Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

06 December 2017

Inflation: Unanswered Questions


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1. The “money supply” theory
2. The theory’s need for granularity
3. The wage-price spiral
4. The effect of interest rates
5. Money lockboxes
6. Other sources of “easy money”
Conclusion

Where is inflation going and why? If you think our experts know the answers, think again. Outgoing Fed Chair Janet Yellen says her “best guess” is that, as quantitative easing fades to black, inflation will rise to her target range of 2% but may overshoot. When, how and why, she can’t say. Her successor Jerome Powell seems to have no more certainty.

That’s odd, to say the least. The economic models for our national economy are about on a par with scientists’ climate models in sophistication and complexity. They use roughly comparable supercomputers, and presumably they have equally skilled programmers.

The problem is the theory. Climate models are mathematically precise. Based on current knowledge of science and past measurements, they calculate precisely how much global mean temperatures and sea levels will rise, depending on how much carbon dioxide our species’ global burning of fossil fuels puts in the atmosphere and when. They can even provide precise “error bars” that state the probability that each answer they give is right.

So-called “macroeconomic models”—those for our whole economy—are nowhere near that level of precision. They don’t have “error bars” because there’s too much confusion about the basic mathematical relationships among variables and therefore the basic equations. Economists are lucky if they can properly distinguish independent from dependent variables.

Why is this so? Well, climate science is basically physics and chemistry, with a bit of geology, oceanography, meteorology and paleontology thrown in. At its core, it’s all about atoms and molecules and how they behave in crowds.

Economics is about how people behave in crowds, as well as individually. And, notwithstanding the “wild card” of quantum mechanics, people are much more complicated than atoms or molecules.

A guy name Richard Thaler just this year got the Nobel Prize in economics for his work debunking the notion that people always do the rational thing, following strict rules of causation like atoms and molecules in classical physics (in the non-subatomic world, that means most of the time). If nothing else, Brexit and the election Donald Trump as president of the United States have proved Thaler’s point.

So the basic theory underlying much of modern economics is suspect. As it turns out, so are most, if not all, of the traditional theories of what causes inflation. At least they don’t seem to work well at this particular time.

This essay outlines my quick take on traditional theories of what causes inflation and why they are wrong or misleading in today’s world. In the conclusion, you’ll find the reasons for my very tentative and diffident belief that there’s not much we can do—or would want to do—to spark inflation. At least at the moment, bond traders appear to agree with me and disagree with the economists.

1. The “money supply” theory. When all else fails, economists often resort to the law of supply and demand. Why? It may be the only “law” of economics that works reliably and consistently in the real world. As applied to inflation, the law of supply and demand holds that, as the supply of money in circulation rises, it increases demand for an (assumed fixed) quantity of goods and services, so the prices of those goods and services will rise. Voilá! Inflation.

This theory is certainly plausible. The law of supply and demand does work. The problem is what constitutes “money.” Economists have invented several different measures of the money supply, but they always seem to be behind the curve.

If you’re trying to predict general inflation—of all prices for all goods and services—this theory doesn’t work very well. In the run-up to the Crash of 2008, financiers created all kinds of “money” in the form of financial derivatives, in absolutely astronomical face amounts. Estimates of the aggregate extant just before the Crash reached the 600 trillion dollar mark, almost thirty times our current national debt. Yet there was no spike in inflation.

After the Crash, the Fed injected at least four trillion dollars into our economy, by buying toxic assets and bonds to hold interest rates down. Again, there was no general inflation. Instead, we nearly got deflation.

Of course, there are lots of goods and services that business buys. In theory, easy money ought to have increased their prices. But that didn’t happen.

Maybe these facts help refute the “money supply” theory for general inflation. Or maybe they just show how human expectations interfere. They certainly did after the Crash, when businesses were fearful of expanding in a falling economy and so kept their hands in their pockets.

Maybe human expectations also interfered before the Crash. They certainly did for me in late 2007. Then I sold out because, like Diogenes, I couldn’t seem to find anyone telling the truth, whether atop our business or political leadership.

