Monday, July 06, 2009

Inflation 2.0

Long time reader MP asks:
I have been an avid Winterspeak reader for a few years now and given your track record on the housing bubble (we corresponded in the past about that) I figure it pays to follow your analysis closely. I’m pretty sold on the Mosler stuff you summarize but the one area where I haven’t seen a concise explanation is that of inflation. Is the argument that inflationary pressure just isn’t a factor, or that money through a payroll tax holiday has no more impact than the money being thrown into the system via the stimulus plans, or something else? I know this isn’t a very precise question…but basically how does the concept of inflation play into this theory? What is the endgame on that?
Excellent question.

"Inflation" is a slippery topic -- the standard definition is an increase in price levels across a broad basket of goods (Consumer Price Index: CPI). The CPI has all sorts of problems with how it is calculated, and how meaningful it is, so I'm not a big fan.

Most importantly, CPI conflates two different factors and gives us a net result which hides more than it reveals: "dilution" (through the creation of more money, which chases goods) and "technological change" whereby new technologies reduce prices. So, someone comes up with a more efficient way of making cars, and cars get cheaper. The Government prints a lot of money, creating inflation, and cars get more expensive again. The net result is that prices stay the same, but the benefits the non-Governmental sector would have received from cheaper cars was taken by the Government printing dollars. In a world of technological process, and constant money, you should see continual, mild, deflation. The more progress there is, the more the Government can take by printing money, without it showing up as higher prices -- you just get the absence of lower prices. This is the typical Austrian view, and it has a lot going for it.

However, adding Mosler's insight from the fiat money world changes how this works. The amount of money in the world is flexible, and most of the "printing" happens via extension of bank credit, not Government printing. Money, like all financial assets, exists as both an asset and a liability, whereas in the "gold standard"-centric Austrian interpretation, money is an asset to its holder and a liability to no one. Financial assets must, by accounting, net to zero. Money supply can increase as balance sheets expand, but they must always net to zero. So the culprit of dilution is credit, not the Fed or the Treasury.

More importantly, the "too many dollars chasing too few goods" is the best definition of inflation -- dollars have to chase goods for inflation to be an issue. If the Government prints money, and it just gets saved, then, although the money supply has been "diluted" (a la that Austrian school) from a practical perspective, it's like the money doesn't exist at all, since it just sits in checking accounts. Does the presence of all that checking account money mean that banks can lend more? No -- bank lending is constrained by capital requirements and demand for credit by creditworthy borrowers, not deposits, and not reserve requirements. If the Government prints money that just gets saved, it's like the proverbial tree falling in the woods: there is no inflationary impact.

Public debt (the deficit) must, by accounting, equal private savings. If the Government spends more then it taxes, that spending bids up the price of whatever the Government is buying. Taxation "sterilizes" the impact of that spending by taking that money out of the private sector. If the private sector naturally saves a lot (like Japan) then it "self sterilizes", enabling the Government to spend more (run higher deficits) without triggering an increase in the CPI. The mystery of Japan, with its sky high savings rate and 30 years of decline, is why the Government bothers to collect any tax at all.

If the private sector, as a whole, decides to save more, you'll see a fall in overall spending, reduction in incomes, debt default, inventory liquidation, and deflationary spiral current in effect in the US. The private sector, as a sector, cannot increase its savings. For one sector to increase its savings, another sector must decrease its savings. Assets must balance liabilities. The Federal deficit must fund the private demands for savings, or you will simply see debt default, lower aggregate demand, and unemployment as incomes keep falling as household try (in vain) to increase savings. Similarly, if the private sector wants to net dis-save, the Federal Government must run surpluses (tax more than it spends) to keep that private credit expansion from creating inflation.

You get inflation whenever you have too many dollars chasing too few goods, ie. too much Government or Private spending not sterilized by taxation or credit restriction. The desire for private sector savings is exogenous, it is Keynes' "animal spirits" and it ebbs and flows based on mass whimsy. When the desire to save is low, or negative, the Government must run surpluses to net destroy money, and/or throttle private (bank) credit extension, to control inflation. If the private desire to save is high, the Government must run deficits to fund that demand, it cannot rely on private (bank) credit extension because that is pro-cyclical. The current monetary response has not stopped deflation because lowering interest payments destroys private aggregate demand, and enriching banks "pushes on a string". The only thing holding up aggregate demand right now is unemployment, as unemployment drives higher deficits, and thus funds private sector savings. It also reduces the private sector demand for savings, as those without jobs run through their savings and/or spend what public transfers they receive.

Inflation control requires counter-cyclical fiscal management, nothing more, nothing less.


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