Separating the cost-push from the inflation

Mine of the 27th is about how the growth of one sector of the economy (relative to the rest of the economy) can create cost pressure that tends to cause cost-push inflation... One sector, like "government" or like my favorite target, "finance".

Mine of the 25th is part of a series about how a decline of labor productivity (caused by labor force growth) may create cost pressure that tends to cause cost-push inflation.

Both posts are about cost-push inflation arising from some source other than rising prices (like the price of labor). In neither post does the cost pressure initially arise from rising prices that must be paid.

• Sectoral growth can create pressure simply because there are more transactions -- more people paying taxes, for example, or more people borrowing money. The cost pressure can arise even without increases in tax rates or interest rates. I say this all the time about interest rates versus the amount of debt on which interest must be paid.
  
  
• Falling labor productivity creates pressure not because it increases wage rates, but because it reduces the output that labor creates. The cost is generated internally, within the business itself, and passed on from there. 

I'm tempted to say that in *no* case does the cost pressure initially arise from rising prices that must be paid. But I can't imagine that's 100% true.

 

I notice that, more and more, I am separating the "cost-push" problem from the "inflation" problem in "cost-push inflation".

The "cost-push" problem -- the cost problem -- may arise from unusual circumstances like extremely rapid increase in the Labor Force Participation Rate for a year,, say, or persistent, long-term growth of the financial sector, or perhaps from other causes.

The "inflation" problem arises when some change in "money" makes possible an increase in spending and aggregate demand, perhaps as a solution to a cost problem or to the "slow growth" problem that arises therefrom.

But we must never forget that of the two, cost and inflation, it is cost that is the greater problem. Cost reduces economic growth. Sustained cost -- which economists have defined out of existence, by the way -- is how civilizations die from suicide.

Inflation may postpone this but does not prevent it.

Starry-eyed and hopeful: Unbalanced sector growth as a source of cost pressure

Inflation & the Rise of the Government Sector: An Analytical Survey (1979) by John H. Hotson

Hotson's opening:

That the rise of the government sector in recent decades is the root cause of the inflation which has plagued these same decades is not a thought which has occurred forcefully to many economists.

Hotson's observation, reinforced by the title of his article, offers support for my running argument that cost-push inflation is driven by the growth of finance:

• Each sector of the economy is a cost to the rest of the economy.
  
  
• The growth of one sector, relative to the rest of the economy, creates cost-push pressure.
  
  
• Unless the central bank relieves the cost pressure by allowing inflation, cost pressure slows economic growth.
  
  
• Sector growth is liable to be a long-term phenomenon, so that the containment of inflation is likely to create long-term slowing of the economy, as the developed world has seen over the past 60 years.
  
  

Hotson reinforces his observation with a quote from Robert Heilbroner:

When we look at the historical picture, the root cause of the recent inflationary phenomenon suggests itself immediately. It is a change that profoundly distinguishes modern capitalism from the capitalism of the prewar era - the presence of a government sector vastly larger and far more intimately enmeshed in the process of capitalist growth than can be discovered anywhere prior to World War II ...

I would change two of Heilbroner's words to one:

... the presence of any sector vastly larger and far more intimately enmeshed in the process of capitalist growth than can be discovered anywhere prior to World War II ...

and that about sums it up.

One measure of size, commonly used as a measure of problems related to government, is the size of the debt. Here's an old graph of total debt, and five components of it, shown relative to GDP:

From my blog post of 23 January 2010
Original Graph by CONTRAHOUR at Seeking Alpha, 28 Jan 2009

 

The graph doesn't show where we are now. But it does show what happened during the time the economy went from "good" to "bad". I'll paraphrase what I said about it before: 

The topmost plotted line shows total debt. On the right-hand side of the graph, the next line down from the top is "Domestic Financial" debt.

On the right-hand side, the most recent numbers show domestic financial debt is the largest component of the debt. On the left-hand side, the graph shows domestic financial debt was the smallest component in the 1960s.

