Post-Keynesian Observations

Understanding the Macroeconomy

Inflation: What Really Causes It and What We Truly Have to Fear

with 13 comments

I’ve been putting off doing this one, in no small part because we don’t have a problem with inflation at the moment. However, since a) people are starting to talk about it as a possible consequence of the debt/deficit and b) it is the only economic concept that I think is even less properly understood than the aforementioned debt and deficit, I thought I’d type something up. It’s actually not all that terribly complicated but is misunderstood for the same reason the budget deficit is: people try to think of what is going on in micro terms (the individual household) rather than macro terms (the whole country). That’s understandable since these people aren’t professional economists and you naturally use what you know as your reference point. What is extremely difficult to understand is why so many of my colleagues are also in the dark on this issue. And what’s downright dangerous is the fact that so is the Federal Reserve.

What are the causes and costs of inflation?

Let’s start with just thinking about the household since that will be familiar. Say you have a family, the Microns, whose annual income is $50,000 and the average price of whatever it is they purchase is $5. In that case, they can buy 10,000 “things” every year: 10,000 x $5 = $50,000. In economics, we would call the $50,000 the Microns nominal income and the 10,000 their real income: on the paycheck it says they earn $50,000, but what the really earn is 10,000. And now, to make the math simple, assume inflation of 100% such that by next year, the price of the average thing rises to $10. Now the Microns can only buy 5000 things. Their nominal income is still $50,000, but real income has fallen to 5000. That’s inflation and by this story the cost is obvious and it appears that inflation is unequivocally bad. The only problem is, it’s wrong. To understand why, you have to take a macro view.

Think about this for a moment: if the Microns were paying twice as much for each thing they purchased, where did that money go? Into a sinkhole in Florida? Of course not, it went to another family (or business–but then that ultimately goes to a family, too). This is because the prices the Microns pay represent the income another economic entity is earning. This is the true impact of inflation: it is always and everywhere a redistribution of income. If the microns real income has halved, someone’s (or some combination of people’s) has doubled. Rising prices mean, for others, rising incomes. It is mathematically and logically impossible for it to be otherwise since when you pay more, someone gets more–there is someone standing on the other side of that cash register If you pay more, someone gets more. If you pay more, someone gets more. If you pay more, someone gets more. I’m saying this over and over because it is so poorly understood, even in economic theory, and to understand what follows you need to keep it in the front of your mind. Rising prices = rising incomes.

In fact, if all prices rose by 10% at the very same time as all incomes rose by 10%, it would be inconvenient but would otherwise have absolutely no impact on people’s real incomes. But, of course, that never happens because the inflation has to start somewhere and some prices are affected more than others. Just think about the 1970s and the early 1980s as the classic example. This was a period of terrible inflation. Look at the numbers below (I left a bit of the 1960s in for reference):

US Inflation
1968 4.2%
1969 5.4%
1970 5.9%
1971 4.2%
1972 3.3%
1973 6.3%
1974 11.0%
1975 9.1%
1976 5.8%
1977 6.5%
1978 7.6%
1979 11.3%
1980 13.5%
1981 10.4%

These were unprecedented numbers and you keep having to remind yourself that the increases compounded–the relatively moderate 5.8% in 1976 was on top of 9.1% the year before that, which was on top of the 11% the year before that, and so on. And this inflation was a worldwide phenomenon. People across the globe were paying higher prices for the goods and services they purchased. Of course, these increases were not uniform and the prices of some goods and services may have fallen. But, on average, there was a large increase.

Did everyone’s standard of living across the globe decline? You are probably already way ahead of me on this one and you know that the answer is clearly and emphatically “no.” Some folks were much better off, because even though the prices they were paying had risen, their incomes had risen far more. That’s because the amount of money they earned was a direct function of those prices that had risen most: those for oil. For the oil industry and oil exporting countries, this was a magnificent period. Their incomes were rising at the expense of those not in the oil industry. Income was being redistributed to them, and that’s how inflation works. Prices start rising in one sector, pulling extra income towards it. The sets into motion a chain reaction, raising some, but not all, other prices. The inflation we report in the news is just the average: the winners saw the prices of what they sell go up by more than the average, while the losers saw their prices rise by less (or even fall). It’s always this way (though it’s easiest to see in the 1970s because the source of the inflation is so obvious).

