Wednesday, October 28, 2020

Employee Compensation vs Interest Paid: The Corporate Business Cost Comparison. Again

  My graphs of 30 September show corporate interest cost (red) and corporate employee compensation (blue), each as a percent of total corporate deductions. I used total corporate deductions as a measure of total corporate costs.

Those graphs ended at 1980. Here's one of them:

Graph #1: Employee compensation falls while interest costs rise

Taking the same data and looking at it out to 2007 gives us this graph:

Graph #2 (from my 2010 post Components of Corporate Cost)

After 1980, employee compensation consistently hangs at the 20% level. Interest cost runs near 8 or 9 percent of corporate costs in the 1980s, then a bit less in the 1990s. Interest cost drops to 5% in 2003-04 but then goes up again, back to 8 or 9 percent by 2007, just in time for the financial crisis.

I'm thinking it wasn't the 8-or-9-percent level that caused the crisis, as we survived the 1980s at that level. So maybe it was the rapid increase after 2004 that brought on the crisis. But no, come to think of it, the Savings and Loan crisis started in the 8-or-9-percent 1980s:

The savings and loan crisis of the 1980s and 1990s (commonly dubbed the S&L crisis) was the failure of 1,043 out of the 3,234 savings and loan associations (S&Ls) in the United States from 1986 to 1995.

Thanks to that crisis, borrowing decreased and interest deductions came down. But then they started going up again.

As an overview of Graph #2, I'd offer the following:

  • Before the 1970s, employee compensation fell gradually (and only a little). During those years, interest costs rose gradually (but rose more rapidly than employee compensation fell).
  • After the early 1980s, employee compensation paid by corporations (as a percent of corporate deductions) hugged the 20% level; when it tried to rise, it failed. Interest costs paid by corporations (again, as a percent of deductions) were less stable, showing both decline and a tendency to increase.
  • During the 1970s (or really, from the late 1960s to the early 1980s, during the most severe inflation of the Great Inflation period) employee compensation had its greatest decline and interest cost had its greatest increase.

I am forced to conclude that the Great Inflation was NOT caused by rising wages, but by rising financial costs. I also must say that the Great Inflation was cost-push, but it was NOT wage-push: It was financial-cost-push inflation.

And I have to add that financial cost has only grown since that time, along with finance. So I must also say we have NOT solved the cost-push problem that we experienced during the 1960s and 1970s.

And let me add that the insurmountable slowing of economic growth that we have seen since the 1980s after inflation was suppressed, this slowing is the OTHER outcome that arises from cost-push pressures: the outcome that arises when those pressures are not relieved by inflation. Recessions aside, economic growth was very good in the 1950s and 60s and 70s; but growth was slower in the 1980s and after (except in the latter 1990s, when the financial sector was recovering from the Savings and Loan crisis). Growth has been slower since the 1980s because of the cost-push pressure created by excessive yet still rapidly growing finance.

Note that I distinguish between the so-called slow growth of the 1970s, which was the result of policy creating recessions to slow the economy to fight the inflation, and slow growth after the 1970s, which was the result of cost-push pressures that were no longer being relieved by inflation. 

If you hesitate to accept that growth was slow after the 1970s, let me remind you what the well-known, well-respected economist Scott Sumner says:

I am not denying that growth in US living standards slowed after 1973, rather I am arguing that it would have slowed more had we not reformed our economy.


my view [is] that the neoliberal reforms after 1980 helped growth...

My view is that the neoliberal reforms did not solve the problem of excessive financial cost, and that despite those neoliberal reforms, the unresolved cost problem led to a continuation of slowing growth and ultimately to the financial crisis.

You might want to note also that the relatively good economic performance of the latter 1990s occurred immediately after the significant slowdown in the growth of debt in the decade after 1985: the slowdown that occurred during the Savings and Loan crisis of 1986-1995. That slowdown brought relief from the cost pressure created by finance. To offset the reduced borrowing, the Federal Reserve increased its holdings of Federal debt in two high and sustained bursts: one in the latter half of the 1980s, the other in the first half of the 1990s. The two unusually large increases are visible also in bank reserves, and in the quantity of M1 money, money which the St Louis Fed describes as "funds that are readily accessible for spending."