2. The theory’s need for granularity. If the “money supply” theory doesn’t work so well when stated so broadly, it works pretty well with a little more granularity. If we look at the Crash as a real-estate bubble, we can see what happened more clearly.

Much of those derivatives were a vain attempt to remove or shift the risk from securitized “liars’ loans” on real property, i.e., loans that under pre-existing credit standards would never have been made. Those loans—and the derivatives that made them possible—constituted an exogenous injection of liquidity into the national real-property market, with differing consequences in different city markets. But the general effect in those markets was exactly what the theory predicted. Viola! Inflation—big time.

A similar thing happened during the first oil shock, in 1973-74, caused by an Arab Oil Embargo. There, the supply of oil went down, with the same amount of money (demand) chasing it. So the price of oil went up sharply, the more so because our first attempt to increase the fuel efficiency of cars and lights trucks was slow and only partially effective. It didn’t help that the prices of oil and gasoline, as I’ve explained elsewhere, are highly inelastic, i.e., small changes in their supply or demand produce big changes in price.

As it happened, this exogenous oil shock also increased the price of just about everything, because the prices of energy and transportation are significant components of the price of everything. The increased price of transportation alone so stretched consumers’ pocketbooks that, as workers, they demanded higher wages, leading to a so-called wage-price spiral. As workers, consumers could do that, back in the seventies, because their unions gave them bargaining power.

3. The wage-price spiral. And so we come to the next big theory of inflation. The wage-price spiral was first identified in the early 1970s, during the Nixon Administration. When times are good, the theory goes, workers demand higher wages, and businesses grant them, recouping the wages by increasing the prices of their products and services. As prices rise, workers demand yet more raises to maintain their standards of living. This vicious circle of increasing wages and prices causes general inflation, which continues until it burns itself out or until the Fed squashes it.

There’s a big hole in this theory, even for the seventies. Times were not so good, at least after the big oil price shock. It hit workers in their pocketbooks, and they tried to recoup their losses through collective bargaining. Labor unions were big and powerful then, and so workers could do that.

Today this theory doesn’t work so well for at least three reasons. First and foremost, workers have lost their bargaining power due to the decline of unions and globalization. If they demand higher wages, the bosses just say, “Bye, bye. We’ll move our factory to China or Mexico, where workers are not so uppity.” Isn’t that, in a nutshell, why Trump is president?

The wage-price spiral during the Nixon years usually started with negotiation between one of the “Big Three” automakers (Chrysler, Ford and GM) and the United Auto Workers after a contract expiration. Often the negotiation produced a wage raise, sometimes after a government-mandated “cooling off” period under the Taft-Hartley labor law, and sometimes even after a strike. Nowadays none of this happens because globalization has given management the upper hand, and because the auto factories that stayed in America mostly migrated to the American South, where so-called “right to work” laws emasculated unions or even kept them from forming.

Second, the oil-price shock, not unrelated exuberance or workers’ demands, was the underlying cause of much of the inflation in the seventies. The inflation spread to the general economy because energy for transportation figures in the cost of virtually everything. Such a shock is not likely today, with experts predicting that fracking will soon make the US a net exporter of fossil fuels, at least for the next decade.

Finally, the “wage-price spiral” theory of inflation doesn’t work well today because economists, in their infinite wisdom, have removed energy and food from the definition of so-called “core” inflation. Funny thing, that. Energy and food are both things that people can’t do without, and therefore their demand curves are highly inelastic. About the only similar essential now remaining in the inflation calculus is housing. (Clothing and cars you can use until they wear out, and even then you can keep patching them. Just look at the 1950s cars still running in Cuba.)

So if you eliminate the two biggest necessities of life from consideration, and if they are the ones whose demand is most inelastic, how good is your remaining theory anyway? In eliminating food and energy from the standard measure of inflation, economists have been doing what Albert Einstein often accused lesser physicists of doing: drilling where the drilling is easiest.

