the U.S.
11. March 2012 at 03:09
I just want to be clear Scott. My IT problems are not due to you (they’re only due to my connection with you.)
11. March 2012 at 07:35
Bill, When the general public thinks about the cost of living, they are sometimes thinking in terms of something like NGDP per person. If their neighbors spend more in nominal terms, the cost of living is going up, as people need to keep up with the Jones.
My grandmother didn’t have a phone when she was young. I do. The invention of the phone increased my cost of living (as the term is used by ordinary Americans.)
I certainly agree with what you say about policy.
You said:
“Depending on what the listeners have in mind when you say “cost of living”, then their answer will be yes or no. If they have in mind “real cost of living”, then they are right to say “no.” If they have in mind “nominal cost of living”, then they are wrong to say “no.”
If you have in mind “nominal cost of living” when you ask the question as just “cost of living”, then of course you’re going to get answers that will make you think your students are wrong. If I was a visitor in the class, then I would have in mind “real cost of living” if you asked that question, and I would have agreed with everyone who said “no” as being correct.”
Why am I not surprised by this? How do you define “real cost of living?”
Benny, That’s right, and the reason most people are less than thrilled when home prices fall is that they own homes. The same reason farmers are less than thrilled by declines in food prices.
ezra abrams, You said;
“If I had to guess, it has to do with prof economists worship of markets, a worship that always seems a bit silly to me.”
I give you credit with prefacing your comment by stating that your expertise is in other fields. You’ve certainly shown that in your questions. But don’t feel bad, macro is incredibly counterintuitive.
Given your lack of knowledge of economics, I wouldn’t be too quick to accuse economists you disagree with of “worshiping markets” especially in posts that have nothing to do with the pros and cons of free market economies.
If you were to reread the paragraph you quoted, you’d see that I answered your question, as I specifically addressed what would happen if wages were sticky, which seems to be the assumption that concerned you. In that case my argument is even stronger. If you disagree, I’d be interested in knowing why.
Andy, That’s an interesting way of looking at things, but I’m not at all comfortable with the notion that inflation estimates should include the public’s subjective estimate of expected returns on capital assets. Would this include stocks? If there was mass hysteria in 1999 and the public expected huge gains in their dot com stocks, would the rate of inflation have turned negative? Set aside the issue of measurement, for the time being. If we could measure these things, should we?
Here’s another way of thinking about things. For existing homes, any price change is a zero sum game for society. One person’s gain is another person’s loss when the price goes up, as there is both a seller and a buyer. For society as a whole, the net change in housing costs only shows up with new homes, and they have fallen in price quite sharply.
I certainly agree that there is ambiguity here, but I’d still be inclined to see the housing price crash as something that tended to reduce the cost of living. Suppose the price of homes fell to $10 in San Francisco, $5 in Chicago, and $2 in Houston? (Reductio ad absurdum) Is there any doubt that the cost of living for Americans would have declined?
Mark, Glad to hear I’m not causing your IT problems.
11. March 2012 at 10:31
“If there was mass hysteria in 1999 and the public expected huge gains in their dot com stocks, would the rate of inflation have turned negative?”
No, because stocks don’t provide a service. There is nothing there to include in a price index. When we include housing in inflation, we’re theoretically interested in “owner’s equivalent rent.” I agree that the BLS’s actual measure of it isn’t very accurate (and it is probably impossible to get an accurate measure), but it’s the right concept. We’re interested in the current cost of living, and that includes whatever it costs to own (not to buy) a house. Houses are unusual among long-lived assets in that their dividends are entirely in the form of services. For measuring the cost of living, we don’t care about the asset aspect, only about the price of those services.
And has the price of new houses actually gone down, for the average potential purchaser? I’m not so sure. If your credit isn’t very good, you could still buy a house in 2006 for a certain price. Now you probably can’t buy it at all. It’s like asking how the price of iPads has changed since 2006. Arguably money is more valuable now because you have the opportunity to buy an iPad, which previously wasn’t available at any price. And arguably money was more valuable (to some people) in 2006 because they had the opportunity to buy a house, which currently isn’t available (to them) at any price. Part (maybe all, or more than all) of the reason rents have continued to rise is that the shadow price of purchasing a home has risen for the marginal purchaser.
11. March 2012 at 18:11
Andy, I have several thoughts here:
1. You may be right about house price appreciation, but I’m still having trouble seeing it. You didn’t respond to my reductio ad absurdum example. Surely that would mean a reduction in the cost of living, so why does it conflict with your argument? My hunch is that it dramatizes the fact that as houses become cheaper Americans can afford a much nicer house. (However some of that is offset by the tightened lending standards that you mention.)
