This is about the economy before covid and, I expect, the economy after covid.
At the Adam Smith Institute: Inflation is not a cost-push phenomenon
The first two paragraphs:
Many economic commentators used to believe (and some still do) that inflation could result from rises in the input costs of production. An increase in the price of raw materials or in the wages paid to workers would have to be passed on, it was supposed, leading to a rise in the price of the finished product. If enough goods were thus affected, this would bring about the general rise in price levels which is popularly called inflation.
If the money supply is unchanged, then price rises for some products will be matched by lower prices elsewhere. If people have to pay more for their essentials, for example, following increased prices brought about by higher input costs, then they will have less money to spend on non-essentials, the demand for which will go down.
When the price of essentials goes up, some spending moves out of non-essentials and into essentials. The demand for non-essentials goes down. Producers cut back the production of non-essentials, and some workers lose their jobs, or work fewer hours. There is less employment in the non-essentials sector of the economy.
But there is not more employment in the essentials sector. Costs went up, and prices went up, but demand didn't go up. We're lucky demand didn't go down, and that's only because the essentials are "essential". Employment stays the same in the essentials sector, and falls in the non-essentials sector. There is a net loss of output and employment. The economy has slowed because of the higher input costs.
There are three more paragraphs in the article at the Adam Smith Institute. But they don't address the problem of declining demand. They don't address the problem that rising cost pressure leads to a slowing economy. They address only the problem of inflation.
//Inflation is an unacceptable solution to the problem of rising cost. The other solution, equally unacceptable, is slow growth. The dual mandate of the Federal Reserve is to achieve "maximum employment and price stability". The one goal is price stability, as opposed to inflation. The other goal is maximum employment, as opposed to slow growth.
Both inflation and slow growth contradict the mandate. Both are unacceptable. And yet, policymakers do a good job of keeping inflation to a minimum, while employment is potluck.
But on second
thought, maybe that's a flawed evaluation. When unemployment falls
to a 50-year low, nobody knows why. And inflation? Inflation has been
contained, running below 2% for some years. Running below the 2% target for some years, as if policymakers are unable to raise inflation to the target.
Maybe it's not that policymakers do a good job of keeping inflation to a minimum. Maybe economic growth is so slow that inflation simply refuses to rise to target."The core problem stems from the fact that neither central bankers nor anyone else knows what causes inflation." -- Daniel L. Thornton
Maybe, instead of trying to contain
inflation and trying to boost growth and employment, maybe policymakers
should concentrate on the problem of rising cost, the problem that has long been
the source of inflation and slow growth.
I know. It's not in the mandate. But that is no excuse.
"Toynbee maintained that the fate of civilizations is determined by their response to the challenges facing them." -- Stefan Zenker
5 comments:
The Fed's mandate as written in the Federal statutes by Congress (1978) is:
"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production,"
That is all that the Fed is required to do. Congress added a subordinate clause after the comma on that statement explaining what that would accomplish:
" so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."
Milton Friedman and the other monetarists had convinced Congress that the only thing the Fed needed to do was keep the money supply in proportion to the growth potential of the economy and the markets would take care of the rest.
The graph below shows that the M2 money supply (mostly made up out of bank lending) did indeed remain at a constant 50% of GDP up to the 2008 collapse.
https://fred.stlouisfed.org/graph/fredgraph.png?g=zq3Z
The problem of course is that M2 was not the only medium of exchange in the economy. There was a huge quantity of other credit instruments that are used as a medium of exchange as long as the markets accept them as being as good as money. In 2008 when many trillions that previously had been reckoned by the markets to be as good as money were suddenly no longer being accepted as money it had a huge impact. A collapse of the money supply did indeed cause deflation for a few months while the Fed and treasury scrambled to restore confidence in the ponzi money supply.
Before that there is no valid evidence that the Fed was ever ever doing anything in response to employment or inflation. That is just a fictional fact free story that is repeated constantly by story tellers.
Interesting! The Fed went with Friedman's monetary rule soon after Humphrey-Hawkins was signed (October 1978). I've read that under Volcker, Fed policy briefly tried a rule like that. For example Robert Waldmann: "... the brief period when the FOMC tried to target monetary aggregates (roughly 1979-82 IIRC)..."
