The Continuing Cost Problem

Inflation, it seems, cannot happen without an increase in the quantity of money or in credit use or velocity. Nonetheless, there may be cost-push pressures that will lead to reduced economic growth unless the central bank "accommodates" the cost by increasing the quantity of money to generate some inflation, or unless the cost issue is otherwise resolved.

Cost-push pressure will lead to slower growth temporarily (perhaps causing a recession) unless the Fed "accommodates" by increasing the quantity of money to offset the increased cost (perhaps causing inflation).

Could there be cost pressure that creates not recession but a continuing trend of decline? If, as I think, economic growth has been slowing since the 1960s, is there an identifiable cost pressure that could have caused this long-term decline?

The price system usually works out cost changes automatically, so to speak. A one-time cost shock, even a big one like oil, will eventually find resolution as a change in relative prices. So, how could there be a cost pressure that creates a long-term trend of decline?

It would have to be a long-term, continuing cost pressure, one that even if resolved today returns tomorrow. If resolved by monetary accommodation, we would see a long-term, continuing inflation (as we saw in the 1970s). If resolved by Volker-like resistance to accommodation, it would lead to recession. But after the recession, inflation would persist (as we saw in the 1980s) unless the cost problem was discovered and eliminated. Or, if resolved by a compromise between accommodation and resistance to accommodation, we would see a compromised economy with both continuing, low-level inflation and a continuing, gradual decline in economic growth -- something quite like our own economy of the past several decades.

Could there be continuing cost pressure like that in our economy? What would be its features?

• It would have to be a massive cost, massive enough to influence our massive economy.
• It would be a slow-growing cost, not a sudden shock like the oil crisis.
• It is likely to be a cost we don't see as a problem: continued cost growth that doesn't much concern us since we don't recognize it as the underlying cause of our economic troubles.

Could there be such cost pressure in our economy?

The greatest trick the devil ever pulled

We don't talk much about cost-push inflation these days. Today's catchphrase is "supply shocks". Here, Scott Sumner:

There's supply side inflation, which is created by shocks like sudden increases in oil prices, and then demand side inflation caused by overspending in the economy. It's really demand side inflation that the Fed is concerned about. There's not much they can do about supply side inflation.

That's a little too tidy to suit me. It certainly seems right, but I don't trust it. I can't help thinking it's too simple. I think Sumner simplifies the story by leaving things out. Things like cost-push inflation.

Some people say there's no such thing as cost-push inflation. Sumner again, quoting Caroline Baum:

This is one of those myths that never dies: cost-push inflation.

Mike Shedlock, quoting "HB":

There actually is no such thing as 'cost push inflation'... Economy-wide, a rise in general prices is only possible if the money supply increases.

Dallas S. Batten, from 1981, in Inflation: The Cost-Push Myth (PDF):

The ultimate source of inflation is persistent excessive growth in aggregate demand resulting from persistent excessive growth in the supply of money.

You know, I want to agree with these views, but they are too rigid. Inflation, they hold, can never be cost-push; it is always demand-pull. Funny, it strikes me that Dallas Batten left out the word "always":

The ultimate source of inflation is always persistent excessive growth in aggregate demand...

Now it reminds me of Milton Friedman, who emphasized the "always":

The recognition that substantial inflation is always and everywhere a monetary phenomenon is only the beginning of an understanding of the cause and cure of inflation.

I like this better. Friedman uses the word "substantial" in a way that leaves a door open: Inflation that is not "substantial" might be due to something other than monetary factors. Seems right to me: The economy is complex enough that we should want to allow for that possibility, and Friedman allows for it.

I like the statement too because the word "monetary" is non-specific enough to include not only the supply of money but also the expansion of credit use and changes in velocity -- or whatever it is that happens when the Fed changes the interest rate.


As for myself, I accept the view that if prices are increasing, it is because spending is increasing. And I accept that spending cannot increase unless monetary factors allow it to happen. I don't see any way around this, even if something other than money is driving the process.

I like what Google finds at Investopedia:

In short, cost-push inflation is driven by supply costs while demand-pull inflation is driven by consumer demand...

The two types of inflation are driven by different things. This leaves plenty of room for the view that inflation can only happen if monetary factors allow it to happen:

• If we begin with too much money in the hands of consumers, consumer demand leads directly to demand-pull inflation.
• If we begin with rising supply costs putting upward pressure on prices, the central bank may have to choose between recession and accommodation. If they try to minimize or avoid recession, the accommodation can give rise to cost-push inflation.