In addition, I still have trouble seeing how higher housing prices lower the cost of owning a home IN AGGREGATE. Yes, I can see how the seller gains when the price rises, but the buyer loses an exactly equal amount. And their welfare should also be in the CPI. So how does the American public as a whole gain from a rise in house prices? I just don’t see it. I recall an article in a good journal that argued higher house prices are always a net negative for society, if the housing stock is growing over time. That’s because for existing homes it’s a wash, and for new construction it is a net negative, for the same reason that higher new car prices are assume to hurt consumers.
I agree with your second paragraph, and indeed that just makes me even more convinced that inflation isn’t a very good indicator of anything interesting. But I’m still stumped by your price appreciation argument. Not saying you are wrong, just confused. BTW, another issue here is durability. If houses became more durable, the cost would fall. It seems to me they got less durable around 1950-80, but have since regained some durability, I’m not sure exactly when that occurred.
11. March 2012 at 20:08
Andy:
Have you ever heard of a labor demand curve? If all this price inflation has been happening and workers have fallen so far behind just because their wage increases come so much later in the chain, then hiring US workers must be a huge bargain by now. Hey, you’re paying them wages that have barely increased, and you get to sell your products for today’s inflated prices. Wow, businesses must be really excited about hiring US workers! Why, I bet our unemployment rate is way down from where it was in the early 70’s. Oh, wait, it’s more than double what it was then? Hmm, something’s wrong here….
It does not follow from stagnant real US wages that US workers are a “huge bargain by now”, as if the US is the only country that has inflation.
Bonnie:
I don’t think you addressed supply-side inflation. What happens to the prices of things we buy when a hurricane wipes out the oil rigs and refineries in the gulf? What does this have to do with the Fed, and what should the Fed do about it, if anything?
I define inflation as an increase in the supply of money and volume of spending. What you are talking about is prices rising, and yes, I am fully aware that a reduction in supply can increase prices. But in the real world market, supply tends to increase, so a sustained increase in prices over time is only explainable by money inflation. I see no reason why one would have to keep mentioning that a reduction in supply is also capable of leading to higher prices, other than being a distraction from what is actually making prices rise in the real world.
As for what the Fed should do, the answer is to close its doors.
This is an important point that I haven’t heard any Austrian address in any specific way, which is sad because it’s something that would have to be rationalized before we could even take steps toward trying to manage (which probably isn’t the best word choice) our national economy according to that prescription.
It’s not surprising that you would say no Austrian talks about prices rising on account of supply falling, because like I said before 99/100 Austrian critics don’t even understand Austrian economics. Every single Austrian economist fully recognizes the fact that rising prices is possible with a reduction in supply and no monetary inflation. But they’re more concerned with the real world so they don’t focus on what ifs as much as what is.
I hate to say this, but the Austrian outlook isn’t going to work with the amount of government intervention in the economy at present, not just having to do with money and banking – because it has sort of the same kinds of outcomes at times, as a hurricane, on the supply side of everything. It would be a very painful experience that would happen quite frequently. Even if I agree that it shouldn’t be doing those things that need a central bank-enabler, it probably isn’t the right course of action to screw down the fed while the government is still hog-wild on the supply-side. Why should Joe Average who is just trying to work and get by have to go through that?
You have it backwards. Without a central bank, the state is far more limited in its ability to aggrandize itself because all of its financing will have to be done via either taxation or borrowing, which is more conspicuous, transparent, and understandable to the masses than stealth inflation tax.
Joe Average is in a far worse position with a state and central bank confiscating his earnings via rising prices, reduction in capital accumulation, and the boom bust cycle, not to mention the state’s ability to grow more so by way of printing its own money and acquiring resources for itself, than he is with a state and no central bank.
You’re making it seem like central banking is a benefit to the “little guy.” You cannot be more wrong. It is exactly the opposite. The little guy is worst off in a central banking world.
12. March 2012 at 04:25
Major_duma$$
I define inflation as an increase in the supply of money and volume of spending….But in the real world market, supply tends to increase, so a sustained increase in prices over time is only explainable by money inflation
no, supply does not constantly rise. it responds to price signals and technology/productivity. Horse and buggy supplies are down. Solar sales are up (thanks to subsidies). Coal production is down (thanks to shale gas shutting down a lot of coal enlectricity plants).
What does “volume of spending” mean anyway? is that the Q, the P, or the P*Q in GDP?
12. March 2012 at 09:48
dwb:
Major_duma$$
You seem upset.
