We are all borrowers now

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Consider the possibility that we live in a world of cost-push pressure driven by the cost of finance.

Nuh-no, I said consider the possibility, not reject it. :)

Yes, I do know that we don't live in a world of inflation. Since Volcker chaired the Fed, people have known Milton Friedman was right: Inflation is always and everywhere a monetary phenomenon. Since that time, inflation has been kept under control.

That is my main concern, and here's why: If inflation is driven by cost-push pressure and policy restrains the inflation, the cost pressure will find release by reducing economic growth.

Slow growth in our time (covid aside), slow growth since the 1980s, and slow growth possibly as far back as the 1950s may be a result of cost-push pressure prevented from creating inflation by  a policy of tight money. When policy does not allow inflation to relieve the cost pressure, the pressure finds release by slowing economic growth.

In the time of Carter and Reagan and Volcker, we thought inflation was the problem that had to be stopped. We stopped it. But nothing was done about the cost pressure that led to the inflation. (Wage growth was reduced. But economic growth continued to decline, suggesting that the source of the cost pressure was not wages.)  Since that time, our economy has become less vigorous. We created policies to boost growth, and they helped. But the economy slowed anyway. And no one seems to know why.

It is time to consider the possibility that we live in a post-Volcker world of cost-push pressure, and that this pressure is the cause of our slowing economic growth.

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When we think of cost-push, we think of oil in the 1970s and the "shock" of a sudden, large price increase. But cost-push doesn't have to arrive as a sudden shock. It can arise gradually. And the cost doesn't have to be due to a large price increase. The cost can grow naturally, stride for stride with a high-growth industry like finance.

Graph #1: GVA Finance as Percent of GDP

The price of oil increased fourfold between October 1973 and March 1974. That was a sudden shock.

The Gross Value Added of financial corporate business increased fourfold between 1945 and 2019. The increase created long-term, gradual, continuing cost pressure. The increase -- double, and double again -- was as large for finance as it was for the price of oil. And the graph shows only part of finance, the part that is counted in GDP.

The graph shows a pause in the growth of finance between 1961 and 1966. This intermission in the growth of finance (and financial cost) reduced the cost pressure. It is no coincidence that inflation during those years reached and temporarily maintained a low level. Inflation was low and stable from 1961 to 1965, almost the whole time of the pause shown on the graph.

The other pause, the one after 1983, contributed to the disinflation of the 1980s.

Could these coincidences be evidence that the inflation was cost-push, driven at least in part by the cost of finance? Consider the possibility.

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So far I have brought to your attention two key points:

• If cost-push pressure exists and policy prevents inflation, the pressure will find release by creating a slowdown of economic growth.
  
• Cost-push pressure can arise from the sudden shock of a price increase, or it can be the result of a gradual change such as the growth of finance. Even if there is no price increase, the natural growth of finance must eventually push cost up as surely as a significant price increase would do.
  

I must point out, though, that the growth of finance since the Second World War was not entirely "natural". It was encouraged and induced by economic policy. Such encouragement is at least part of the reason for the growth of finance and the increase in financial cost. 

And wouldn't the irony be profound if the long-term slowdown of US economic growth arose from policies designed to boost economic growth by encouraging the growth of finance!

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One more point must be made. It has to do with the nature of the cost that creates cost-push pressure: The cost is widespread, but the income it generates is concentrated in one industry or one sector.

The oil crises of the 1970s affected everyone. We waited on long lines for gasoline and paid outrageous prices. But the windfall went only to the oil industry, not to everyone.

With wage-push, the windfall (you would think) went to labor. I don't think it ever was wage-push, except possibly for a brief time. But then, during that time the windfall went (or would have gone) to labor.

The cost is widespread, but the income gain is concentrated: The same is true of finance. We are all borrowers now, but the cost associated with borrowing becomes income only to finance.

This kind of imbalance, with widespread rising cost and narrowspread rising income, is typical of cost-push inflation. Demand-pull is different, as both rising cost and rising income are widespread. Because of this difference, demand-pull tends to boost the growth of output and income, while cost-push tends to reduce the growth of output and income except in the sector of concentrated income gains.

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This is a simple idea, Occam simple.

In the United States, and elsewhere that finance has grown, long-term economic decline develops along with finance when finance creates cost-push pressure and policy reduces the resulting inflation.

If finance is the source of cost-push pressure, and policy has induced the growth of finance, then it should be obvious what must be done to solve the problem of declining economic growth: Reduce the cost pressure by eliminating or reversing the policies that induced the excessive growth of finance. 

When we gather the evidence showing that finance is indeed the source of the cost pressure, we will observe that

• excessive finance, not a decent wage, is the root of our economic troubles.
• before Volcker, finance created continuing cost pressure that led to the Great Inflation.
  
• since Volcker, continuing cost pressure has driven the decline of economic vigor.

That's just for starters. But the problem is not Volcker or the battle against inflation. The problem is the cost of finance, the incessant growth of finance, and the policymakers' mindset that says the incessant growth of finance is a good thing.

Finally, consider the possibility that there are sound economic reasons to restrain the growth of finance, reasons like preventing the cost pressure that leads to economic decline when policy takes action against inflation.