A picture is worth a thousand words

Graph #1: Profit as Percent of Gross Value Added, for Financial Corporate Business (red)
Profit as Percent of Gross Value Added, for Nonfinancial Corporate Business (blue)

Are you ready for the end of the Brexit transition?

 

Found this site while looking for stagflation data for 1965...

https://www.gov.uk/transition

 

Been up for a while now, apparently. I didn't know they were doing anything. 

They made a web page.

A few highlights:

 

But why are they calling it the "end" of the transition, now that they're ready to start? It seems to me like a subtle admission it's doomed to fail.

They think like bankers, that's the problem

I focus on cost, the cost of credit versus the cost of money. If you want to use credit, you're gonna have to pay interest on the money you borrow. If you want to use money, you may have to work to get it, but once you have it, you have it and you don't have to pay interest on it.

I distinguish credit from money by whether or not you have to pay interest on it. Some people reject this idea, but there is no thought more important in our economy: Credit is money we have borrowed.

And what is debt? Debt is the money we pay interest on. Debt is the amount of money we have borrowed and not yet repaid. Debt is the measure of credit in use.

Suppose the interest rate is 3%.

Suppose credit-in-use in the US is about 3¾ times the size of the quantity of money. That means, for every dollar of money, we're paying about 11 cents in interest charges. This was the situation in 1946.

Suppose credit in use in the US is about 38 times the size of the quantity of money. At an interest rate of 3%, for every dollar of money, we're paying about $1.14 in interest charges. This was the situation in 2007 (except the interest rate was like 5% in 2007).

The average cost of interest per dollar in 1946 was 11 cents. The average cost of interest per dollar in 2007 was more than a dollar more than 11 cents. (And that's assuming an interest rate of 3%.)

That's why I distinguish between money and credit: So I can see this cost.

If you say "this is the result of economic policy" then I say yes, you are absolutely right. But I will also say policymakers have it wrong. I don't think they look at "the average cost of interest per dollar of money" at all. How else could they let interest cost increase so much? How else could they fail to notice that the high cost of interest is a problem?

They think like bankers, that's how. For them, more borrowing means more business. That kind of thinking creates problems for the economy.

Policymakers think using credit is good for economic growth. It is. But debt's a killer. Using credit creates debt, and the debt's a killer.

By the way, using money does not create debt. But you knew that.

Policymakers think using credit is good for economic growth. So they create policies that make it easier for us to use credit. Okay, but using credit creates debt. Our debt increases because of their policies. And policymakers don't create policies to help us reduce our debt. 

Take the tax deduction for mortgage interest, for example. You don't pay tax on the interest you pay. This is to encourage people to get mortgages. And wouldn't you know it, when the financial crisis arose, 2007-2008, mortgage debt was the big part of the problem.

We should scrap the tax deduction for mortgage interest, and replace it with a different policy that creates an equivalent tax break for homeowners. Instead of getting a tax break for paying interest, we should be getting a tax break for making extra payments on the mortgage. Instead of getting a tax break for having a mortgage, you'd be getting a tax break for paying it off early.

When you take out a loan, you get the money along with an obligation to pay it back, with interest. That's what credit is: money, plus the obligation to pay it back. 

If I borrow a dollar and spend it, I'm spending credit. But only the "money" part of the credit changes hands. The obligation to pay it back stays with me. The "debt" part of credit stays with the borrower. The "money" part of credit is the part that changes hands when we spend it. And the person who receives it receives money, not credit, because she didn't borrow it. I did. (Read that again.)

There is a problem with paying debt back early. If policymakers change the tax deduction so it encourages us to pay off our debt early, by making those payments we will be reducing the quantity of money in the economy. This undermines the whole concept of using credit: Using credit doesn't help the economy grow if we pay back the money too soon. When we pay it back, it's not in the economy anymore, being spent. That's the problem with paying debt back early.

There is a simple solution. Let the Fed keep an eye on the "average cost of interest per dollar". Let them increase the quantity of money -- that's money, not credit -- in the economy, increase it enough to offset the effect of us paying back our debt early. One way to do it? Let our paychecks grow a little faster. It's not rocket science.

By the way, the money I'm talking about is the money that changes hands. M1 money. That's the money we receive as income, the money we spend, the money that's "readily accessible for spending".

But maybe you don't like the idea of letting our paychecks grow a little faster. I admire your altruism. And you are right: We have to prevent the inflation that might be induced by rising pay. No problem.

Instead of suppressing the increase of money, policy should be suppressing the increase of credit. We went over this already. Tax breaks for home mortgages have to change. Tax breaks for business use of credit have to change. The "bankers' mindset" of policymakers has to change: Stop encouraging the growth of finance!

If we do it right, the increased growth of money is offset by decreased growth of credit-use, so our improving paychecks create no inflationary pressure. At the same time, the increase of money and the decrease of credit-use reduces the average cost of interest per dollar. It reduces the cost of finance. It relieves the cost pressure created by the rising cost of finance.

And you know what? Relieving the cost pressure created by finance improves living standards, lifts profits and improves economic growth.

Let us begin.