Clearly, domestic financial debt has been the fastest-growing component of our debt.

The growth of one sector, relative to the rest of the economy, creates cost-push pressure. If the sector's growth is natural, it may not be a problem. But if the growth arises from an unnatural cause such as economic policy that consistently favors the growth of finance, it could very easily be a problem, and one most difficult to solve.

Let me paraphrase Hotson's Heilbroner quote:

The graph shows the presence of a financial sector vastly larger and far more intimately enmeshed in the economy than can be discovered anywhere prior to World War II ... When we look at this historical picture, the root cause of the recent inflationary phenomenon suggests itself immediately.

These days, inflation is among the least of our economic problems. Forgive Hotson and Heilbroner their focus on inflation. Hotson was writing in 1979, Heilbroner in 1978. 

Me, I have a somewhat different concern.

Do keep in mind two things. First, economists' diagrams of inflation show that 

• Demand-pull inflation works itself out through faster economic growth
  
• Cost-push inflation works itself out through slower economic growth

Economist Frederic Mishkin explains:

[D]emand-pull inflation will be associated with periods when output is above the natural rate level, while cost-push inflation is associated with periods when output is below the  natural rate level.

The growth of finance creates cost-push inflation, not demand-pull. So we can simplify the Mishkin quote by omitting the "demand-pull" part: Mishkin says "cost-push inflation is associated with periods when output is below the natural rate level." Output "below the natural rate level" means economic growth is slow. Mishkin is saying that cost-push inflation makes the economy slow. 

The economists' diagrams tell us the same thing: cost-push inflation makes the economy slow.

I prefer to think that cost pressure makes the economy slow, and that if they let some inflation occur, the central bank relieves some of that pressure and the economy slows less. But we can go with it Mishkin's way for now, if you prefer.

Mishkin's statement makes sense if we assume cost-push inflation is temporary: We get a few years of slow growth, and then things return to normal. Economic performance returns to the natural rate level.

But if the inflation is sustained
But if the cost pressure is sustained, the economy will seem to be permanently below the old natural rate level. Economists will say the natural rate has fallen, and they will lower their estimate of the natural rate. At least, that's what happens with potential output.

The new estimate may bring the natural rate down to the actual growth level. We can, however, expect the cost pressure to continue driving actual economic growth down until it is again below the estimated natural rate. But this doesn't happen because "cost-push inflation is associated with periods when output is below the natural rate level." It happens because cost pressure reduces economic growth.

Maybe we should look at the natural rate as a best-case estimate of growth, an estimate that arises from actual economic performance. The economy doesn't grow slowly because the natural rate is low. It's the other way around: The natural rate is low because the economy is growing slowly.

Furthermore, if cost pressure has made the economy slow but the cost pressure still exists, the economy will slow more.

This is what happens when the inflation is cost-push. It continues to happen as long as the cost problem continues to exist, and it happens whether the central bank allows inflation or not. Do what you will -- abandon Keynesian theory, come up with supply-side policies to boost economic growth, deregulate finance, whatever -- the decline of growth continues regardless, until the cost problem is resolved, one way or another, for better or worse, rising again or falling to ruin.

"And on the pedestal these words appear:
'My name is Ozymandias, king of kings:
Look on my works, ye Mighty, and despair!'
Nothing beside remains..."

Scott Sumner said

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.

Yes, the economy slowed. Yes, the reforms helped. But the reforms did not solve the problem. They did not solve the cost problem. And after Paul Volcker solved the inflation problem in the early 1980s, economists quit looking for a cost problem. Instead, they defined "cost-push" out of existence.

And since the reforms did not address the underlying cause of slow growth -- the cost problem created by the continuing growth of finance --  the economy continued slowing despite being boosted by reforms. Things grew worse, and here we are today, starry-eyed and hopeful that the post-pandemic economy will grow enough to somehow justify the inflation we are now being told to expect.