There is plenty of room to agree with hard-liners who insist that prices can't increase unless money and spending increase, yet still hold that cost-push pressures can sometimes be the driving force. And there you have it: cost-push inflation.

But I would be willing to never again use the phrase "cost-push inflation" if you would be willing to allow for the possibility that cost-push pressures may at times be responsible for the monetary accommodation that results in the inflation you call demand-pull. Cost-push inflation may be a "myth", but cost-push pressures are real.

The greatest trick the devil ever pulled was convincing the world that continuing cost-push pressure doesn't exist.

Demand-pull versus cost-push

If the problem is "too much money chasing too few goods" then you've got demand-pull inflation. Milton Friedman described it:

"When a country starts on an inflationary episode, the initial effects seem good. The increased quantity of money enables whoever has access to it ... to spend more without anybody else having to spend less. Jobs become more plentiful, business is brisk, almost everybody is happy -- at first. Those are the good effects. But then the increased spending starts to raise prices...."

Anna Schwartz described it:

"An increase in the supply of money ... stimulat[es] spending. Business firms respond to increased sales... The spread of business activity increases... In a buoyant economy, stock market prices rise... If the money supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits."

Friedman's "Jobs become more plentiful, business is brisk, almost everybody is happy" is a description of the economy in a time of demand-pull inflation. So is Schwartz's "buoyant economy".

Cost-push is a different animal. You have to raise prices, or your profits will fall. You have to have more take-home pay, or your standard of living will fall. Jobs are not plentiful, business is not brisk, the economy is not buoyant, and almost nobody is happy about it.

In a cost-push world, the problem is not too much money, but too much cost. Profits are squeezed. So is our standard of living. And the economy is not buoyant. And yes, restraining the growth of money restrains the increase of prices. But it doesn't solve the cost problem.

Demand-pull is the inflation of a good economy. Cost-push is the inflation of a troubled economy.


Fritz Machlup, whose Another View of Cost-Push and Demand-Pull Inflation was published in May of 1960, wrote:

I believe that for an explanation of the consumer-price inflation from 1945 to 1948, and from 1950 to 1952, the basic model of the demand-pull inflation does as well as, or better than, any of the other models, simple or complicated. On the other hand, for the period 1955-59 several cost-push models appear to do better, and I am prepared to regard the consumer-price increases of these four years as a result of a cost-push inflation.

Samuelson and Solow, in their paper of May 1960, offered a similar assessment. Regarding the inflation of the latter 1940s, they wrote:

"most economists are now agreed that this first postwar rise in prices was primarily attributable to the pull of demand...

This emphasis on demand-pull was somewhat reinforced by the Korean war run-up of prices after mid-1950. But just by the time that cost-push was becoming discredited as a theory of inflation, we ran into the rather puzzling phenomenon of the 1955-58 upward creep of prices, which seemed to take place in the last part of the period despite growing overcapacity, slack labor markets, slow real growth, and no apparent great buoyancy in overall demand."

Demand-pull inflation arises amid plentiful jobs and brisk business in a buoyant economy. Cost-push inflation arises despite "growing overcapacity, slack labor markets, slow real growth, and no apparent great buoyancy in overall demand."

Burns couldn't identify the cost

In January of 1970, Arthur Burns -- who accepted cost-push as a theory of inflation -- became chairman of the Federal Reserve. From Arthur Burns and Inflation (PDF) by Robert L. Hetzel:

In November 1970, the minutes of the Board of Governors show Burns telling the Board (Board Minutes, 11/6/70, pp. 3115–17) that

prospects were dim for any easing of the cost-push inflation generated by union demands.

Wage demands: Cost-push. But then Hetzel expands the story:

Burns had a real or nonmonetary view of inflation. That is, inflation could arise from a variety of sources other than just money.

Could, and did, Burns thought. To summarize Hetzel's summary:

• In 1970, Burns said inflation was caused by wage demands. In 1971, Nixon imposed wage and price controls. Wage and price controls "worked as intended", Hetzel says: "they held down wage growth and the price increases of large corporations". Nonetheless, "inflation rose to double digits by the end of 1973".
  
