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?

Policy.

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.

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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.