And that's how cost pressure works. Inflation is not the problem we must focus on.

The second thing to keep in mind is the slowdown of economic growth. And that the solution is to reduce the size of finance, the overgrown sector that is the source of the cost pressure. We must also eliminate the policies that induce excessive growth in that sector.

There was NO initial price increase ...

If you have cost-push inflation explained as a "wage-price spiral" it is easy to picture me and my boss, each in turn, getting an increase: first my wages, then his prices, then my wages again, and so on.

But how do we know the spiral started with my wages? The chicken, or the egg?

It is easy for me to accept the "spiral of increase" as a process in motion. But how does the spiral get started? That's the stumbling block.

So okay, I have to go to the boss for a raise because the cost of living is going up. But no: We're already mid-spiral at that point. The cost of living has already gone up. The process is already in motion. The cost-push doesn't start with me. The initial "push" is unexplained.

I think this is why the "oil shock of the 1970s" is so often used as an example of cost-push inflation. Not only was it a sudden "shock" to the economic system, and a massive one, but also it is easy to picture an external force imposing a cost on our domestic economy. It is easy to see this as the initial push that starts a cost-push inflation and a wage-price spiral.

Of course, the Great Inflation of 1965-1984 began in 1965, or possibly earlier, and the first oil shock didn't begin until late in 1973. So there is a possibility that even the oil shock was not the initial push of that inflation. More than a possibility: to my mind a certainty.

And, too, you have explanations like the one George Dorgan offers:

Economists commonly explain the rising oil price between 1998 and 2008 as due to the growth of emerging markets. They classify the resulting inflation as demand-pull inflation. We argue that the cost-push inflation of the 1970s was also a reflection of rising global demand. For us, oil prices had remained too low between 1950 and 1970. They had to catch up quickly to the reality: with rising deficits and wages in the U.S. The picture only changed with the outbreak of the Yom Kippur War in October 1973.

According to Dorgan, the problem goes back to the 1950s, and the rising price of oil was due to demand-pull, not cost-push. 

So the oil shock of the 1970s may be a good example of built-in inflation and how inflation continues, but it doesn't answer the question of how cost-push inflation gets started.

I have the same problem with built-in inflation and conflict inflation and inflation driven by expectations: These explain why inflation continues, not how it gets started.

This is what makes the inflation of 1955-57 so fascinating, or at least my April 13 explanation of it: It began with an unusual year-long increase in the Labor Force Participation Rate. The supply side was "unprepared for the firehose of new workers" (to use Waldman's phrase) and the effect of the year-long increase on "the returns to experience" (to use Vollrath's) caused a fall in the growth of productivity.

The fall in the growth of productivity meant that business was getting less output per hour, and less output per dollar of wage cost. The fall in productivity growth created rising cost in the business sector.

The initial push did not happen when some guy went to his boss and demanded a raise. The initial push arose from a fall in the growth of productivity. And the fall in the growth of productivity arose from the unusual increase in labor force participation. So we can look two causes back, and still not see increasing cost as the prime mover of the 1955-57 inflation. This is not just fascinating. It is significant. It should lead economists to revise their thinking and their explanations of cost-push inflation.

There was no initial price increase that created the cost increase that started the cost-push inflation of 1955-57.

BLS employment definitions

 I want to keep this link handy!

https://www.bls.gov/cps/definitions.htm

It even includes stuff like this:

Another glance at the 1955-57 inflation

Percent Change from Year Ago, Producer and Consumer Prices  1950-1962

The increase appears to begin mid-year 1955, six months or so after the 1955 increase in the Labor Force Participation Rate began, with producer prices rising ahead of consumer prices. 

However, as the "Percent Change" view of this monthly data shows, the price rise appears to have begun in January of 1955 -- along with the unusual year-long increase in Labor Force Participation:

Percent Change, Producer and Consumer Prices  1950-1962

Exploring

I just discovered that the "current dollar output" of the business sector follows the same path as "gross value added" of "GDP: Business":

Graph #1: Current Dollar Output (yellow) centered on GVA Business

To see that they follow the same path, I indexed both series to the same date.