“I define inflation as an increase in the supply of money and volume of spending….But in the real world market, supply tends to increase, so a sustained increase in prices over time is only explainable by money inflation”
no, supply does not constantly rise.
I didn’t say CONSTANTLY rise. I said supply tends to rise. This is true. Even the sloppy real GDP statistic shows a rising tendency in supply.
it responds to price signals and technology/productivity.
No, that’s false. Supply both responds to and affects price signals. Productivity is just another word related to supply, so it’s rather tautological. Technology is both affected by capital accumulation (scientists can learn more about the world when they have more physical resources at their disposal), and affects capital accumulation (by introducing new cost saving methods of production that increase the rate at which certain resources can assist in the production of new resources).
In other words, technology and price signals are both affected by, and they both affect, supply and productivity. It’s not a one way street the way you are making it out to be.
Yes, I realize in your silly worldview that demand in money terms, i.e. “spending”, is needed to be the ultimate primary force that drives everything in the economy, or else you’d have no justification for the state / central bank to print and spend for the sake of increasing spending. You need to make spending primary because the state and central bank bring nothing “real” to the table, unlike private producers.
Horse and buggy supplies are down. Solar sales are up (thanks to subsidies).
Supply is an aggregate concept. Horse and buggy supplies going down has been not only matched, but more than matched, but a corresponding increase in supply of cars.
At any rate, solar sales going up is only good if the sovereign consumer values solar energy enough to sacrifice consumption of other things. Yes, I realize in your silly dictator worldview that as long as the state can coercively bring about something you subjectively value, like increasing solar energy sales, then it’s all worth it, it’s all a net gain, and that opportunity costs don’t apply. You’re not an economist. You’re a demagogue whose only apparent function in life is to act like a useful stooge for the state, who you believe cares about you.
Coal production is down (thanks to shale gas shutting down a lot of coal enlectricity plants).
You’re again ignoring the supply that more than made up for the reduction in coal. As coal production goes down, nuclear, hydro, solar, gas, and oil production goes up. It’s not a constant supply of wealth. There’s more overall supply.
What does “volume of spending” mean anyway? is that the Q, the P, or the P*Q in GDP?
I don’t like to use “P” and “Q” because there is no such thing as a single quantity of goods “Q”, nor is there a single price “P” for goods as such. They are crude statistics that can’t explain it as well as verbal explanations.
The volume of spending is the total sum of all instances of spending for all goods and services that take place over a given period of time, say one year. With a higher quantity of money, there tends to be a higher total sum of money spent on everything, and vice versa.
Before you yammer on about “velocity”, I will anticipate by saying that velocity is in fact a fudge factor that is needed to balance the PQ=MV equation. It has no independent meaning or reality apart from the other variables, and is simply the quotient PQ/M.
14. March 2012 at 04:53
Scott:
“Most people would consider San Francisco to have a higher cost of living that Kansas City, even if apartments were the same price. But if apartments were the same price, the BLS would say housing costs were the same.”
I take it when you say “cost of living” here, you mean specifically the cost of shelter. But if apartments were the same price, then the large disparity in the overall cost of shelter would probably not exist, since a lot more people in San Francisco would choose to rent instead of buying, and house prices would go down (or vice versa in Kansas City). The BLS’ measurement of OER is not as accurate as one would like, but it’s not complete nonsense either: there really is a margin on which rental housing competes with owner occupied housing, and the margin would expand if relative costs were out of equilibrium.
You argue that the effect of house price increases on the wealth of new purchasers offsets the effect on the wealth of owners. With respect to measuring the cost of living, it seems to me that argument only works if you think of a house as a permanent asset for the new purchaser. Otherwise, the cost to the new purchaser will be offset by proceeds from a later sale. I would argue that, since heirs typically sell decedents’ houses rather than occupying them, the “permanent asset” view is not a good description of reality. (I agree that changes in house prices don’t affect aggregate wealth, but the issue here is not aggregate wealth but the cost of owning a house.)
14. March 2012 at 05:11
Andy, I’m still having trouble following your argument:
Suppose people and houses lasted forever, would I be right?
Suppose houses only last a few years, like cars. Would I be right?
It seems like your argument implies the answer to both questions is yes, but I’m not quite sure.
I’m pretty sure that the gap in single family home prices between cities is often much bigger than the gap in rental prices. But I can’t be sure. We do know that 60% declines in new home prices had relatively little effect on the price of rental units in lots of sunbelt cities. I think that fact supports my argument that the two markets are segmented.