Not that this is necessarily a bad thing. Think for a moment about the reasons a price can rise. Maybe demand has increased. Why shouldn’t you make more money for selling something people want? Good for you, that’s what capitalism is supposed to be all about. The rising prices enrich you, they encourage others to sell whatever it is you are making, and it causes consumers to look for substitutes: all of these are useful reactions in terms of how the free market is supposed to work. This is, incidentally, what economists call demand-pull inflation (because demand pulls prices up). Hence, if the huge jump in oil prices in the 1970s was simply because driving your car became much more popular, then so be it.

But there are other reasons the price could rise, which generally fall under the category of cost-push inflation. In these cases, basic costs of production cause a rise in the price. I remember reading in an economics textbook of the example of anchovy fishing off the coast of Portugal. Apparently, anchovies are not juts for pizza. They are also a major part of cattle feed. One year, for some reason the anchovies didn’t show up in their usual places and so the harvest was very light. Since there had not been a chance in the demand for the tiny, salty fish, this caused a rise in price. It cost cattle-feed manufacturers more to produce cattle feed, meaning that ranchers had to pay more, too, and on down the line. The fact that the anchovies didn’t show up caused inflation, which affected the incomes of those involved. Who won or lost in this case gets more complicated than in the above scenario as it will depend on various elasticities and other parameters, but clearly standards of living are affected. Again, however, this is what the market is supposed to do. If the supply of a resource changes, prices need to change to create the appropriate incentives (to find new sources, develop alternatives, etc.). This is something that happens in an otherwise healthy capitalist economy–and it’s not what happened in the 1970s. The rising prices were not a result of us running out of oil.

There is a second kind of cost-push inflation, however, one that is a function of market power. Market power is the ability to avoid competition (for an extended discussion, see my posts on the health care industry: http://tinyurl.com/264j4lq). This is a bad thing. The problem is that business people are greedy. As the father of capitalism, Adam Smith, wrote:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

Dirty bastards! Many people think of capitalism as a pro-business system, but it’s quite the opposite. Set up properly, it leaves business as powerless, at the mercy of the folks that Adam Smith really wanted to see in charge: the consumers (again, there is a much more detailed discussion of this under health care reform in this blog).

Of course, businesses, consistent with Adam Smith’s characterization, do what they can to avoid this. It is obviously a lot more fun to be a monopoly than to be in competition, and they will do what they can to get as close to their ideal as possible. It is the job of government policy makers and economists to make this difficult (hence the existence of anti-trust laws, for example). It’s a never-ending battle, and you win some and you lose some (part of that battle is businesses and their lobbyists arguing to the general public and politicians that capitalism is about making life easier for businesses–ha, now you know better!).

Again, you are probably ahead of me on this: those businesses successful in gaining market power for themselves can raise prices, and this causes inflation and a redistribution of income towards those with the market power. However, unlike the other two cases above, there is not underlying good here. It serves no greater economic purpose to have those who have avoided competition get more of your money. If someone gets rich by facing competition and winning, good for them. They must have been selling something other people wanted when they had a choice. But, that’s not the case here, and it’s not just firms who can have market power. So can workers and, in some cases, countries. And now we are finally to an explanation of the 1970s.

Four letters: OPEC, or Organization of the Petroleum Exporting Countries. It’s a long (but fascinating, in no small part because my first love is military history) story as to how they came to decide to exercise their power at the close of 1973. In short, they, being primarily Arab nations, were very upset with US support of Israel in the 1973 Arab-Israeli War (which the latter came perilously close to losing). This gave them the focus to agree on how they would go about raising prices by voluntarily reducing supply. You can have a glance at the results here:

http://www.eia.doe.gov/aer/txt/ptb1107.html

Saudi crude oil jumped from $2.10 in 1973 to $9.60 in 1974. By 1982, it was $34. This was not demand-pull and it was not the kind of cost-push related to acts of God (like anchovies not showing up or hurricanes destroying resources). It was market power, pure and simple, and it was a massive redistribution of income to OPEC countries and oil companies. It served no useful purpose (unless your goal was to see the West punished for helping Israel–it certainly did that).

