Where's That Inflation?

Chris Coyne

Veronique de Rugy explores the answer to this question in her latest piece at Reason.com.

Co-bloggers Steve and Pete (Boettke) are quoted.

Comments

[bill woolsey]

You know, it is supply and demand. It is the quantity of money and the demand to hold money, not just the quantity of money.

A bubble is not a price rising and then falling. For example, a hard freeze in Florida doesn't create a speculative bubble in orange prices.

The natural interest rate is not fixed. It depends on expectations of future profits and future income.

[Richard Ebeling]

What the monetarists miss, as Steve and Pete point out in their quotes in Veronique's article, is that monetary changes impact on the structure of relative prices and the micro-patters of relative demand first, before any measured change in the price level aggregates.

This has to be the case because as the Austrians (and many of the better 19th century classical economists) understood, changes in the quantity of money have to entire (be withdrawn) at some particular place in the economy, increasing (or decreasing) the cash balance position of some particular individuals.

Their modified spending patterns (induced by the monetary change) then disperses out through the rest of the economy from that specific "injection point."

Only after the resulting modfifications in the structure of relative prices and demands will have impacted sufficiently may some measured index of some selected prices then indicate whether their has occurred a change in prices "in general."

That is why what is (or has been) happening beneath the "macro-aggregate surface" is far more fundamental than whether or not over a particular period of time the general price indices have "significantly" changed or not.

The economics profession has never caught on to what Hayek was really emphasizing in both "Monetary Theory and the Trade Cycle" and "Prices and Production." That the next step for monetary theory was to more fully integrate monetary analysis with micro process theory.

That is why Hayek argued that his agenda was to analyze money's impact on the structures of relative prices and production stages. And not the macro-aggregates that he considered to be one of Keynes' fundamental flaws in focusing upon.

Richard Ebeling

The economics profession has still not caught up with the Hayek of the 1930s.

[bill woolsey]

Richard:

How do these injection effects occur when it is reserve balances banks hold at the Fed that have ballooned?

I am sure that relative prices are different than what they would have been if the quantity of money had fallen.

Why is that the proper benchmark?

When the banks start to spend the excess reserves, the excess reserves will disappear and the quantity of money held by members of the general public will start to expand.

If and when the Fed fails to reduce the monetary base in response to the rising money multiplier, and the weekly figures for the quantity of money start to skyrocket, then perhaps there will be injection effects that will show up before the CPI starts to rise.

I will grant that other measures of the quantity of money (like M1, M2, and MZM) have increased, but the increases are modest. Perhaps those increases have caused injection effects and will soon result in increases in the price level as well.

I just want to insist that nothing of consequence has ballooned as of yet. We will see if that happens when the money multiplier begins to rise.

[Steve Horwitz]

Bill,

My recollection of my conversation with Vero was that I said more or less just what you say in the last bit here. I said that I was very fearful of inflation given the increase in the base (so in that sense "inflation was happening") but that we weren't seeing much in the way of visible signs of it yet because that base was still sitting in bank reserves. I continue to believe that it will be very difficult for the Fed to undo that massive expansion in the base without it entering the spending stream and manifesting itself as inflation.

That said, the point of Richard's comment, as I read it, was that the damage done by inflation is what emerges from the relative price effects when the excess money supply enters the spending stream. Therefore a focus on aggregates like the price level for understanding the real problems with inflation is misplaced. The real problems are microeconomic. It might or might not be true that relative price effects happen before the CPI picks up the increase. The point is that the RPEs are what matter, not the change in CPI.

I discuss this all at length here: http://www.gmu.edu/rae/archives/VOL16_1_2003/5_Horwitz.pdf

[Jerry O'Driscoll]

What is inflation? Armen Alchian and Ben Klein, not Austrians, argued that an inflation measure must include asset prices. We are still recovering from an asset boom and bust that was accompanied by comparatively little CPI inflation except toward the end.

Monetary policy is increasingly transmitted first through asset prices, and only then through final goods prices. If you wait to see the whites of their eyes -- CPI inflation -- you already have massive misallocation of resources.

We have not yet unwound the previous bubble (especially not in commercial real estate), and are already inflating the next one. That is being financed by a carry trade and is bidding up real-estate prices in Asia. And commodities. Hence the public rebuke of Geithner and Obama in Asia.

In a global economy with formal and informal pegs to the dollar, the injection effects need not be in the US. Much of this can be financed w/o money creation -- at least not in the US. Perhaps Bill Woolsey has access to numbers for the money supply in Singapore, HK and elsewhere.

[Lee Kelly]

If the Fed doesn't contract the monetary base when velocity begins to rise, then we'll see a general rise in prices.

In my opinion, Austrian economics is great on the boom and not so great on the bust -- I blame the influence of Rothbard. Economists like Horwitz, Selgin, and White end up fighting to be recognised as Austrian economists. Is it really a title worth fighting for? I wonder sometimes.

Earlier this year, I bought the standard Austrian story, but the last 9 months have been a test of sorts. The failure of a general rise in prices to materialise led me to seek new answers, and I believe I have found them. Of course, I am still concerned about future price rises, but not nearly so much and for different reasons.