Just checking

 

Links: Google Ngram Viewer, Business Insider 

Financialization

The "Continuing Cost Pressure" Theory of Stagflation

From Investopedia, Inflation vs. Stagflation: What's the difference? by Tony Daltorio:

There are two main theories about what causes stagflation. One theory states that this economic phenomenon is caused when a sudden increase in the cost of oil reduces an economy's productive capacity. Because transportation costs rise, producing products and getting them to shelves gets more expensive, and prices rise even as people get laid off.

Another theory posits that inflation is simply the result of poorly conceived economic policy. Simply allowing inflation to go rampant, and then suddenly snapping the reins, is one example of a poor policy that some have argued can contribute to stagflation. Others point to the harsh regulation of markets, goods, and labor combined with allowing central banks to print unlimited amounts of money.

Oddly, Simplicable offers the same two theories:

Stagflation is caused by shocks to an economy such as a sudden price increase in energy. It can also be caused by economic mismanagement such as an overly aggressive expansion of money supply.

Good grief! So does Wikipedia. And Proshare. The same two theories.

The one theory says a supply shock (like "a sudden increase in the cost of oil") can lead to higher manufacturing and distribution costs, and to higher prices which reduce demand and slow the economy. The other theory says bad policy is the cause.

It seems to me that stagflation could arise either way. Surely there is more than one way it might happen. And yet, neither theory is completely satisfactory. The theory of bad policy is not specific. The "supply shock" theory is too specific: A sudden increase in the cost of oil is not the only thing that can create a negative supply shock. Given the right circumstances, any rising cost could lead to stagflation. It wouldn't even have to be sudden.

What circumstances? The rising cost would have to create long-term, continuing cost pressure, pressure that even if resolved today returns tomorrow. Not one or two oil shocks fifty years ago, but something that happens repeatedly or continuously.

People who say "there's no such thing as cost-push inflation" often point out that if not for monetary "accommodation" by the central bank, cost-push pressure would only create a change in "relative" prices: If the price of oil went up, other prices would go down until balance was restored. I can see that. But if it's a repeating or continuing cost increase, it's a different ball game.

If the cost of oil doubled every year, for example, all other prices would soon "relative" themselves down to zero. In that situation, I don't think even monetary accommodation could help. If it was only a 20% increase each year we'd last longer, but still the cost of oil would kill off our civilization, probably before we found some other way to do ourselves in.

What would be the properties of a cost that creates long-term, continuing cost pressure?

• It could be a slow-growing cost, not necessarily a sudden shock like oil in the 1970s.
  
• It would have to be a massive cost, massive enough to impact our massive economy. And
  
• It might be a cost we don't see as a problem: continuing cost growth that, for some reason, doesn't much concern us.

The only cost I know that has these properties is the cost of finance.

//

Surely there are more than two ways stagflation could arise. Allow me to offer a third theory of the cause of stagflation: Continuing Cost Pressure.

Rising cost squeezes profit. Producers increase prices to restore profit. To the extent that the monetary authority "accommodates" higher prices by increasing the quantity of money, the result is inflation. To the extent that the monetary authority refuses to accommodate higher prices, the result is slowing growth. Producers are left to cope with their reduced profit as best they can, but low profit is an impediment to growth, and unprofitable business is unsustainable.

If the cost was a temporary, one-time shock to the economic system, this wouldn't be a new theory. But if the cost creates repeating or continuing long-term cost pressure, the story is entirely new. For as long as this cost pressure continues, the relative adjustment of prices can never come to an end. And all the while, the price trend is always "up" for the pressurized cost, and always "down" for everything else.

Again, I am describing the cost of finance.

//

Why is it that finance creates continuing cost pressure? Surely it's not because of the rate of interest. That rate goes up sometimes, and down sometimes. And lately it has spent a lot of time at "the lower bound". Surely the problem is not the rate of interest.

That's correct. The problem is not the rate of interest. The problem is the cost of interest. Five percent interest is a rate, not a cost in dollars. If you pay five percent interest, you pay five cents for every dollar you owe. It isn't a lot because it's five percent. It's a lot because we owe so many dollars. Dunno how that gets overlooked all the time, but it does -- except when we're talking government debt.

The problem is the cost of interest, and all the other fees and charges that go along with it. And the debt, the principal that must be repaid, that's part of the cost problem, too. And the cost always increases, because debt is always growing. Finance is always growing. And finance is always growing, because policymakers think that's good for the economy.

//

People sometimes figure the size of finance by considering employment in finance as a share of total employment. I can see that. Those people actually are working, same as the people who don't work in finance. They receive income, and the cost of it adds something to the price of output.

But all those people who work in finance only add up to around seven or eight or nine percent of the workforce. If you count just interest paid in the US, it came to 9% of GDP back in 1962. It was 31% of GDP during the 1982 recession, 32% before the 1991 recession, 27.9% before the 2001 recession, and 31% again in 2007, shortly before the "Great" recession. The average cost, for the years 1980 thru 2009, was 26% percent of GDP.