• Burns then changed his story and blamed "special factors, such as increases in food prices due to poor harvests and in oil prices due to the restriction of oil production." But, says Hetzel, special factors are by nature one-time events: "In 1974, inflation should have fallen as the effect of these one-time events dissipated, but it remained at double-digit levels that year."
• Burns then changed his story again, this time blaming government deficits. He even padded the numbers, Hetzel says, adding the debt of Fannie Mae to make the deficits look bigger.

That's Robert Hetzel's story, not mine. What Hetzel says, speaking in general but applying the thought to Burns, is:

The economist cannot “explain” the model’s failure to predict by assuming that the world’s underlying economic structure changes in an ongoing, unpredictable way.

I'm not sure Hetzel is right. Seems to me that once cost-push inflation gets going, everybody gets a turn. So the cause of the inflation would look different, depending on when you look into it.

Whatever. What I get from Hetzel is that Burns could not identify the cost that was driving inflation.

But the fact that Burns could not identify the problematic cost does not mean that there was no problematic cost. On the contrary, the decline of economic growth is evidence of problematic cost. And central banks' 2% targeting today is evidence of problematic cost.

Volcker ignored the cost

Paul Volcker became Fed Chairman in 1979. Marcus Nunes writes:

On becoming chairman of the Fed, Volker challenged the Keynesian orthodoxy which held that the high unemployment high inflation combination of the 1970´s demonstrated that inflation arose from cost-push and supply shocks ...

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.

Volcker ignored the cost problem. And you know, inflation came down. There are different explanations for the fall of inflation, but I'm pretty comfortable with the "centuries of experience" story: Centuries of experience tell us that prices cannot go up if there is not enough money to support the higher price level.

I have no problem with that. But I do have a problem with Volcker's assumption that rising cost does not matter. When prices are rising because we have "too much money", cost is not likely to be a problem. But when prices have to rise because costs are rising, slowing the growth of money and credit does not solve the cost problem. It may reduce inflation, but it does not solve the problem.

Volcker chose to ignore the cost problem. Economic growth slowed as a result.

In a cost-push economy, inflation is a solution to the cost problem. Putting extra money into the economy reduces the problem of problematic cost. I think it's the wrong solution, because increasing money growth is only a way of coping with the cost problem. It doesn't solve that problem. But restricting money growth makes the cost problem worse -- and that was Volcker's solution.

Wikipedia says Volcker "is widely credited with having ended the high levels of inflation seen in the United States during the 1970s and early 1980s." Sure, and here we are today, with central banks round the world shooting for two percent rather than zero, and talking stable inflation rather than stable prices. And with no one talking about the cost problem that drives inflation and decline. No one but me.

A Cost Problem?

Is it grasping at straws to say that there could be a cost problem? Don't prices resolve that problem automatically when money growth is constrained? Isn't that what centuries of experience shows? No. The centuries of experience show how things worked in centuries past.

Past performance is no guarantee of future results. And for decades now, things seem not to work as they once did. Stable prices are no longer compatible with economic growth.

Source: Robert Sahr, in sumprice_1774-2012.pdf

Prices can only resolve a continuing cost problem by rising: that is, by passing the problem on to the next guy.


Why have central banks opted for 2% inflation rather than no inflation? For "insurance against deflation", according to Kristie Engemann of the St. Louis Fed.

And why is deflation a problem? Investopedia says

If deflation occurs ... a vicious cycle can ensue that drags an economy into recession or depression as economic activity grinds to a halt.

And from The Economist of 2015:

One might think falling prices would be something to celebrate. But concerns about deflation traps and downward spirals abound.

Deflation is bad because it increases the odds of a downward spiral turning growth into recession, recession into depression, depression into something worse. Central banks have opted for 2% inflation to fend off deflation and decline. Because when inflation is below two percent, they tell us, the risk of decline is too great. Apparently, price stability is no longer compatible with economic growth.

Consumer Price Index in the United Kingdom, 1209-2016

Price stability is no longer compatible with economic growth? When did that happen? From the graphs, you could guess it started early in the 20th century.

You could well be right. Keynes thought that "post World War I capitalism" differed significantly from "nineteenth-century" capitalism due to "the emergence of the rentier class". That's according to Oeconomicus, Volume XII. I haven't looked into it that far back, myself, so I can't say it started early in the 20th. I am saying it's true now, and you can see it if you look.

I have traced the cost problem as far back as the early 1960s. Samuelson and Solow may have found cost-push in the 1950s; Fritz Machlup definitely found it. Because of the problem of rising cost, price stability is no longer compatible with economic growth.


