It´s all about spending

Given what we hear from the Glen Beck crowd, some members of the FOMC and even from reputable names outside of economics (for example, Alvaro Vargas Llosa, son of the Nobel winner Mario Vargas Llosa), after two millennia, a lower bound, we still have great difficulty understanding the concept of inflation. Ok, I know it´s hard because people think of inflation as a price phenomenon, so that an increase in a VIP (Very Important Price) such as oil is called inflation. More precisely, an increase in a VIP is said to be the cause of inflation. Check this quote from a specialist publication – The Economist:

But a jump in inflation caused by higher commodity prices and a rise in VAT—in an economy with spare capacity—is quite different from one caused by excess demand and a pay-price spiral. It intensifies the squeeze on households from other tax rises and curbs consumer spending. Although the central bank is facing calls to tighten monetary policy soon, that would be warranted only if there were signs of inflation getting embedded into expectations and feeding through to higher wages.

This Economist quote reminded me of similar reasoning from a Deutsche Bank economic report from early 2000, where I read: “The rise in oil prices (it had more than doubled over the previous 12 months) can be good” (!). In effect the rise in the price of oil was viewed as a “safety valve” for Greenspan since the rise increased household spending on energy by US$ 50 billion, thus reducing by the same amount resources available for other expenditures, which made a soft landing of the economy more likely. It went on to conclude that Clinton had erred in pressuring OPEP to increase output!

This is all very muddled thinking. Apparently inflation has many “causes” that have different implications. If it is “caused” by a rise in a VIP, it is somehow “good” because it intensifies the squeeze on households and curbs consumer spending (which, I presume, would reduce inflation?). If it is “caused” by “excess demand” it results in a wage-price spiral (which, I presume, perpetuates inflation?). Fifty years ago those “situations” were termed  “Cost push” and “Demand pull” inflation, respectively.

And I´m not making this up. No one doubts that Arthur Burns, a Director of the NBER, adviser to President Eisenhower, Ambassador to Germany, teacher of Milton Friedman, George Stigler and Alan Greenspan, and Fed Chairman, was very knowledgeable in economics. Even so, he presided over the “Great Inflation”. Not in the sense that he was in “the right place at the wrong time” but in the sense that he was responsible for (i.e. caused) the “Great Inflation”. The best and most readable story of “Arthur Burns and Inflation” is the one rendered by Robert Hetzel of the Richmond Fed in a Review article from 1998. The essence of the story is in the following paragraph::

Burns had a real or nonmonetary view of inflation. That is, inflation could arise from a variety of sources other than just money. He believed that a central bank could cause inflation by monetizing government deficits but did not attribute inflation to that source in the early 1970s. Instead, he attributed it to the exercise of monopoly power by unions and large corporations.

Obviously later he blamed it on the power of oil producing countries. To Burns inflation arose from supply shocks (“Cost Push”), against which monetary policy couldn´t do much, except compensate for the negative impact on growth and employment of these shocks! And it was exactly this “compensation” that resulted in the nominal spending (NGDP) upward trend that characterizes the 1970´s, which had the effect of “watering” the so called wage-price spiral. So “cost push” morphs into “demand-pull” and becomes a single process called Inflation!

At the time, Friedman´s dictum “Inflation is always and everywhere a monetary phenomenon” was like a shout in the wilderness: there were few listeners!

But if you think a bit more, you will find that the “cost push” part of the process many times is a result of a previous “demand pull”, i.e. a rising spending trend, something that only monetary policy can provide.

The figure below provides a good illustration. Nominal spending growth began trending upward after 1965. At first nothing much happened, mostly because inflation expectations were not entrenched. That soon changes, however, and workers and firms start taking the fact that prices are rising into account in their decision process. To the “Cost push” believers the solution is to enact “incomes policies”, an euphemism for wage and price controls. In the very short term inflation dips, but only to return stronger.

Meanwhile, oil producers see their prices are fixed in dollars, implying their incomes and margins are going down in real terms. Initially, instead of buying “Cadillacs” from General Motors whose prices were going up, they take advantage of the fixed exchange rates regime that was in place until mid 1971 to buy “Mercedes” from the Germans. When President Nixon “closed” the Gold Window in August 1971, the dollar depreciated strongly against the Mark and other currencies.

To the oil producers this was a “double whammy”. Both “Cadillacs” and “Mercedes” became more expensive to acquire. Using the Egyptian, Syrian, Israeli conflict as an excuse, OPEP declared an oil embargo and oil prices shot up. OPEP, which had come into existence in 1960 and had never yielded much negotiating power, became powerful and feared. In early 1979, with inflation in the US on the rise they promoted the second “oil shock”. Both were clearly the result of previously escalating inflation. They were not it´s Cause as we frequently hear.

The Atlanta Fed has an ongoing Inflation Project. Among other interesting stuff, they constructed data on “flexible” and “sticky” CPI. The respective 12 month rates of change are graphed below.

Eyeballing the picture I tentatively conclude that an inflationary process may be characterized by the fact that all prices become “unstuck”. In that situation it is rational for different groups – workers, producers – to devise ways to protect their real incomes. Relative price changes still take place during the inflation – some prices change more (or less) than others. This was what happened during the “Great Inflation”. Following the “Volker adjustment” of the early 1980s the process changes, with flexible prices fluctuating quite a bit while “sticky” prices remain just that: sticky.

This has happened because nominal spending growth (NGDP) has been stable (no rising trend like in the 1970s). In mid 2008 when spending growth plummets, sticky prices inflation drops, independently of what´s happening with “flexible” prices.

The irony of it all is that many people, economists included, effectively are saying that they prefer the economy to remain deep inside the “hole” rather than see inflation rise a bit from an increase in spending growth that would anyway be reflected mostly in real output growth (lower unemployment and rising employment). Go figure!