These are the three kinds of inflation. I’ll call them demand-pull, cost-push/act of God, and cost-push/market power. All three redistribute income, but the first two do so on a basis that makes economic sense. They enrich those who should be enriched and thereby create signals for entrepreneurs and consumers regarding what should happen next. If the prices of lumber go up because there has been a massive boom in housing, then the fact that lumber manufacturers get more money acts as a signal to others to enter that industry (which is what consumers want) and it is an incentive to builders to find a substitute for lumber. If the prices rise because a forest fire burned down our trees, it still makes sense for lumber prices to increase. That’s the appropriate signal to the market. Only inflation created by market power is clearly harmful. We should stop it. But how? What policies are available to us?

Policies to prevent inflation

The obvious way to stop demand-pull inflation is to lower demand. The government could, because there is a housing boom leading to bottlenecks in the building industry, throw the entire macroeconomy into recession. That makes little sense, however, because demand-pull inflation sends appropriate signals and redistributes income on a logical basis. And, anyway, it’s hard enough to get the economy in expansion without causing recessions on purpose. What moron would do that!? (HINT: The Federal Reserve. More on this in a moment.)

With cost-push/acts of God, there is little that can be done (prayer?) directly and, besides, the price changes make sense. The government could act to make any transition easier, but if there ain’t no anchovies, there ain’t no anchovies.

Cost-push/market power is bad, about that there is no question. Unfortunately, while solving it in theory is very easy (get rid of the market power!), doing so in practice is messy. You have to directly address the problem, meaning that you’ll have to fight some business, labor group, country, or set of countries that really, really like having market power. If it’s one of the first two, they’ll line up their lawyers and economists and fight it out with the government’s. Who wins is an open question. Not that I am suggesting that we shouldn’t do this–we absolutely should, the survival of capitalism depends on making sure that accumulations of market power like this do not occur. They will because those greedy business people are also smart. But, we have to fight back. Unfortunately, there is no magic wand we can wave to make it all better. The only basic defense here is a general understanding on the part of citizens and their government that this is a constant problem, one for which we must remain vigilant. It’s funny that Americans, to whom democracy is supposedly such an important ideal, have very little trust for their democratically-elected government and yet at the same time have such faith in the market system. In terms of giving power to the people, it works just about as well as democracy: it’s not terrible, but it’s certainly not perfect. Keep a close eye on both.

Policies we actually employ

I entitled this post, “Inflation: What Really Causes It and What We Truly Have to Fear.” What I’ve said so far is that demand-pull inflation and cost-push/act of God are reasonable responses to economic stimuli but that cost-push/market power is all-around bad. However, my reference in “What We Truly Have to Fear” was not to market power, but to the Federal Reserve. In the US (and most other countries), policy does not follow what I’ve discussed above. Cost-push/market power inflation is almost completely ignored (maybe this is starting to turn around again, but since the 1980s we have had a very lax anti-trust attitude in the US) and it has been demand-pull inflation that has been made out to be the villain. The economists at the Fed see it as their job to force the US economy into recession when they see demand-pull inflation threatening–and they see all inflation as demand-pull. Hence, they act to stamp out expansions in response to the perfectly reasonable response of the market to increases in demand (I have a whole class in how they would have developed such a theory, but it’s a bit much for the blog).

If you are old enough to remember the early 1980s, you may recall the incredibly high interest rates. This was on purpose, a policy response of the Voclcker Fed to the inflation caused by OPEC. It caused the worst recession since the Great Depression (a title it only lost very recently!). Unemployment skyrocketed from 5.9% in 1979 to a peak of over 10% during 1982. This was all done on purpose in order to control inflation that they viewed as demand pull. It was, of course, not.

Unfortunately for those of us uncomfortable with the government causing unemployment on purpose (and for no good reason, assuming there is a justification for such a policy), it appeared to work. Here’s the last bit of the numbers above, with a few more tacked on:

US Inflation
1978 7.6%
1979 11.3%
1980 13.5%
1981 10.4%
1982 6.2%
1983 3.2%
1984 4.4%
1985 3.5%
1986 1.9%

WOW! 1.9% inflation! That’s incredible given what had preceded it! It looks like we should give the government carte blanche to cause the worst recession since the Great Depression whenever they need to! After all, demand-pull inflation is terrible since it enriches people who sell things that others want and it creates appropriate signals to entrepreneurs and consumers.