Whether it was by intent on not, those who post and comment on this blog are largely responsible for my change of opinion.

[Jerry O'Driscoll]

Lee Kelly: My first reaction is to go back to Bill Woolsey's comment about money demand. Velocity has collapsed, as has the money multiplier (answer to why the higher order money measures show little growth).

The next issue is that raised by Steve Horowitz. How can the Fed unwind this? Many, including Anna Schwartz, doubt the Fed will be able to do technically (becuase of the type of assets it has acquired). Then there is the question of the will, or the absence thereof.

And finally, there is my point that you are looking at the wrong prices and, for now, in the wrong country.

[Pablo Kuri]

Jerry,

Follow the money: http://online.wsj.com/article/capital.html

[Pablo Kuri]

+ Marc Faber´s expectations of what the Fed is doing and what are the possible outcomes. I would be specially alert to his answer on whether he is buying... turns out he bought early on the monetary expansion. There is the video sequence also in this link.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aJeWTfIgi4WM

[Bill Woolsey]

I favor stable growth in nominal expenditures on final goods and services. I don't favor responding to past changes in the CPI

Nominal expenditure remain 1% below its peak and someting like 9% below the past 5% growth path and 7% below a modified 3% growth path consistent with stable prices in the future.

I don't know what various foreign central banks are doing with their monetary policies. But if they are increasing them to maintain a dollar peg, and the result in excessive growth in expenditures on output in their countries, then that is their problem.

Not all increases in asset prices are bubbles. Not all increases and then decreases in asset prices are bubbles.

Starting from equilibrium, an excess supply of money can cause lower market interest rates. But when nominal expenditures have falling, and expectations shift, the natural interest rate changes. When other things are not equal, lower market interest rates don't necessarily imply an excess supply of money.

I don't think there are any easy answers. But stable growth in nominal expenditures looks like the least bad option to me. And that currenty signals excess demand for money, not excess supply.

[Richard Ebeling]

From June 2008 to October 2009, "M-2" increased by about 8.5 percent.

While this is not a massive ballooning compared to the increase in the monetary base, this is not "monetary restraint," either.

And if the the Treasury is not able to get the Chinese and other foreign sources to fund the trillion-dollar deficits, much of that $2 trillion that is sitting as "excess reserves" may very well start entering the economy to fund all the planned government expenditures above what the government takes in as taxes.

What HAS NOT happened is a monetary deflation. That is for sure.

So the present monetary circumstances bears no resemblance to the monetary contraction of the early 1930s.

Richard Ebeling

[Lee Kelly]

In my opinion, whether there is deflation doesn't matter by itself. The important thing is what other variables are doing *relative* to the price level, money supply, or whatever.

M2 was expanding in early 2008, but there was no change in the growth trend. Meanwhile, the growth rate of nominal expenditure started declining and velocity "fell off a cliff." In other words, the Fed did not adapt monetary policy to changing economic conditions. What was not tight monetary policy in late 2007 became so in early 2008; thus, the downturn was exacerbated and the secondary recession initiated.

The Fed took so long to pull its finger out that the unprecedented expansion of the monetary base was probably an appropriate response. However, the situation would not have arisen in the first place if the Fed was a competent manager of the money supply.

Really, I just want the Fed to emulate what I think free banking would achieve in its absence.

[DG Lesvic]

Kelly,

You wrote,

"Really, I just want the Fed to emulate what I think free banking would achieve in its absence."

That would be nothing.

Were a bank, in a free and competitive banking system, to inflate, its depositers would flee to a bank that wasn't inflating, and the only banks left would be that those that were not inflating, the ones that were doing nothing.

[DG Lesvic]

Kelly,

You also said, "the unprecedented expansion of the monetary base was probably an appropriate response."

Apparently you missed the discussion we just had below: Let me repeat a bit of it:

Prof Horwitz said, "I am in favor of central banks not allowing major decreases in the money supply and I am in favor of central banks expanding the monetary base in the face of a significant increase in the demand for money."

My response: "But the money supply has decreased because the market foresees an increasingly hostile climate for investment, and the need to keep its money out of the path of an oncoming avalanche and provide for rainier days.

Why would you take it from those who had earned it to give to those who hadn’t, from the prudent to the imprudent, from those who would conserve it for the rainier days and the opportunities for recovery where they appeared, to give to those who would throw it into the path of an oncoming avalanche?

[Mikeikon]

Could it be that the inflation already happened--on the way up to the crisis?

Businesses, banks, and investors had all these profits that were really based on leverage, and yet everyone was going around behaving as if that money really existed. So, in a sense, it did, which caused inflation on the way up. The crisis came and then the money was discovered to be imaginary.

Normally, this would mean massive deflation (and unemployment during the restructuring) since prices have to correct to reflect the real size of the money supply and those who now hold the purchasing power (those who actually hold real dollars who were ripped off through inflation on the way up). Instead, what the Fed is doing is making all that imaginary money real by inflating the money supply and using it to bail out the institutions that failed. So, instead of causing inflation, it's simply preventing deflation and putting us back where we were.