It is true that all the money that's interest cost to us is interest income to somebody. But we still have to pay it, you know? It's still a cost. We don't get to use that money to buy other stuff. And the people who receive that interest as income, they're not likely to spend it. I know, because aggregate demand is down. They put most of the interest with the money they earn interest on, and earn more interest. 

And the money in finance doesn't come back into the economy unless we borrow it, which increases the number of dollars we owe and pay interest on. Or unless the saver spends, of course, but that's anathema to the saver.

Then too, they don't get their interest income in exchange for work. They didn't make something and get paid for it. They just made money. So income increased, and output didn't. People were paid, like, output plus finance, to produce output. So the purchase price of output is the cost of output plus the cost of finance. And every time the size of finance gains on the size of GDP, the purchase price of GDP increases again. Just by growing, finance exerts continuing upward pressure on prices.

//

Employment in finance adds to the cost of output, pushing prices up. Interest paid reduces profit and subtracts from aggregate demand, slowing economic growth. The cost of finance contributes to both sides of stagflation: to rising prices and to slowing growth.

If the cost of finance was a one-shot cost, like an oil crisis, maybe we wouldn't even notice a problem. But finance as a rule grows faster than GDP, so it creates continuing cost pressure.

//

Finance grows faster than GDP. Therefore, financial cost grows faster than GDP. It's like a slow-moving version of an oil crisis where our use of oil increases every day. Even without an embargo, the cost of it eventually becomes a killer. Oh, and the credit crisis of 2007-08 was the embargo.

Back at the end of World War Two, finance wasn't yet big. Not by today's standard. People had little debt, and interest rates were low. Our lovely little finance, back then, had a lovely little financial cost that didn't much interfere with economic growth. Benefit outweighed cost. And finance, I'll venture, actually helped the economy grow.

But as we enjoyed the fruits of finance, finance grew. And financial cost grew. And there came a moment when the benefit of finance and the cost of finance were equal. That moment, I'll venture, was the end of the golden age. And finance continued to grow.

Back in the 1970s, we were already in the habit of using credit and accumulating debt. Back in the 1960s, policymakers discovered that the benefits of finance far outweighed the cost. They have busied themselves ever since, putting policies in place to expand the availability and use of credit, policies that encourage the growth of finance. And finance continued to grow.

Since the end of the golden age, for the economy as a whole, finance has been a losing proposition. At first, only a little. It was hard to see, because for a long time we thought finance was always good for the economy. But finance continued to grow.

Having grown faster than the economy for generations, finance became massive enough to influence our massive economy. And because of its massive size, the cost of finance came to outweigh the benefit. Finance started to harm to the economy. And still, finance continued to grow.

We still need finance. God knows, we need it. Somehow, we need finance more now than we did when it was little. And yes, that's part of the harm done by finance.

And finance continues to grow.

Two brief quotes before tomorrow's post

 

From Randal K. Quarles, Vice Chair for Supervision, Board of Governors of the Federal Reserve System, October 18, 2018:

Traditionally, as taught in Econ 101, inflation provides a signal on whether the economy is operating above or below its potential level. If inflation moves up in a sustained manner, not just because of temporary shocks, then the economy is likely operating above its productive capacity, as firms have the leeway to raise prices given the strength of demand. Likewise, if inflation moves down persistently, then the economy is likely operating with some slack, as firms restrain prices to sell their products in the face of weak demand.

 

From Scott Sumner, Ralph G. Hawtrey Chair of Monetary Policy at the Mercatus Center, November 12, 2018:

So, as you may know, the Fed does inflation targeting at about two percent, but it's really more complicated than that because there's different kinds of inflation. 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.

 

Quarles distinguishes between temporary and sustained inflation, notes that economic shocks are ordinarily temporary, and points out that sustained inflation is likely due to something other than a shock.

Sumner distinguishes between supply side inflation (created by shocks) and demand side inflation (caused by overspending). He points out that the Fed's money management only works on demand side inflation.

Tomorrow, I identify supply side inflation that is caused by a permanent shock, not a temporary one, though "shock" is not really the right word to describe it.

"Inflation" isn't a good word to use, either. When we focus on inflation, we're assuming inflation is the problem. But inflation really isn't the problem.

In addition to overspending and sudden, temporary cost shocks, I identify subtle but relentless cost pressure as a cause of inflation. This pressure is a problem which can result in a "sustained" inflation.

The overspending that Sumner mentions has only one likely outcome, inflation, because "the economy is likely operating above its productive capacity" as Quarles says.

But a supply-side cost shock has two possible types of outcome. One is inflation, resulting from overspending if the Fed allows it. The other is a slowing of economic growth as rising costs eat into profit, if the Fed refuses to permit overspending and inflation.

Like a temporary cost shock, continuing cost pressure may result in either inflation or the slowing of economic growth, depending on the Fed's response.

But a key point is often missed by people who focus on inflation: If continuing cost pressure is the problem, and the Fed doesn't allow a continuing inflation adequate to relieve the pressure, then the result will be a continuing slowdown of economic growth.

Suppressing inflation solves the inflation problem, but it doesn't solve the problem of continuing cost pressure. We must solve the problem of continuing cost pressure, so that we can prevent both inflation and long-term decline.