Beginning around 1990, the decline in debt and the increase in M1 money brought a noticeable increase in the quantity of funds readily accessible for spending, relative to the bills we have to pay. The increase peaked late in 1993 and was drawn down gradually. Not until the year 2000 was it fully exhausted. As a result of the change in financial and monetary balances, US real GDP growth was never below four percent from Q2 1996 to Q3 2000.

Moreover, inflation remained low despite the increased quantity of money, because the financial sector was smaller, credit use was less, financial costs were lower and, most significantly, because the extra money only filled a hole in the economy that was created by the reduced use of credit.

Alan Greenspan spoke of our "new economy" as if it might last forever, and attributed the good economic performance largely to technology. Ironically, Greenspan was the main man at the monetary authority during the decade of slow debt growth and rapid M1 money growth. I don't know how he could have failed to notice these changes.

Anyway, the Great Inflation of 1965-1984 was set in motion by rising financial cost. It was followed by the S&L crisis that led to reduced growth of financial cost for a decade. That, combined with unusually fast growth of the funds available for spending, reduced the financial cost embedded in the average dollar. We were then able to spend less money to pay for the money we spend, and spend more on the output we produce. And that -- not technology -- is why we had the good years of the latter 1990s.

Oh, technology made it happen, sure. But reduced financial cost made it possible.

Sunday, October 25, 2020

"This pattern is significant in about 70% of the advanced economies."

From Using critical slowing down indicators to understand economic growth rate variability and secular stagnation by Craig D. Rye and Tim Jackson. I found it by accident.

This paper utilizes Critical Slowing Down (CSD; instability) indicators developed by statistical physics to analyse economic growth rate variability and secular stagnation in historical GDP data.

CSD measures instability, they say. And then, this:

The most commonly occurring pattern [in the GDP data] is characterised by an increase in CSD from the 1900s to 1940s, a decline in CSD between the 1930s and the 1970s, then a further increase in CSD from the 1960s to 2010. This pattern is significant in ~70% of the advanced economies.

An increase in CSD, a decline in CSD, and then further increase in CSD. Betcha that would match up well with an increase in finance, a decline in finance, and then further increase in finance.

Yes, and when I wrote the previous paragraph I was thinking of this graph from Thomas Philippon

Source: SSRN

and this text from Philippon's FinEff.pdf:
The sum of all profits and wages paid to financial intermediaries represents the cost of financial intermediation. I measure this cost from 1870 to 2010, as a share of GDP, and find large historical variations. The cost of intermediation grows from 2% to 6% from 1870 to 1930. It shrinks to less than 4% in 1950, grows slowly to 5% in 1980, and then increases rapidly to almost 9% in 2010.

I want to put the CSD data and Philippon's together on a graph. But I have to nudge it. The dates for the CSD are given in decades, while Philippon's are given in years. And the CSD data is only "increase" or "decline". It provides no values that can be compared to Philippon's percentages. So the graph can only show increase, decline, and turning points.

Here's what I came up with:

Don't read too much into it. All I have to work with is dates. The upper and lower turning points are just that -- turning points. The values are not all the same for the uppers, nor for the lowers, as you can see on Philippon's graph. And the two lines meet in 2010 only because that's where the data stops.

However, the paths of the two lines are similar. Also, red always leads, and blue always lags. There might be something to this. Before finance (red) goes high, CSD (blue) shows stability. But as the size of finance increases, instability begins to increase. When finance is high, it peaks and begins to fall; but instability continues to rise for a time before it starts to fall. Finally, instability follows finance down (toward stability) and continues down while finance reaches its low point and begins to rise again.

This pattern makes so much sense to me that I think, given more recent data, we'd see the blue line peak not with the red in 2010, but perhaps a decade after.

I also find it interesting that the red and blue are more widely separated near the lower turning point, and less widely separated near the upper. The lag time varies, depending on whether finance is low or high. The higher finance goes, the sooner it impacts stability.