What this story leaves out is the following. First off, our hands are obviously tied when it comes to market power being a function of something that lies outside our legal jurisdiction, as happened with OPEC. We can find ways of making what they sell less important to us (as we did), but that’s about it. We can’t drag them before a Congressional committee and accuse them of anti-trust violations. Fortunately, however, we didn’t have to. They fell apart on their own.

On September 22, 1980, Iraq invaded Iran. The war, which resembled the Western Front in WWI but with missiles and jets (and included chemical weapons), dragged on for eight long, bloody, and terribly expensive years. With both countries in terrible financial straits, they started cheating on the OPEC agreements they had made (the agreements that had led to the high prices). And, if they were going to cheat, others decided to do so, too. Take a look at the figures again and see when the inflation starts to fall. And things got much worse for OPEC (and better for the rest of us!) as their agreements collapsed. Oil prices fell and inflation suddenly and miraculously came under control. What solved US inflation? Saddam Hussein’s dreams of empire, not Paul Volcker’s economic policies!

The debt, deficit, and inflation

I suggested in the opening paragraph that part of my motivation to write this now was because people were saying that the debt and deficit could cause inflation if we tried to pay them off by monetizing them (i.e., by simply printing money). I think this entry is probably long enough so I’ll be brief here. Two things: 1) printing money doesn’t cause inflation if the economy is not already at full employment, i.e., if we are not already at the point where we are at maximum capacity. Otherwise, it just creates jobs and output. 2) If it does create inflation, it’s demand-pull.

And that’s enough for today!

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Written by rommeldak

July 22, 2010 at 7:31 pm

Posted in Uncategorized

13 Responses

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  1. couple of things.

    I trace the end of the 70’s inflation to the deregulation of natural gas in 1978 that led to the increase of production and the substitution that broke OPEC.

    Second, the price level in general is necessarily a function of prices paid by govt when it spends (and/or collateral demanded when it lends), not that it’s always politically optimal to use that as a policy tool. But sometimes it is.

    Warren Mosler

    November 21, 2010 at 5:13 am

  2. Howdy, Warren!

    I quite agree that the end of the inflation was brought on by a combination of factors, including policy and private sector initiatives to reduce dependence on oil (as you mention). But it seems to me that the straw that broke the camel’s back was the Iran-Iraq war, which greatly accelerated the cheating and meant that there was no payoff for following quotas. Of course, maybe this is a function of the fact that my first love in military history and I therefore want to believe the war was more important.

    With respect to the second point, while that adds the government as yet another player in the fight over income shares, it does not otherwise change the story, does it? Essentially, we have various groups in the macroeconomy trying to gather more resources to themselves. The government is also one of those players and they can have an impact–though not always a decisive one–on the outcome of the battle.

    rommeldak

    November 21, 2010 at 11:54 am

  3. Now I’m more confused, as I am typically on Warren’s side, that the solution to a supply shock is to find alternatives to supply.
    However, you define this as cost-push/market power inflation rather than demand-pull inflation. I only mention demand-pull inflation because your solution to lower inflation is to find alternatives to supply (your lumber example).

    Confusion reigns.

    senexx

    March 10, 2011 at 7:25 pm

    • Howdy! Sorry it took me several days to reply.

      I’m not real sure what you are saying. Quite right, I am defining a supply shock as cost push. However, this is pretty standard micro. I don’t know of anyone who would call it demand pull.

      With respect to finding alternative sources of supply, that would, indeed, be a solution to either kind of inflation. Again, I’m not (to my knowledge) saying anything controversial here.

      Apologies if I have missed your point (and I feel as if I have)!

      rommeldak

      March 14, 2011 at 9:32 pm

  4. No you haven’t missed the point. Just me being a learner (I would say student but that implies I’m enrolled in formal academic study). I’ve misunderstood something here somewhere.