4. The effect of interest rates. The use of interest rates to control inflation also presents another conundrum. In the seventies and early eighties, the Fed raised interest rates dramatically to curb the general inflation that had started with the exogenous oil shock. I remember that time well. Interest rates for home mortgages were in double digits, increasing the total price (including interest) of buying a home with a mortgage by multiples in the high single digits. As a result, I and many of my generation had to wait about ten years to buy our first houses.

Funny thing, that, too. At the time and for decades afterward, pols and citizens blamed the Fed and Paul Volcker, its then chairman, for the high interest rates and all the economic dislocations that they caused. But, after a few years, the high interest rates seemed to do their trick, and high inflation subsided, along with high interest rates. How much the auto industry’s later crash program of fuel efficiency, plus the discovery of deep-sea drilling and North Sea oil (at about the same time as the oil shock) had to do with that “solution,” no one appears to have calculated.

What’s funny is that now Janet Yellen and her successor both expect higher interest rates to work the other way: to spark inflation, rather than to control it. The theory seems to be that interest rates are the price of money, and if you raise them arbitrarily they will raise the price of everything else because everything costs money.

All I can say about this theory is that I don’t understand it and must bow to the economic priesthood’s special expertise. I do understand the Volcker theory that high interest rates help reduce inflation by making money more expensive and thereby reducing its circulation, i.e., its effective supply.

5. Money lockboxes. If you have read this summary carefully so far, you’ve probably concluded that inflation is beyond the ken of people not admitted to the high priesthood of macroeconomists. But it gets worse.

There several are ways in which vast increases in wealth don’t affect the supply of money available to purchase goods and services at all. The most important, which I’ve described in detail elsewhere, is Baby Boomers’ retirement funds. Trillions of dollars of relatively liquid cash, with more to come, are locked up in Boomers’ retirements. Congress may have raided the so-called “lockbox” of Social Security many times, but the lockboxes of private retirement funds are truly off limits.

Take my retirement, for example. When I retired, my net worth was probably at its peak. Besides my home, my money is mostly in annuities and tax-deferred retirement accounts. I could use the retirement accounts to buy things, but for two reasons, I mostly don’t. First, my parents survived the Great Depression; they taught me to save and never to touch principal. Second, as I get older in an increasingly irrational world, the financial security that money can buy seems far more valuable than any product or service.

So I content myself with the income from Social Security, my annuities, and the annual minimum required distributions from several retirement funds. That makes me quite comfortable but far from rich. And anyway, as age reduces my appetites, I just don’t spend a lot generally. Patronizing restaurants, theaters, concert halls and cruise lines is not going to spark general inflation.

If other Boomers are like me—and I think they are—there are tens of trillions of dollars locked up in private retirement lockboxes that will never be used for much of anything but geezer delights, gifts to relatives, and investment vehicles (stocks and bonds and their derivatives). Collectively, all that money might be helping inflate the prices of securities (stocks, bonds and their derivatives), but it won’t affect the prices of goods or other services, far less the stuff that most poor people buy.

A similar analysis applies to the trillions of dollars untaxed profits that our major corporations have stashed overseas. If our Congress gives them incentives to bring that money home, will they spend it or just sit on it?

If there were really attractive investments that they could make in their own or related businesses, in this globalized world they would probably find them overseas, where the money now sits tax free. The fact that they haven’t done so suggests that the corporations are treating this money much as Boomers treat their private retirement funds: as rainy-day funds and balance-sheet boosters.

If corporations bring this money home, they might use it for dividends to shareholders or stock buybacks, which might “trickle down” to goods and services. But the probability of using it to buy equipment or services directly, which managers haven’t already bought abroad, seems low. So whether kept stashed abroad or brought home, this money seems destined for one lockbox or another, just like Boomer’s private retirement funds.

6. Other sources of “easy money.”. Will the Trump-GOP tax scam now before Congress change this picture? Will giving trillions in tax breaks to corporations and the rich? Probably not so much.