And yes, the lag time depends on finance, not on CSD, because finance leads and CSD lags. Finance is the cause, and instability is the effect.

Talk about not reading too much into a graph!

I added bullet points to this sentence from the article:

A wide range of ‘head-winds’ or inter-decadal drivers of secular stagnation are discussed by the literature, including 

  • public debt overhang, 
  • reduced aggregate demand, 
  • reduced innovation (supply), 
  • policy uncertainty, 
  • changes in demography, 
  • decline in education attainment growth, 
  • increased inequality, 
  • decline in labour productivity growth, 
  • decline in the quality of primary resources and 
  • changes in the structure and organisation of the financial sector.

I see reduced aggregate demand on the list, and increased inequality on the list, but I don't see the excessive size of finance that creates the inequality and reduces the aggregate demand. The structure and organization of finance is on the list, but not the size and cost of it. 

Ignoring a problem doesn't make it go away. Just the opposite.

This part I thought was interesting:

CSD behaviour as outlined by Wiessenfeld (1985) and Wisel (1984) is best described with an abstract example of an oscillating system. Consider an object that is suspended between two springs, in a windy environment (the spring-object-spring system; Fig. 2a). The springs provide a deterministic restoring force (black arrows), and the wind provides a series of stochastic perturbations. As the wind pushes the object away from its equilibrium position the springs pull the object back, leading the system to oscillate about its equilibrium. If the springs are strong (strong restoring), the oscillations are fast and small. If the springs are weak (weak restoring), the oscillations are slow and large. If the relative strength of the springs becomes weaker over time, then the oscillations of the system transition from small and fast to large and slow (Fig. 2b).

This transition is characteristic of CSD behaviour.

Later, they come back to the "spring-object-spring" model:

The findings of this study suggest that CSD indicators may be useful for exploring inter-decadal macro dynamics. For example, the behaviour of the spring-object-spring system described in the introductory section is qualitatively similar to the behaviour of many non-equilibrium growth models. These include the Goodwin cycle, Minsky’s financial instability hypothesis and the Minksy-models researched by Keen (2013) and others.

Goodwin I don't know, but Minsky and Keen look at instability arising from finance. The size of finance, which didn't make the list of headwinds above, is surely relevant. And if you look at Figure 2b, the sine curve gaining amplitude over time shows the kind of growth that occurs in the financial sector of the US economy: relentless increase.

The problem is not that "the relative strength of the springs becomes weaker over time". That's an analogy. The problem is that the relentless growth of finance gives rise to instability.

Wednesday, October 21, 2020


I googled why is economic growth slowing

  • Why A New Wave Of Economists Are Championing Slow Economic Growth

    Unbridled optimism, unbridled pessimism:

    Some growth economists, like the University of Houston’s Dietrich Vollrath, say stagnation can actually be a sign of prosperity, an indication that a country has neared its ceiling for economic success, or shifted the material basis of its economy — say, from manufacturing to services. In this view, it’s not necessarily a bad thing if growth slows to a crawl during a stable economic period.

    Other economists believe that unending economic growth is not only misguided; it’s dangerous. Kate Raworth, an ecological economist at Oxford University's Environmental Change Institute, subscribes to the theories of environmental scientist Donella Meadows, author of the 1972 book "The Limits to Growth." Meadows said growth was a “stupid” goal — impossible to sustain — and a potential threat to the environment.

    Raworth and Vollrath concede that GDP growth was a fairly good metric for economic success through much of the 20th century, when GDP and more direct markers of economic health, like unemployment and median income, largely paralleled each other. But since the 1970s, GDP growth has become detached from material improvements for workers.

    Vollrath I know from his Growth Economics blog. He's sharp, he's funny, and he's interesting. Raworth I don't know, but I remember hearing about the Meadows book. It had a lot of authors, six maybe, and my source was quite impressed by the book. But this was years ago, long enough ago that years later -- but still years ago -- I gave up on the idea that we were reaching the limits to growth.

    Here's the thing. This is not a criticism of Vollrath and Raworth, for they only "concede" to the article's authors that GDP is no longer a good measure because "since the 1970s, GDP growth has become detached from material improvements for workers." 