Here's the thing: the GVA series is given in billions of dollars. The Output series is given as indexed data, so you don't know how many billions it is. But now I can convert the Output series to billions, or just use the GVA series instead.

 

  

"Price per unit of Real GVA" as a measure of inflation

Graph #2: Comparing Unit Price of Real GVA to the GDP Deflator

To my eye they look quite similar. Let me zoom in on the 1950-1962 period:

Graph #3: Comparing Unit Price of Real GVA to the GDP Deflator, 1950-1962

This graph is for comparison to the inflation graph in mine of 13 April. Here, the "percent change from year ago" in price-per-unit (blue) runs at zero from 1954:Q4 to 1955:Q2, then rises to 3.03% by 1956:Q1. It runs high until 1957:Q2, then starts to fall. 

As noted on the 13th, this inflation was driven by the cost pressure created by falling labor productivity that was caused by the rapidly rising labor force participation rate of 1955. And maybe the graph also provides evidence that high interest rates can bring down even cost-push inflation.

High interest rates, however, do not solve the cost problem that is the proximate cause of the proximate cause of cost-push inflation -- if you get my drift. Fortunately, the rapid increase of labor force participation was only a one-year event.
 

 
I also found a "Profit per unit of real GVA" series at FRED. Taking that profit as a percent of "Price per unit of real GVA" generates this distinctive pattern:

Graph #4: Profit-per-Unit as percent of Price-per-Unit of Real GVA of NCB

The malaise of the 1970s is clearly visible after the fall from high (above 10%) profits to low (below 10%) profits in the latter 1960s. One decade of low profits was more than enough to change mainstream economic thought. Since Reagan, the highs have gone higher and, since 2000, even the laws that govern the functioning of the economy appear to have been altered by policy.

I don't know how else to describe it.

"relatively low and relatively stable"

I'm still looking for an explanation of the 1955 increase in the Labor Force Participation Rate. I figure it was caused by return to civilian life after the Korean war. But I hesitate to say it because the timing seems off, and because I should be able to find something on the internet that actually identifies the cause of that 1955 increase. However, that's not my topic just now.

Unmentionables

According to The Rise and Fall of Labor Force Participation in the U.S. at the St. Louis Fed,

If you know only one aspect of the data on labor force participation, it should be this: Labor force participation used to be relatively low, it rose during the 1970s, 1980s and 1990s, peaking in 2000, and it has generally been declining since 2000.

That's great, if you only want to know the one thing. 

Here's their next thought:

From 1948 to 1966, the labor force participation rate was relatively low and relatively stable, averaging 59.1 percent.

Low and stable. Except for a one-year increase of more than two percentage points, which shall go unmentioned. 

Unmentioned. I wonder why that is.

Here, some of my notes that didn't make it into the 13 April post:

The Labor Force Participation Rate (LFPR) shows the percentage of the working-age population that has a job or wants one. When baby-boomers reached working age, the rate went up. When women in the workforce became a thing, the rate went up. The LFPR increased from 58.6% in January 1965 to 66.8% in January 1990, or 8.2 percentage points in 25 years. A remarkable increase.

The LFPR increased from 58.1% in December 1954 to 60.2% in December 1955, or 2.1 percentage points in just one year. A remarkable rate of increase. If it had continued at that rate, it would have equaled the 1965-1990 increase in less than four years.

Not worth a mention?

Productivity

In the 1950s, cost-push inflation was sometimes attributed to low productivity.

In The Wage-Push Inflation Thesis, 1950-1957 Lowell E. Gallaway (1958) wrote:

Simply stated, the wage-push inflation thesis holds that money wage rates have increased more rapidly than physical productivity and, consequently, have exerted upward pressure on costs and prices.