That leaves us with a sub-optimal distribution of resources, but prevents the painful correction.

...

Is there any truth to what I just said?

[DG Lesvic]

Mikelton,

Sounds pretty near right to me.

[Jerry O'Driscoll]

I always appreciate Bill Woolsey's comments because he offers a clear statement of his position. But he just politely restated Treas. Sec. Connelley's famous quip: "It's our currency, but your problem."

The producer of the global reserve currency cannot engage in such behavior w/o consequences for the world and its own economy. There will be reflux from the paper wealth created in Asia into the US economy.

[Jerry O'Driscoll]

For those interested, I was interviewed for a Podcast on the international aspects of US fiscal and monetary policy at www.cato.org.

[DG Lesvic]

Mr Woolseys's Keynesian program to bring the market back to health is just more of the poison that made it sick in the first place.

Just more funny money and squandering will solve all our problems.

That is economics on its head.

[Pablo Kuri]

A wall of money to sovereign debt: “It’s because of the wall of money that comes from extremely accommodative monetary policy globally,” said Edwin Gutierrez, an emerging-market money manager who invests $5 billion in assets for Aberdeen in London. “There is just absolutely loads of liquidity out there still trying to find a home for that money.” From bloomberg: http://www.bloomberg.com/apps/news?pid=20601087&sid=ajFHnGFuSkXY&pos=6

[Jerry O'Driscoll]

Pablo: Thanks for the link. The world is awash in lquidity, but there is no credit for U.S. firms.

[Leonardo]

As long as we keep an eye on a partial price index, like CPI is, while considering a wide monetary measure which we do not know where it does flow to (actually out of the restricted basket CPI refers to), we will keep misinterpreting the actual inflationary stance.

Moreover: if prices should tend to lower, because of low-cost Asian contributions or general over-consumption retreatment (a bubble can be seen as a form of this phenomenon too), is not substantial stationarity of prices actually mere inflation instead?

Thanks

[Bill Woolsey]

Jerry O'Driscoll:

"The producer of the global reserve currency cannot engage in such behavior w/o consequences for the world and its own economy. There will be reflux from the paper wealth created in Asia into the US economy."

I think I understand a reflux. An individual bank that lends too much money will have adverse net clearing and must meet its obligatins with settlement medium. How is it that foreign banks or central banks lending money in their currencies creates an obligation for U.S. banks or the Fed to pay off those liabilities?

If the U.S. was on the gold standard, and the rest of the world used dollar assets--kind of like Bretton Woods, and the U.S. expands dollars, and the foreigners expand their currencies, then it seems likely that all of that foreign money will end up generating a demand for U.S. gold.

But we don't have a gold standard.

If the maintenance of slow growth of nominal expenditure in the U.S. implies that foreign central banks who peg to the dollar have excessive growth in nominal expenditure, then they get higher prices. That leads to increased U.S. exports and reduced U.S. imports. And when this happens, maintaining nominal expenditure in the U.S. will require a dampening of demand.

What is happening (I think) is a reduced net capital inflow to the U.S., or a net capital outflow. The natural interest rate in the U.S. is higher. Higher market interest rates are needed to clear markets. That generates less consumption spending and investmnet spending in the U.S.. The U.S. produce more goods domestically, and produces consumer or capital goods for people in other countries.

The alternative "solution" is for the U.S. to contract nominal expenditure in the U.S. so that the foreign countries will not expand nominal expenditure. When prices fall in the U.S., then the U.S. will export more and import less. The same allocation of resources described above occurs. But foreigners who peg their currency to the dollar don't have inflation.

If the foreign countries don't want to have the inflation, and the U.S. stabilizes total expenditure, then they let their currencies appreciate relative to the dollar, and the U.S. exports more and imports less. Everything else is the same.

I say, stable growth of nominal expenditure for the U.S. and let the rest of the world decide whether they want whatever inflation or deflation that implies for them with a fixed exchange rate, or they can float.

The notion that stable growth of nominal expenditure in the U.S. is somehow equivalent to working hard to promote fixed exchange rates while undertaking a policy of progressively increasing nominal expenditure growth (like the sixties and seventies) is absurd.

[Jerry O'Driscoll]

Bill Woolsey,

My point was a simple one. If you are producing the reserve currency, you need to take account of the effects of your policy on other countries. We are repeating the mistakes of the 1960s and 70s, which led to inflation and dollar crises.

Our banker, the Chinese, has told the president to stop spending and running up deficits. Much as DeGaulle did in the 1960s and 70s. Nixon demonized him, but in the end the Europeans forced Volcker to tighten. Perhaps Obama will ignore the Chinese for a time, but that will only worsen the crisis. (Pete's recent post on the fiscal situation and the resposnes are on point here.)

The "reflux" I mentioned is spending generated by the commodity and Asian real-estate bubbles. With appartments going for $57 million in Hong Kong, condos in NYC will begin to look very cheap (not to mention housing in Las Vegas).