    Yeah, "growth has become detached" and maybe that makes GDP a less useful measure. But the problem is not that we still use GDP; and abandoning GDP is not a solution. The problem is that the material improvement of workers is falling behind. This is the problem that must be solved. I'm saying something here that's so obvious it shouldn't have to be said.

  • Slow economic growth is a sign of success

    This article is by Dietrich Vollrath, noted in the first article. Vollrath writes:

    In the US, GDP growth for 2019 was 2.3%, meaning it has been nineteen years since growth hit 4%, and nearly as long since it touched 3%. For the UK the story is similar, as it has been fifteen years since growth hit 3%... But the slowdown we’re observing isn’t something we can fix – or that we would want to fix – because the slowdown was never a consequence of things that went wrong.

    "The slowdown is a consequence of things that went right," Vollrath says. Two main factors, he says: "the fall in fertility during the 20th century, and the shift of our expenditures away from goods and towards services."

    Regarding fertility, Vollrath says for example,

    The opening up of many professions to women, along with growth in overall wages, meant that it made sense for many women to delay marriage.

    And he reaches the conclusion that 

    The growth slowdown today is a consequence of family decisions made decades ago in response to rising living standards and the expansion of women’s rights.

    That doesn't fit will with the change from one-worker families to two-worker families, which was in large part a response to declining living standards and the desire to maintain income. After all, "since the 1970s, GDP growth has become detached from material improvements for workers."

    Regarding the shift from goods to services, Vollrath writes "Productivity growth in services is lower than for goods", and

    If a restaurant — a service — tried to operate with half their normal staff, you’d complain about the slow service and lack of attention. In comparison, if a manufacturer produced a laptop – a good – with half as much labour, you’d never know. This makes productivity growth harder for services than for goods. As we shifted expenditures towards services, aggregate productivity growth was thus bound to fall.

    Maybe. But with greater demand for services, the demand for labor should be high, because (as Vollrath says) the restaurant can't operate well with half their normal staff. The growth of services should have created high demand for labor, and therefore lots of high-paying jobs. We don't have those jobs.

    Later in the article, he writes:

    If you’re still uncertain that the growth slowdown is a consequence of success, ask yourself what you’d give up to bring growth back to 4%. We could destroy half of all our goods: cars, couches, TVs, laptops, houses, trampolines, and so on. That would lead to a massive shift of spending towards goods as we scrambled to replace everything, and we’d see a jump in productivity growth.

    When I was a kid and we were getting 4% growth, people would buy a new car every three years. These days, we do that on a much smaller scale with iphones. And in Japan, I once heard, when the mortgage is paid off they tear down the house and build a new one. This "toss and replace" approach is definitely a way to keep the economy moving. "Ask yourself what you’d give up to bring growth back," Vollrath writes, expecting the reader to see the idea as foolish. And maybe it is. But when you keep the economy moving you generate jobs and you generate income. And when you don't, you don't.

  • The U.S. Is Slowing Down And There’s Nothing Trump Or The Fed Can Do

     This article is by Raul Elizalde of Path Financial LLC. Elizalde writes:

    On our end, we looked at seven decades of GDP growth data to shed some light on the trend growth potential for the U.S. economy. After stripping out recessions, which can be caused to externalities that may not reflect productive capacity (such as oil shocks or a derivatives-based financial crisis) we calculated the 10-year average GDP growth rate. It shows a clear, steady decline ...

    A clear, steady decline of economic growth, Elizalde says, across seven decades.

  • Why Does Economic Growth Keep Slowing Down?

    This article from 2017 is by Fernando Martin of the St. Louis Fed. The opening paragraph:

    The U.S. economy expanded by 1.6 percent in 2016, as measured by real gross domestic product (GDP). Real GDP has averaged 2.1 percent growth per year since the end of the last recession, which is significantly smaller than the average over the postwar period (about 3 percent per year).

    Slow recent growth, as noted by Vollrath above. 3% growth longer-term, as noted in Elizalde's article. And nothing about the good (4%) growth of the golden age that followed the Second World War.