    I was thinking of the Oil shock of the 70s being the equivalent of less anchovies around which you’ve described making it demand pull. You’ve described the Oil shock as demand pull and the Anchovies as cost-push but yet both in the examples you provide are being caused by a limited supply. (Please keep reading if you intend to reply)

    I think I see where I went wrong. You said it was demand pull IF we all drove more during the 70s but then you said it was cost-push because of OPEC and the anchovies as Cost-Push.

    It took some thinking but think I understand now.

    On alternatives to supply for either forms of inflation I was thinking primarily of the Oil situation which is precisely why we need to embrace the Green energy renewable resources to limit the effects of any more Oil Supply shocks.

    Senexx

    March 19, 2011 at 8:17 pm

  5. Yeah, that’s it. And, yes, alternative energy sources would indeed be a logical alternative (and not throwing the entire economy into recession, as we did in real life!!!).

    rommeldak

    March 19, 2011 at 10:07 pm

  6. rommeldak,

    If relative changes in supply and demand cause inflation, what does it mean to say that all prices are constantly increasing on average?

    vimothy

    March 24, 2011 at 5:50 pm

  7. Howdy, vimothy! Sorry it took me a while to get back to you.

    I’m not quite sure what you are asking, I’m afraid. You say, “If relative changes in supply and demand cause inflation, what does it mean to say that all prices are constantly increasing on average?” Ah, maybe I get it. Are you asking, why, if relative changes in supply and demand cause inflation, is it not true that roughly half of all prices fall while roughly half rise? Why do they all tend to rise? If that’s what you are asking, I think this issue is this: every price in the macroeconomy enters into the cost equation for another product. So, if the price of lumber rises, there is no offsetting decline somewhere else, but a series of increases. This is not to say that each will be the same percentage (say, 10%). As such, there will be a redistribution of income. But, bumping up any price is going to set into motion a series of such movements.

    Please let me know if that wasn’t the question!

    rommeldak

    April 3, 2011 at 12:28 pm

    • Hi,

      Yes, you’ve understood my question. Sorry, use of the word “constantly” was a bit ambiguous—I should have written “continuously”.

      I meant that if you were to take the expected price change for any randomly selected group of goods then you would probably find that it is greater than zero. I.e., why is it that, on average, prices seem to rise?

      You note that many prices are the cost of inputs in the production process, so that rise in the price of lumber, say, will feed through into prices of other goods. This is a very general statement. We might want to talk about market structure, the shape of producer cost functions, consumer preferences, etc, but if we assume arguendo that it is true, then I’m not sure whether the question has really been answered. The price of output is rising because the price of inputs is rising, but why is the price of inputs rising?

      Let me make a further observation about relative prices. Say that the economy produces two goods A and B, and that the relative price of A to B is 2:1. If the relative price of B rises so that the exchange ratio is now 4:1 then the relative price of A has necessarily fallen. It is possible for all prices to be rising; it is not possible for all relative prices to be rising.

      vimothy

      April 6, 2011 at 5:53 pm

  8. Hi again, Tim. Let me pull out some of your statements and address them individually.

    *********************

    You note that many prices are the cost of inputs in the production process, so that rise in the price of lumber, say, will feed through into prices of other goods. This is a very general statement. We might want to talk about market structure, the shape of producer cost functions, consumer preferences, etc…

    You have a deeper question here, but before I get to it let me say that this is something I’ve wanted to do because it could be very interesting. That is, to trace the effect of an increase in a particular price throughout the macroeconomy. I think one could do this using a system dynamics model (basically a computer simulation). I don’t think general equilibrium lends itself to this, nor would it be as realistic. Prices change in real time. And the effects and path would, indeed, be affected by market structure, etc.

    *********************

    The price of output is rising because the price of inputs is rising, but why is the price of inputs rising?

    I would say that roughly speaking there are three basic reasons.

    1. Acts of God: This is the easy one. I remember reading in an intro micro book once that the anchovy harvest off the coast of Portugal fell way off one year. Why? No one knows, but the price of anchovies went way up because the supply dropped so much. This led to a series of price increases since anchovies were also used in cattle feed. Why did cattle prices rise? Because cattle feed prices rose. Why did cattle feed prices rise? Because anchovy prices rose. Why did anchovy prices rise? An act of God: anchovies didn’t show up off the coast of Portugal!

    2. Increase in demand: Say there is a housing boom and this causes bottlenecks in the building industry. The price of lumber may increase.