14. March 2012 at 05:13
I’d also be interested in where the flaw lies in my reductio ad absurdum argument that the cost of living would obviously fall if the price of Hollywood mansions declined to $10.
It’s a silly example, but precisely what is silly about it?
16. March 2012 at 08:35
Scott:
“Suppose people and houses lasted forever, would I be right?”
In theory, no. Rational people should be willing to go back and forth between buying and renting if the difference in cost goes up and down. In practice, it’s murky. My impression is that buyers seldom go back to renting if they have a choice. But arguably that’s because prices and expectations adjust so that renting never becomes attractive. (There is obviously some transition cost in going from buying to renting, not necessarily a very large one. Since there are always new households and current renters on the margin of buying, they can keep prices in line with rents and expectations so that we never observe a situation in which it is advantageous to switch from buying to renting.)
“I’m pretty sure that the gap in single family home prices between cities is often much bigger than the gap in rental prices. But I can’t be sure. We do know that 60% declines in new home prices had relatively little effect on the price of rental units in lots of sunbelt cities. I think that fact supports my argument that the two markets are segmented.”
The alternative explanation is that there is a correlation between the level of home prices and the expected rate of change. I’m guessing data would support that hypothesis. Boom areas typically have prices that are both high and rising. So people buy expensive houses expecting a low net cost of ownership, because they expect to be able to sell them at higher prices. So house prices vary a lot between cities, but perceived cost of ownership doesn’t.
“I’d also be interested in where the flaw lies in my reductio ad absurdum argument that the cost of living would obviously fall if the price of Hollywood mansions declined to $10.
Here’s the thing: there is an upper bound on the periodic cost of ownership of a house, and that upper bound equals the purchase price plus interest and maintenance costs. If you buy a house for $10, the worst case is that you will sell it for $0, and you will have lived there for a price of $10 plus interest and maintenance. So your ex post owner’s equivalent rent, even in the worst case, was not very much. If you buy a house for $1,000,000, the worst case is that you will sell it for $0, and you will have lived there for a price of $1,000,000 plus interest and maintenance, so your OER in the worst case was a lot.
But when you buy a house, you’re interested in the (perceived) average case (perhaps risk-adjusted), not the worst case. The average case can’t be any worse than the worst case, but it can be a lot better. If you buy a house for $2,000,000 and you expect the price to go up, the expected periodic cost is less than the cost of interest and maintenance, and if you expect the price to go up quickly enough, the expected cost could be negative. If you buy a house for $1,000,000 and you expect the price to go down, the expected periodic cost is more than the cost of interest and maintenance, and it could theoretically be as much as $1,000,000 more — which means it could be quite expensive even if the cost of interest and maintenance is zero. If you buy a house for $10, the expected periodic cost cannot possibly exceed interest and maintenance by more than $10. So unless maintenance is exorbitant, that house is cheap to own.
Basically, the problem with your reductio ad absurdum is that it doesn’t consider option value. A house comes with a put option with a strike price of $0. When the house costs $2,000,000, that option is nearly worthless. When the house costs $1,000,000, the option is still nearly worthless. When the house costs $10, the option is extremely valuable. Your ex ante cost of ownership is always net of the option value. When the price goes down from $2,000,000 to $1,000,000, this has little effect on the option value, so we can’t draw a conclusion about the cost of ownership. When the price goes down from $1,000,000 to $10, the option value skyrockets, so we can be certain that the net ex ante cost of ownership has fallen.
16. March 2012 at 11:31
Andy, I’m at a disadvantage here for two reasons:
1. You seem to be using a non-ratex model, and I usually assume ratex.
2. We are not debateble a sensible definition of the price level (the price of stuff made in America) but rather a bizarre defintion–the “cost of living” which is not the average price of goods.
But I’ll throw out a few observations.
1. At a low price ($10) doesn’t the call option become very valuable? Or do I have that backward? In any case, if the price of a Vegas condo falls from $500,000 to $200,000, it seems to me there’s not that much downside risk, but lots of upside if the economy recovers. You seem to be assuming that the expected price appreciation was greater at $500,000 than $200,000. That seems odd, given construction costs would be the key “fundamental” here. Not saying you are definitely wrong, but we are being forced (in my view) to construct “cost of living” numbers on irrational delusions of people. That seems questionable.
2. Going back to my original argument. I believe that if the price of new homes plunged 32%, and it was just as easy to buy them as before, and the price of rental apartments also pluunged 32%, then the average American would still see that as “bad news,” and not a reduction in the “cost of living,” even though it would answer all your objections. I can’t prove it, but that’s my hunch.