    But then Martin shows a graph ("10-Year Averages of Annual Growth Rates") and says

    Long-run growth rates were high until the mid-1970s. Then, they quickly declined and leveled off at around 3 percent per year for the following three decades. In the second half of the 2000s, around the last recession, growth contracted again sharply and has been declining ever since.

    Fernando Martin knows growth in the golden age was high. He even points it out. But he says the same thing economists always say -- three percent -- as if it would be good enough if we could get back to 3% growth.

    But growth contracted sharply in the mid-1970s and "contracted again sharply" during 2005-2010. Maybe these two contractions are related? Maybe they have a common cause? What looks like growth "leveling off" at 3%, on his graph, manages to miss what Elizalde's graph shows: "clear, steady decline" in GDP growth.

Maybe we need to look back to when the economy was good and look for what went wrong. Maybe we should do that, rather than pretending 3% growth was the best we ever averaged and the best we might ever hope to achieve.

Sunday, October 18, 2020

And this cost-push crap is important because

This cost-push crap is important because economic growth has been slowing for a long time, for so long that many people now think slow growth is normal.

Slow growth is normal, you know, for a country at the end, when it is dying. A lot of people might say slow growth is just one of the things that happens when a country is dying.

But slow growth is the disease. It's what kills the country.

Wednesday, October 14, 2020

We still need to solve the cost-push problem

The problem with cost-push inflation is not the inflation, but the cost-push. If we're seeing prices rise, if we're seeing inflation, then I'm willing to agree it must be that there is enough money (or credit, or velocity) to allow it to happen. But if the inflation is cost-push, then the inflation is not the problem: The cost-push is the problem. For if the cost-push pressure is not allowed to vent as inflation, then it will put downward pressure on profit. And that will put downward pressure on economic growth. And that puts downward pressure on you and me.

I have a problem with people who insist "there's no such thing as cost-push inflation". But not because they insist it's the quantity of money that allows inflation to occur. I have a problem with them because their argument is incomplete. They want to prevent the inflation, and that's as far as their thinking goes. They never think about what else might be affected by the cost-push pressure if it doesn't find release through inflation.

It finds release by slowing the economy. And the slowing continues until the pressure is relieved.

I am not saying we should opt for inflation. Heavens, no. I'm saying that suppressing inflation doesn't solve the cost-push problem. I'm saying we need to solve the cost-push problem, so we can prevent both inflation and long-term decline.

Saturday, October 10, 2020

One of these quotes is economics. The other is gossip.

Samuelson and Solow:

... 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.

Romer and Romer:

"If monetary policymakers in the 1950's had figured out the essence of sensible policy, the mistakes of the 1960's and 1970's cannot just have been the result of continuing ineptitude or misunderstanding. Rather, something must have changed."

Monday, October 5, 2020

The problem ignored by Paul Volcker (and everyone since)

In a study of economic policy in the 1950s, Romer and Romer write: "We show that policy in the 1950's was actually quite sophisticated." They do not say "actually quite sophisticated by present standards" but this is clearly what they mean.

They highlight similarities between present policy and that of the 1950s. They write: "Their model of how the macroeconomy operated contained ... a remarkably modern view of the causes of inflation...." And they praise the 1950s for its "sensible view" of full employment -- again meaning by present standards sensible. The economic thinking of the 1950s is held to be nearly as good as ours today: remarkably modern and sensible.

Romer and Romer also contrast 1950s policy to that of the following two decades. To the latter they attribute a "simplistic Keynesian model." The authors write:

"If monetary policymakers in the 1950's had figured out the essence of sensible policy, the mistakes of the 1960's and 1970's cannot just have been the result of continuing ineptitude or misunderstanding. Rather, something must have changed."

What changed? "One obvious candidate," they write, "is the model of the economy."

In 1960, Samuelson and Solow wrote 

... 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.

Are Samuelson and Solow among the economists of the 1960s and '70s who were responsible for the newly arising ineptitude and misunderstanding? Was Arthur Burns?