Inflation is associated with economic growth. Deflation is associated with decline. If economists and policymakers are worried about deflation, they are worried about economic decline. These days they let money grow at an inflationary rate to avoid economic decline.

Why are they worried about decline? Because the threat is real, obviously. But why? Why has decline become a real threat? Because of the continuing cost problem. Because of the cost problem, price stability is no longer a viable option, and insufficient inflation makes decline a worrisome possibility. Strange it may be, but true.

We can cope with the cost problem by targeting "stable inflation" or we can shoot for zero inflation and watch our economy decline. There is a cost, a significant cost that was apparently not significant before the 20th century, but became significant in the last 100 years or so.

By the way, if the cost problem is getting worse (which it is) then in the future we will find that stable inflation at 2% is no longer sufficient. Just in the last ten years, you will remember, many people have argued for a higher inflation target.

In addition, the never-ending story of government focus on the needs of business -- lower taxes, less regulation, and all -- is, like the 2% target, a way to prop up growth. I would say it is an alternative to using inflation to induce growth, except it isn't an alternative. We do both.

We do both, and we still don't get decent growth. Oh, and if the cost problem has no end, then in the future we will find that everything we have done is not enough. We will discover that the need to improve business conditions, like the need to raise the inflation target, is endless.

I'm tempted to say this all is simple and should be obvious. It's not obvious, because nobody talks about the continuing cost problem. Not since Volcker. Since Volcker, everybody thinks that solving the inflation problem proved there is no cost problem. Just an occasional supply shock that we can't do anything about, as Sumner put it. But the decline of economic growth proves the "there is no cost problem" theory wrong.

Wouldn't prices resolve a cost problem?

The price system can resolve a one-time cost shock, even a big one like oil. But the price system cannot resolve a continuing cost shock.

Special factors "are by nature one-time events", Robert Hetzel says. By definition, then, you cannot have a continuing cost shock. This is how economists address the problem of continuing cost pressures: by rejecting the possibility that they could exist.

Naturally, if long-term, continuing cost pressures cannot exist, then cost-push inflation cannot exist. This conclusion, too, arises from the fact that economists have chosen the word "shock" to explain the thing that was once called cost-push inflation.

The use of the word "shock" is an implicit denial that long-term, continuing cost pressures can exist. So I guess if such pressures do exist, our economy is in trouble.

Come to think of it, our economy is in trouble.

An unresolved continuing cost problem leads to inflation and decline

Robert Hetzel presents the view of Arthur Burns, saying "rising costs erode profit margins and eventually turn expansion into contraction." I recently argued in favor of that view, then against it, then again in favor. The resolution of my conflict worked out along these lines:

What causes recessions? Curses! It still makes sense, what Burns said: Rising costs cause recession. But then, don't we also have rising costs during the expansion? You can't expand if you don't spend more. So it's not a sure thing that rising cost leads to recession.

Rising cost won't lead to recession unless cost is rising faster than profit. Is there a way we might have rising costs that are not matched by rising profit? Well yes: We had the oil crisis, where everyone saw cost increases but only oil producers saw profit increases.

This kind of imbalance, with widespread rising cost and narrowspread rising profit, this kind of imbalance can turn expansion into recession. And if the cost imbalance can turn expansion into recession, then a lesser cost imbalance, or one soothed, say, by a target of two percent inflation, might give us sluggish economic growth at best.

Should such a cost imbalance remain unresolved for decades, our economy would be one of gradually declining economic growth and persistent "mild" inflation.

Sound familiar?

Why the cost problem endures

If the cost imbalance has been created by flawed policy, then policymakers' same flawed thinking is likely to assure that the imbalance is never corrected. If economists and policymakers think, for example, that using credit is always good for growth and that private sector debt can never be a problem, then there is no stopping the growth of finance and no stopping the growth of the financial cost-push.

Finance. Well, the cat's out of the bag now.

Finance is unique

What makes financial cost unique as a source of the cost-push problem is the Las Vegas effect: money that goes into finance tends to stay in finance. The wages of labor, by contrast, tend to come out almost immediately, and almost entirely. The Vegas effect creates cost imbalance without limit unless the size of finance is restrained by rigorous policy.

The growth of finance is not endlessly sustainable, because it creates a gradually growing cost problem for those who pay the cost that is income to finance. This growing cost problem at some point begins to reduce economic growth, which creates a second problem: declining income for those who pay the cost that is income to finance.