 In Time magazine, 15 July 1957, we read:

General Motors set up the first automatic "annual improvement factor" increase in wage contracts in 1950

and

The upward trend of wages was due not only to the scarcity of labor but also to the spread throughout industry of the G.M. idea of automatic increases. This ran counter to traditional business practice because it placed emphasis on a long-term rise in productivity and kept wages rising even when productivity temporarily stopped rising (as it did last year) or business temporarily slackened (as in steel and autos this year).

Note that they knew in 1957 that productivity "stopped rising" in 1956. That is the productivity problem I attribute to the 1955 increase in the Labor Force Participation Rate.

Note also that a decline in productivity increases labor cost to business, just as wage hikes do. It would be a simple mistake to blame wage hikes when the problem was low or falling productivity. But you couldn't fix the problem by holding wages down, not in the 1950s, and not since the 1980s.

In the early 1960s, productivity was still sharply in focus. In 1996 the L.A. Times recalled that President Kennedy

used a tactic his economic advisor, Walter W. Heller, called “jawboning” to urge business and labor to behave responsibly. In Kennedy’s time, that meant pay increases shouldn’t exceed productivity gains--and price hikes shouldn’t exceed increases in wages.

And again:

In his [January 11] 1962 State of the Union, Kennedy declared, “Our first line of defense against inflation is the good sense and public spirit of business and labor--keeping their total increase in wages and profits in line with productivity.

Networker writes:

Kennedy, since the Inaugural Address and beyond, had been asking Americans and American business to exercise restraint to enable the United States to meet its obligations and strengthen its economy. The Steel Workers of America agreed to hold off their demands for higher wages if the Steel Companies, on their part, would not raise the price of steel. The workers kept their end of the bargain, the companies did not, ordering a price increase after a strike was averted. This dishonest and irresponsible act angered Kennedy, as is made clear in the following speech.

Then, from Kennedy's April 11 1962 speech:

... there is no justification for an increase in steel prices. The recent settlement between the industry and the union, which does not even take place until July 1st, was widely acknowledged to be noninflationary, and the whole purpose and effect of this Administration's role, which both parties understood, was to achieve an agreement which would make unnecessary any increase in prices.

In his very next sentences, again, productivity was central:

Steel output per man is rising so fast that labor costs per ton of steel can actually be expected to decline in the next 12 months. And in fact, the acting Commissioner of the Bureau of Labor Statistics informed me this morning that, and I quote, "employment costs per unit of steel output in 1961 were essentially the same as they were in 1958."

It's a good speech. Kennedy was angry. He called for "a higher sense of business responsibility for the welfare of their country".

It's not like Kennedy didn't know about productivity and cost. He knew. He was focused on it. And he tried to keep prices from rising.

It didn't work. I wonder why that is.

Another unmentionable

Why didn't it work? This wasn't the latter 1950s. The economy was not adjusting to a sudden increase in labor force participation. Nor was it the latter '60s, nor later. The big change in labor force participation due to the Baby Boom and Women In the Workforce had not yet begun. It was 1962. Productivity growth was high again. Where was the problem?

I'll go back to saying what I always say: Debt was accumulating. The cost of finance was rising. Surely, by the time interest on household debt was taking more than 5% of employee compensation, people considered it part of the cost of living. Surely, rises in our paychecks had to cover the rises in our interest payments.

Annual Household Interest Costs as a Percent of Employee Compensation
Interest Costs go above the 5% level (red) before 1960

Annual Household Interest Costs, Growing as a Percent of GDP

And with household interest cost growing faster than GDP from 1946 to 1986, wage hikes that just covered the interest cost would surely have looked like inflationary increases. Looked inflationary, and were inflationary.

People were covering their costs. It was cost-push inflation, due to the rising cost of finance. It looked like inflationary wage increases for a reason. But finance didn't get the blame. Wages did.

Come to think of it, the policies that encouraged all that borrowing didn't get the blame, either. I wonder why that is.