In 1970, Arthur Burns became Chairman of the Federal Reserve. Josh Hendrickson writes:

... the view of Burns and others was that inflation was largely a cost-push phenomenon. Burns thought that incomes policies were necessary to restore price stability...

These economists represent the change from the so-called "sensible" policy. Marcus Nunes writes of the return of the sensible:

On becoming chairman of the Fed [in 1979], 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.

Hendrickson agrees:

Gone were notions of cost-push versus demand-pull inflation. The Fed simply assumed accountability as the creator of inflation.

What changed? The Federal Reserve abandoned the idea that cost-push inflation was possible.

After that, everybody abandoned the idea that cost-push inflation was possible. Scott Sumner, for example, says the cost-push idea is "completely discredited". And then we have

  • Sumner at the same link, quoting Caroline Baum:

    This is one of those myths that never dies: cost-push inflation. Milton Friedman was adamant that both prices and costs rise in response to an increase in aggregate demand, which is a function of the Fed’s money creation.

  • Mike Shedlock, quoting one of his readers:

    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 in 1981, from 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.

Money, Batten says. Money, Shedlock says. Money, Baum says. Money, money, money. You know, I want to agree with them and with the many others who share their view, but that view is just too damn rigid. Inflation, they assert, can never be cost-push; it is always demand-pull.

They are "adamant", all of them. But they offer no other argument. It's always and everywhere the Quantity of Money argument. If you want more, you only get the same argument louder and more forcefully, as if you were deaf.

Hey, it's a strong argument, quantity of money, and I accept it -- but not to the exclusion of all else. I always think there might be more than one underlying cause of things. The economy is never so simple that it is right to dismiss every cause but one.


The Problem with Volcker's View

Ben Stein on inflation, in The New York Times (2007):

For a while, we thought it was “cost push,” or a big increase in the cost of certain goods and services. Then we decided that it could never be cost push and instead had to be “demand pull,” or aggregate demand surpassing aggregate supply.

First, we thought it was cost-push. Then we decided it could never be cost-push. There's the rub: We "decided". We decided there could be no other cause of inflation. We dismissed any other causes and called them myths. And we became adamant. This is a problem for me.

I accept the view that if prices are increasing, it is because spending is increasing. I also accept that spending cannot increase unless monetary factors allow it to happen. I don't see any way around it, even if something other than money is driving the process. But I'm not adamant; I also accept 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 forces. That still 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 no one [except James Forder and Abba Lerner] seems to have noticed that when you suppress demand enough to suppress cost-push inflation, you get less growth. This is what's wrong with restrictive monetary policy as a solution to the cost-push problem: It gives us a slowing economy.

The Adjustment Assumption

There is an assumption, I think, implicit in Volcker's view. The assumption is that prices will always adjust relative to other prices, in an automatic process that takes place in the market. And, you know, this assumption -- based on "centuries of experience" -- is generally correct. But it is not infallible.

The assumption is that everything adjusts. If something doesn't go along, if it doesn't adjust, it can throw a monkey wrench into the whole idea that "prices will always adjust relative to other prices".

If everything always adjusts, then we cannot have cost-push inflation. But if almost everything always adjusts, or if everything ordinarily adjusts, then we can have cost-push inflation.

My view, probably obvious by now, is that we do have cost-push inflation. This means I must believe there is a monkey wrench in the works, and some cost is not adjusting properly. That being the case, I should either identify the monkey wrench or abandon the cost-push story. 

No problem. The monkey wrench is finance. The cost of finance is the problematic cost. The cost of finance does not adjust sufficiently, relative to other costs.

Why doesn't finance adjust sufficiently, relative to other costs?


But give me a moment now. I recently quoted James Forder saying the cost-push approach was "greatly disparaged". According to Forder, the disparaging view was that

prices could not continue to rise unless the policymaker allowed for nominal demand to increase to accommodate the higher prices, and therefore that the real source of the inflation lay with the policy, and with excessive demand.