On the one hand the increasing cost of finance, and on the other declining income growth in the non-financial sector: Together they work like a vise, squeezing the sector that is the source of income to finance.

The irony is that finance itself is the source of the cost problem that slows economic growth and ultimately pushes the cost of finance beyond a sustainable level.

The Growth of Financial Cost

Sometimes a story of resource constraints is told, where economic growth is so vigorous that logjams develop: the production of natural resources, for example, cannot keep pace, the prices of those products rise, profits fall in the sectors that use those resources, and you get cost-push inflation. But logjams due to excessive vigor cannot be the best explanation of cost-push pressures in an economy that refuses to be vigorous.

The most frequently told story in recent decades seems to be that the labor market gets tight. We get a logjam in the supply of labor, and labor costs rise. According to this story, labor costs are the root cause of cost-push inflation. But rising wages do not create a cost imbalance, as rising wages lead to widespread rising demand, which leads to widespread rising profit. Not to mention that for the longest time, wages have not been rising. There must be a better explanation of cost-push pressures.

There is a better explanation: policy. When inflation appears to be a threat, the central bank raises interest rates. Inflation is associated with growth, so to reduce the threat of inflation they reduce growth by raising financial cost.

When interest rates rise, the cost increase is widespread. But financial cost creates income for finance. When financial costs rise, the income of finance increases. Our existing anti-inflation policy creates -- or adds to -- the cost we know as widespread rising financial cost, but also as increasing income in the financial sector.

Because of policy, profit rises faster than cost in the financial sector, while rising cost and falling profit elsewhere in the economy cause growth to slow. A cost imbalance is created by this, which can lead to cost-push inflation that is completely unrelated to labor and natural resource costs. And it can turn expansion into recession, as Arthur Burns said.

Moreover, because this is our policy, finance is the cost that typically leads to recession. Finance benefits by this policy, at the expense of all the rest. As the graph below shows, early in the expansions that follow recessions profit of non-financial corporations typically rises (as a share of total corporate profits). Later in the typical expansion, when concern about inflation arises and interest rates go up, rising financial costs drive non-financial profit down while financial profit rises:

Financial (red) and Non-Financial (blue) shares of Corporate Profits, 1933-2018

Financial profit rises (as a share of total corporate profit) before or during every recession shown on the graph -- except the 1974 and 1980 recessions which, coincidentally, can be attributed to rising oil prices. Financial profit rose from less than 6% of corporate profit in 1943, to more than 19% in 1970, and from 12.27% in 1981 to 42% in 2002.

By design, because of our anti-inflation policy, finance is the cost that typically leads to recession. But policy doesn't only create the cost imbalances that create our recessions. Policy also assures the growth of the financial sector in other ways. For example, policy kept "most" business interest expenses fully tax deductible for a hundred years, from 1918 to the Tax Cuts and Jobs Act of 2017.

The pressures created by economic policy, coupled with the economic forces that arise from human nature, give rise to perpetually growing financial cost. These same forces assure that the financial sector grows beyond its economies of scale. These forces keep financial costs growing until they create cost imbalances that reduce non-financial sector profit, reduce growth, and cause recession, time after time after time. To prevent this imbalance, policy would have to prevent the extremes that arise from human nature, rather than encouraging them.

Financial cost is also financial income. The more harm financial cost does to the productive sector, the more people see financial investment as a better option than productive investment. This further boosts the growth of finance. Over the whole period from 1943 to 2002, financial sector profit gained on non-financial sector profit. Basically, from World War Two till the financial crisis, finance was increasingly thought to be the better investment. That thinking did massive harm to economic growth and productivity.

Ironically, the microeconomic solution, where financial-sector performance induces us to move more of our money into finance, deepens the macroeconomic problem of cost imbalance. Not only does financial profit gain on nonfinancial until recession is created; financial profit also grows faster than non-financial profit over the long haul, making economic growth in the "good" years between recessions increasingly difficult to achieve.

MARKUP 3 FIT

Not only does financial profit gain on non-financial in the run-up to recession; but also over the long term, the trend has been for financial profit to gain on non-financial.

It is true, of course, that financial sector profit is growing because the financial sector is growing. It may even be true that financial sector profit has grown faster than non-financial because the financial sector itself has grown faster than the non-financial.

Okay. Well, sure. And that is the problem.