But I never thought this might have been in response to a Congressional mandate.
I like the idea of going back to the original document to get a feel for the meaning of the document. But I think most people don't bother with that. In this case I think most people remember the subordinate clause that states the policy goals: "the goals of maximum employment, stable prices, and moderate long-term interest rates."
For those people, then, and for anyone who sees the goals of economic policy as 1. stable prices and 2. jobs and growth (not necessarily in that order) I point out that cost-push pressure creates not only a tendency toward inflation but also a tendency toward slow growth. Cost pressure works against both elements of the dual mandate. That's really the key point I was trying to make.
1. cost pressure creates upward pressure on prices and downward pressure on economic growth.
2. almost everyone on the internet rejects the possibility of cost-push inflation and (implicitly) the possibility of problematic cost pressure.
3. our economy has been slowing pretty much since Volcker ran the Fed. (Much was done to boost growth, but the fact that it needed to be done is evidence of the slowing.)
The argument I'm making is that slow growth since the Great Recession, slow growth before the Great Recession, slow growth since Volcker, and all the attempts to boost growth since 1980, all of this follows from the cost-push pressure that everyone ignores. People march to the tune of "we defeated inflation" as if that's the end of the story. It is not the end of the story. The cost pressure continues, and it is defeating us. The end of the story will not be told until after the next Dark Age.
//
To my eye, your graph shows that the Fed failed to "maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential". It didn't fail with M2 money. But for the big credit aggregate TCMDO (formerly called "Total Credit Market Debt Owed" as I recall) they failed completely... Maybe that's the reason you included TCMDO/GDP on the graph.
[continued]
Look at the ratio of TCMDO to M2.
Or M2 to M1.
Or for that matter, TCMDO relative to the monetary base.
All these graphs show money being stretched by credit creation -- something that WOULD NOT HAPPEN if the Fed applied Friedman's rule vigilantly to the monetary *AND* credit aggregates, to use Congress's phrase. We seem to agree on this, as you write: "The problem of course is that M2 was not the only medium of exchange in the economy" etc.
If they kept the TCMDO-to-Base ratio at a constant level, debt would never accumulate into a problem, even if the aggregates failed to grow "in proportion to the growth potential of the economy".
Friedman's rule is incomplete if it is not applied to money AND credit.
//
Also: Narrow money is the least costly and broad the most costly money, measured in terms of interest cost per dollar of output. As the ratio of broad-to-narrow increases, financial cost increases. And the cost-push pressure increases.
Fed policy (at least until 2008) was to restrict base growth but encourage credit growth. That's bad policy.
Fed policy should allow credit to grow only as fast as base and no faster, while letting out narrow money (or depending on Federal deficits for that purpose, or even by permitting somewhat faster growth of take-home pay) at the desired growth rate. This policy would prevent the increase of the financial cost I describe, and contain financial cost pressure.
Assuming that broad-to-narrow is presently too high (there is too much credit in use) it should be reduced by Fed policy (and by Congress revising all of their pro-credit-use legislation). There is undoubtedly an optimum range for the broad-to-narrow ratio that best promotes economic growth. Reducing the ratio to that level would reduce financial cost pressure while promoting growth.
No doubt that's what Humphrey and Hawkins had in mind :)
Here is a summary of Friedman's monetary theory that inspired Congress to write 12 U.S. Code § 225a
https://www.investopedia.com/terms/k/k-percent-rule.asp
According to Friedman, attempts by the Fed to fashion monetary policy around targeting employment and inflation are self-defeating and would always fail. According to Friedman, the correct policy was to maintain the money supply proportionate to long term potential for economic growth and that would result in maximum employment and stable prices. That is exactly what the law says the Fed should do.
Friedman was proud of the fact tht the Fed was following his theory for nearly 30 years:
https://files.stlouisfed.org/files/htdocs/datatrends/pdfs/mt/20050601/cover.pdf
Friedman died just before it all blew up in 2008
I like that Investopedia link, jim. First they say the "k" value is "2-4%, based on historical averages".
Then they give Friedman's numbers: "an annual rate between 3 to 5 percent."
That's a great example of the decline in expected GDP growth.
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