It's the money-money-money view, again. But the policy of accommodation is not the policy I'm talking about. Accommodation is a compromise between zero inflation, on the one hand, and full satisfaction of the cost that refuses to adjust, on the other. With the compromise, you keep inflation down (though not at zero) but you also lose some economic growth

It is true that a policy of accommodation creates some relief from the cost problem by allowing some inflation to occur. But the inflation is a result of the cost problem. In other words, that inflation is "a problem" but it is not "the problem". The problem is the cost that refuses to adjust. Suppressing inflation does not resolve the cost problem.

When there is a cost that refuses to adjust, cost-push pressure arises. The stubborn cost demands more income from other cost sectors, reducing profit in those sectors. Those other sectors respond by increasing prices in order to restore profit. The cost pressure spreads.

If the central bank responds by accommodating the price increases, inflation (as in the 1970s) is the result. If the central bank refuses to accommodate, recession (as in the Volcker recession) is the result. If the central bank responds with partial accommodation, the result (as during the Great Moderation) is inflation along with slowing growth. Whenever inflation arises in response to a cost that refuses to adjust, inflation is the result. It's the stubborn cost that is the problem.

In our case, that cost is financial cost.

Now, again: Why doesn't finance adjust sufficiently, relative to other prices? Policy. But not the policy of accommodation. The policy that prevents financial cost from adjusting when other prices adjust is our policy of encouraging the use of credit.

Because we encourage the use of credit, the use of credit grows. Debt accumulates. Financial cost grows. Financial cost grows more than other costs. Financial cost cannot adjust sufficiently, because policy makes financial cost the fastest-growing cost. Financial cost only becomes slow-growing when the economy objects violently, as it did in 2008-09. [The Fed's solution at that time was an attempt to reduce financial cost by reducing interest rates to the lower bound. But the quantity of debt was so vast that the lower rates did little to solve the problem.]

The policy that encourages the growth of finance makes financial cost unable to adjust. Or maybe I have that wrong. Maybe it's not policy that drives the growth of finance. Maybe human nature drives the growth of finance. But whatever it is that drives the growth of finance, it makes financial cost unable to adjust enough to satisfy the "prices will always adjust relative to other prices" assumption.

Maybe it's both: our policies encourage the growth of financial cost, and human nature also drives the growth of finance. And then, one can also assume, human nature drives us to create policies that encourage the growth of finance.

All of the above? Probably. As I said, the economy is never so simple that it is safe to dismiss all causes but one. 

In sum, if there is any factor that can impede the relative adjustment of prices, cost-push pressures are real, and cost-push inflation becomes a real possibility.

The growth of finance is such a factor.

The Growth of Finance

Way back in 2009 at The Baseline Scenario, Simon Johnson wrote:

The issue is not finance per se, i.e., the process of intermediation between savings and investment. This we obviously need to some degree. But do we need a financial sector that now accounts 7 or 8 percent of GDP? (For numbers over time, see slide 19 ...)
As far as we know, finance was about 1 or at most 2 percent of GDP during the heyday of American economic innovation and expansion – say from 1850...
I know of no evidence that says you are better off with a financial sector at 8% rather than, say, 4% of GDP.

I've seen other statements that put finance around 8% of GDP. The highest I've seen is "around 9% of GDP" according to Thomas Philippon, reported in 2013 by Benjamin Landy at The Century Foundation.

Despite what you may have heard people say, GDP does not measure all economic activity. "All economic activity" means all spending (plus any non-monetary trade that there may be). GDP measures only "final" spending.

A lot of the activity that doesn't get counted in final spending is financial activity. So, financial activity relative to GDP is liable to be a lot more than 8 or 9 percent.

Suppose we look at the cost of interest -- not the rate of interest, but the cost -- relative to GDP. This ratio itself will give us an interest rate of sorts. If the financial sector grows relative to GDP, we will see an increase in this rate, an increase in interest cost relative to GDP. To give the number stability, I subtract the Federal Funds interest rate, the policy rate. This calculation gives a number that runs low in the early years; increases through the 1970s; then runs high until the Great Recession, and somewhat lower thereafter. 

I brought the data into Excel, added an exponential curve for the period of increase, and added lines showing the average values before and after the exponential:

Graph #1

In red, the graph shows the average for the period 1960-1970, the exponential for 1969-1989, and the average for 1982-2010. The blue line ends at 2019.