    3. Market power: Say a group has market power (OPEC, for example) and is able to mark up price and/or reduce supply. This raises price.

    *********************

    Let me make a further observation about relative prices. Say that the economy produces two goods A and B, and that the relative price of A to B is 2:1. If the relative price of B rises so that the exchange ratio is now 4:1 then the relative price of A has necessarily fallen. It is possible for all prices to be rising; it is not possible for all relative prices to be rising.

    I am in absolute agreement, and often times that is the purposeful goal of those causing the inflation. For example, in the 1970s and early 1980s, with the inflation caused by OPEC, I would guess that damn near all prices rose. But, oil rose the most–and that’s what OPEC wanted, because it meant that they were better off. They were after capturing more income for themselves and they succeeded in doing so because even though all prices rose, the one for the product they sold rose the most.

    *********************

    why is it that, on average, prices seem to rise?

    I would have to think about that. I would suspect that part of the answer is that perhaps the market, in general, is less competitive than it used to be in, say, the 19th century? But even then, there was certainly a general trend towards higher prices. It seems reasonable to me to think that if there are groups like OPEC in the economy at any given time, who are trying to edge up the prices of the products they sell in order to get more income for themselves, then this would impart an inflationary bias into the entire macroeconomy. But I can’t honestly say that this is something I have studied.

    rommeldak

    April 6, 2011 at 6:30 pm

  9. john thanks for the great post from a fellow texan from austin. i’m a laymen so your post outlined the types of inflation was helpful. now as far as when these types of inflations occur, am i right in thinking that public sector spending creates inflation when spending exceeds the productive capacity of the private sector (demand pull). while inflation from private sector spending comes about from either excessive credit expansion (demand pull), overheated economy (demand pull), or supply side shocks (cost push – aka. ’73 oil prices). would you agree with those statements and if so are there any other situations where inflation is caused by private sector?

    Craig

    April 13, 2011 at 5:12 pm

  10. Howdy from up north, Craig! Let’s see here, I’ll lay out your questions and comment below them.

    1. “…am i right in thinking that public sector spending creates inflation when spending exceeds the productive capacity of the private sector?”

    That is certainly one way that inflation could be caused. if the government continued to try to stimulate the macroeconomy past the point of full employment, then demand pull could exist.

    2. “…while inflation from private sector spending comes about from either excessive credit expansion…”

    As a matter of fact, I’m planning a post on this in a couple of weeks, but on my Forbes.com blog (just search for john t. harvey forbes in Google and you’ll hit it). This view harkens back to the old “too much money chasing too few goods” approach, and in a monetary monetary economy it can’t really happen. Back when we had a commodity money, like gold, it is certainly possible to increase the money supply past money demand and thereby cause inflation. However, we have a credit money system. The Fed sells TBills to raise the money supply, and they can’t force you to do that. Either you wanted it or you didn’t. Actually, it’s more appropriate to say that rising prices cause rising money supply, and not the other way around! But more on that in a couple of weeks.

    3. “…overheated economy (demand pull)…”

    Yes, although in real life this is very rare (look at the 1990s expansion, for example, which should have caused terrible inflation by this theory).

    4. “… supply side shocks…”

    Yes.

    In terms of your question, I would say that it is important to bear in mind how market power can play a role–less-competitive firms and workers can drive up prices. Actually, this is all OPEC was. Also, inflation can be caused via financial market speculation, as we are witnessing today with commodities and oil.

    Thanks for reading!

    John

    rommeldak

    April 13, 2011 at 7:31 pm

    • I’m a recent follower (6 months) of some of the MMT discussions (Moslers blog) so your credit money system makes sense. I guess excessive credit expansion results in asset inflation but not necessarily general inflation.

      “money supply exceeds money demand causes inflation” i guess this would occur under a gold backed currency because interest rates would rise causing an overall increase in the cost of doing business which would be passed along to consumers in the form of higher prices.

      ah yes i forgot about those wonderful speculators. should of remembered considering this article today – http://www.ritholtz.com/blog/2011/04/are-oil-prices-driven-by-speculators

      thanks again for your time … and all your posts

      Craig

      April 13, 2011 at 8:07 pm


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