The big tax cuts for the very rich will go right into their pockets. What will they do with them? Probably much the same as any upper-middle-class retiree would do. They’ll invest them in real property or in securities—stocks, bonds and their derivatives—raising their prices but doing nothing to or for the prices of goods and other services (except maybe luxury goods). Economists know, in general, that the rich save far more than the poor, because they have so much more than what’s needed for bare survival. (An investment vehicle available to the rich but not to the rest of us is expensive art. Could that be why a recently discovered painting of Leonardo da Vinci called “Salvator Mundi” sold at an all-time record auction price of $450.3 million?)

Will the big tax cuts for corporations have a different effect? Probably not. They will have much the same effect as allowing corporations, or encouraging them, to bring their foreign tax-free hoards home. Some corporations may use the extra money to buy equipment to expand their operations or make their information technology more efficient. But most will probably sit on the money, give it to shareholders as dividends or stock buybacks, or keep it for a rainy day or to fund new and unforeseeable future investments.

Conclusion. So what are the possible sources of inflation today? There don’t seem to be many.

Governments from ours to China’s have been burned enough by the Crash of 2008 and other real-property bubbles that they are going to use every lever of public, financial and fiscal policy to avoid them. The big money held by retirees and corporations is likely to drift into investment lockboxes and unlikely to flow into binge buying of goods or non-investment services. The present oversupply of oil will keep oil prices in check, as will fracking for the foreseeable future. In addition, electric cars and renewable energy will help keep the lid on oil and gasoline prices. As for a wage-price spiral, the demise of unions and the globalization of labor have made workers’ pressure for raising wages impotent. How can you have a wage-price spiral if workers have no power to demand higher wages?

All this doesn’t preclude minor bubbles in very specific, granular categories of goods and services. For example, repatriation of foreign cash hoards of, or corporate tax relief for, companies like the Silicon Valley Five (Amazon, Apple, Facebook, Google and Microsoft) could cause wage bubbles in esoteric fields like artificial intelligence. A similar bubble might occur for wages among scientific experts in genomic medicine. Likewise, as electric cars go mainstream, a commodity bubble might arise in lithium, the elemental metal that all their batteries now use.

But a general rise in prices of goods and services remains hard to foresee. Most likely, the sole effect of the Fed’s raising interest rates will be to raise the returns on bonds and so, concomitantly, lower the prices of stocks. That may shift money from one part of the securities industry to another. It may also create some winners and losers, even among retirees. But sparking general inflation? I just can’t see how.

The national model we are most likely to follow seems to be Japan. That nation is on the forefront of every demographic curve. It’s had nearly a generation of low inflation, if not deflation, caused by an aging population with a good social safety net and all the economic lockboxes that that implies. Its youth, like ours today, is having trouble finding good jobs and affordable housing. But its youth, unlike ours, is not burdened by unsupportable student debt and so probably has a more lucrative future.

Not only is there little prospect for inflation here. Without significant political changes, there is little prospect for the wider distribution of wealth, which might be a precursor to inflation. The rich, who are getting all the attention, save and invest; only the poor and lower-middle classes spend much.

If current tax plans come to fruition, corporations will hold their tax windfalls in lockboxes or distribute them to shareholders, and therefore largely to the wealthy. The wealthy will hold their windfalls or invest them in more paper. And the lower middle class and heavily indebted students, who would be most likely to spend their windfalls on goods and services, will get the least.

So the rich will get richer, big corporations will thrive, indebted former students will continue to live with their parents and struggle to find affordable housing, and life will go on. The only clear prospects for massive fiscal changes are for new sinks of money: the natural disasters that spooked us all this year and that global warming will make more frequent and more devastating as time goes on. Spending on repairs for those disasters may cause minor bubbles in emergency supplies and construction materials, but general inflation? Probably not.

A simpler way to digest all this information is to return to basic supply-demand analysis, i.e., the so-called “money supply.” At the moment, the effective money supply is quite restricted. Most of it is locked up in specialized financial instruments like the national debt (some $20 trillion), financial derivatives (some $700 trillion), corporate coffers (a few trillion), private retirement lockboxes (probably tens of trillions), prospective tax relief for corporations and the very rich (about two trillion), and emergency relief funds. There is not much left over, in the hands of ordinary workers and poor people likely to spend, to raise the prices of goods and services generally.

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