The early-years average is 5.8% of GDP. The later-years average is 3½ times that, around 20.5 percent of GDP. If you start with 5.8% of GDP and almost double it, then almost double it again, you get to 20.5% of GDP.

By this measure, the cost of interest since the mid-1980s has averaged over 20% of GDP. Feel free to add to this number the 8 or 9 percent of Simon Johnson and Thomas Philippon -- numbers likely based on employment in the financial sector as a share of total employment -- to bring the size of finance up near 30% of GDP.

Nobody else comes up with a number like this. But then, nobody else includes the full measure of interest cost in their calculation. Typically, I think, they include only the "final spending" portion of finance, and compare this to the GDP. That's valid arithmetic, but it doesn't give you a good picture of the cost of finance.


The adamant, who insist policy is the problem -- the policy of accommodation -- may have trouble at first to see that the cost-push problem is not really inflation at all, but the pressure that causes growth to slow unless the Fed accommodates by permitting inflation. Perhaps they will find some satisfaction when they realize that I attribute the problem to policy, as they do -- but to the policy of encouraging the growth of finance, rather than the policy of encouraging inflation.

Others may be shocked to realize that the policy of limited accommodation -- the compromise that brings us some inflation and some slowing of growth -- explains what has been happening in our economy since interest rates started going down in 1981.

As for myself, I find it screamingly obvious that we have overlooked the real cost-push problem. When you get cost-push inflation, the problem isn't the inflation. The inflation is a result. The problem is the cost-push pressure: a rising cost like finance that does not adequately adjust, but which we somehow overlook. 

If the cost of finance increased suddenly from 5.8% of GDP in the 1960s to 20.5% by the mid-1980s, a 1% increase in the cost of finance after the mid-80s would require an increase of 3½% or more in other sectors, just to maintain balance. If accommodation by the Fed allowed inflation to rise to 2%, but no higher, only about half of the cost-push pressure would find relief through inflation. The unrelieved pressure would be forced to find relief in the slowing of economic growth.

The slowing of economy growth over the last 40 years is evidence of this continuing cost pressure. 

The irony -- there always has to be irony -- is that the 2% inflation allowed by the Fed would be greater than the 1% increase required by finance. So the financial sector would be doing just fine, while in the rest of the economy, cost pressures would cause further slowing of growth.

Friday, October 2, 2020

Why focus on the inflation of half a century ago?

Why focus on the inflation of the 1950s and 60s and 70s? Because it was cost-push, and the problematic cost was never discovered, never dealt with. This means the problem still exists today: not the inflation problem, but the cost problem -- the problem ignored by Paul Volcker and by everyone since.1

The problem, since the 1950s, was growing financial cost. That problem grew until the financial crisis of 2008. For a brief moment, then, everyone knew finance was the problem. But again the problem was not dealt with, and now -- even before Covid, I mean -- the economy is worse than it was before 2008. 

The downhill march continues.


1. Not everyone. I don't ignore the cost problem. Nor does James Forder, who wrote

... it was possible – and in fact quite normal – to doubt that inflation between 1955 and 1957 was due to excess demand...
So alternative explanations of inflation were needed, and several were suggested, most of which have tended to be described in not altogether appropriate terms as 'cost push' theories of inflation...
Such approaches to inflation were later greatly disparaged on the basis that prices could not continue to rise unless the policymaker allowed for nominal demand to increase to accommodate the higher prices, and therefore that the real source of the inflation lay with the policy, and with excessive demand. But these points are based on a poor appreciation of the cost push idea...
Lerner (1960b), using his idiosyncratic terminology of 'buyers'' and 'sellers'' inflation, captured the point perfectly, saying (p 121)
The appropriate treatment for buyers' inflation is to cut down the excessive spending that causes it. This may be done by a restrictive monetary or fiscal policy. But if restrictive monetary or fiscal policy is used against sellers' inflation, spending is reduced when it is not excessive, so that we get a deficiency of demand, depression and unemployment...

James Forder and Abba Lerner and me. Perhaps there are others?