Friday, November 05, 2010

You can't move consumption forward

Paul Krugman gives you half the story for how inflation expectations is supposed to work. The poverty of the model is clear:
So what the Fed needs for inflation targeting is a way to tie its own hands — or, more accurately, the hands of future Fed officials. That was the whole point of my line about credibly promising to be irresponsible.

In practice, that’s really hard, especially when you have such divergent views among Fed officials themselves. The best precedent is 1933 — which was first pointed out by Peter Temin and Barrie Wigmore. In that case, the end of the gold standard convinced people that there really had been a pro-inflation, or at least anti-deflation, regime change.
When the US went off the gold standard in 1933 it switched to a fiat currency, and therefore was able to deal with the liquidity and solvency problems holding down aggregate demand in the 30s, and keeping the country in the Depression. People didn't suddenly say "Oh, our savings will be inflated away -- let's buy stuff" nor did they say "Oh, our savings will be inflated away -- let's build factories". They kept banks from collapsing and ultimately funded WW2 without worrying about the bank vaults being empty now that they had a printing press.

In economic models, expected inflation feeds into the discount rate, which then governs individual decisions about whether to postpone consumption. The idea is that when inflation expectations go up, the individual will move consumption forward, wheras if inflation expectations go down, the individual will defer consumption (ie. "save").

In reality though, it's easy to defer consumption (just buy the thing later) but it's very hard to move it earlier. You cannot pre-eat a years worth of meals, nor can you pre-live in a years worth of housing, so you won't need either of those things in the future (when it's more expensive).

Third world countries tell you what people actually do when they expect high inflation. And it isn't buying cars nor building factories.


Blogger The Arthurian said...

"You can't move consumption forward" = "You can't push on a string."

The most amazing thing about that Krugman quote may be that he gives credit to somebody else for coming up with something before he wrote it or said it or knew it.

4:27 AM  
Blogger Tom Hickey said...

This is one of the stupidest things I have ever heard Krugman say. Anyway, pulling demand forward involves debt; it's not like consumers are sitting on piles of cash collecting interest. Instead, they are saving to rebuild broken balance sheets or delevering to prevent default. Nor is business going to invest in the absence of hard evidence that effective demand is increasing.

Krugman has often written derisively about "the confidence fairy." He is a victim of the expectations fairy.

9:59 AM  
Blogger Devin Finbarr said...

"Third world countries tell you what people actually do when they expect high inflation. And it isn't buying cars nor building factories."

The response, of course, is to try to exchange your inflating currency for a more stable currency. So what currency is a more stable, respected currency than the dollar? Not the Yuan. Maybe this one?

What's interesting is that we could simultaneously be experiencing both significant inflation and a recession due to low aggregate demand.

People's balance sheets are in tatters, but they have lost a lot of faith in the dollar. Because of the balance sheet problem, demand is low, and people are not buying cars and building factories. But because of the confidence problem, the price of imported commodities and gold is rising. Ordinarily, this might trigger a fall in the dollar relative to other currencies, and thus stimulate exports. But other currencies are equally unstable, and the U.S. no longer has much of an export industry to stimulate. The falling dollar, when it comes, will mean more unaffordable imports and lowering living standards, not more exports.

The solution is to have balance sheet repair in a way that doesn't dilute current dollar holders (by simply multiplying the face value existing Federally backed paper by X%).

Instead, the government is diluting dollar holders and giving the perception of diluting dollar holders, without performing significant balance sheet repair. Its worst of all worlds.

11:57 AM  
Blogger The Arthurian said...

Tom, if I may... You say "Anyway, pulling demand forward involves debt." I say No: Pulling demand forward involves spending.

It is not the fault of consumers that since the end of World War II, economic policy has restricted the quantity of money while encouraging the use of credit. Such policies have created a world where "pulling demand forward involves debt."

So yes, in a sense you are right; but clearly, those policies have failed.


1:04 PM  
Blogger Tom Hickey said...

Art, thanks for elaborating what I intended. People have been going into debt in order to spend instead of drawing on either current income or savings, or else selling assets because these have been insufficient. As Michael Hudson observes, this forced reliance on debt to consume instead of accepting a lower standard of living didn't just happen. It was orchestrated by rent-seekers, and it is called financialization. It was also a result of the real wage not keeping pace with productivity gains, which were committed to "profits" that were really monopoly rent.

Randy Wray explains financialization and its effects through creating fictitious capital in Minskian terms in a recent post at

4:26 PM  
Blogger Digger said...

I would dispute that the US went off the gold standard in 1933. Internally yes, externally no. FDR made a huge mistake in not going all the way. This was the root cause of much mischief to come. It allowed the conceit that trade instead of the internal economy should rule.

His action of increasing gold to $35 while forcing US citizens to turn theirs in for $20.67 essentially pegged the dollar at 59 cents in terms of the pre-1913 dollar for foreign holders. \

This made gold overvalued and the dollar undervalued so gold gravitated to the USA.

It wasn't until 1942-43 that the Roosevelt dollar, the gold dollar and the British pound achieved parity, so I will use that as a base period instead of 1913.

That the 1943 dollar was worth the same at home and abroad was why Lord Keynes and Harry Dexter White was able to mesmerize Bretton-Woods attendees and why people like Benjamin Graham, who saw physical production as more important, were ignored.

By the time Truman signed Bretton-Woods the greenback was worth 93 cents compared to the gold dollar. By the time Treasury Secretary Snyder signed it was 86 cents. By the time the IMF started regulating it was 75 cents.

To quote Charles Walters "This business of foreign banks cashing in their bucks for 100 cent dollars, while the same dollar held by Americans was worth much less, may have been intended or otherwise. The two-tier dollar meant that an American producer, farmer or otherwise, endured a hidden export tariff of 33.3 percent. It also created a 25 percent subsidy for imports entering the United States."

When Nixon finally did what Roosevelt should have done, the Roosevelt dollar was worth 41 cents which made the hidden export tariff 144 percent and the import subsidy 59 percent.

Any wonder why the hustlers from Bentonville were able to take over US retailing and the US physical production base was hollowed out?

We are still suffering the fallout today and will continue to so until we return to a physical economy based on gifts from nature, structural balance between raw materials, labor and capital, and money creation based on real production, real employment and real national security based on feeding the people properly.

6:25 PM  
Blogger The Arthurian said...


Nothing so complicated.

Anti-inflation policy reduces the quantity of money.
Pro-growth policy increases the level of spending.
The combination increases the reliance on credit.

Everything else is the result of policy.


11:45 PM  
Blogger winterspeak said...

Digger: In some ways, we have yet to leave the gold standard entirely. Mentally, most of us are still in 1932.

When I look at the great hustlers of our time (and they are legion), Walmart is not at the top of my list. That they appear at the top of so many others' however suggests that there is a con on somewhere.

9:37 AM  
Blogger Fernando said...

"They kept banks from collapsing and ultimately funded WW2 without worrying about the bank vaults being empty now that they had a printing press."

WW2 happened much later after inflation had come back and M2 was rising consistently. Also inflation returned BEFORE bank lending returned to normal, the dollar devaluation sent the WPI up by 30% and the CPI up by 10%

Now you say that if inflation expectations are high this wont bring consumption forward. Think about this, what if everyone in the US knew that in exactly 12 months the prices of all products in the CPI were going to go up by 1000%, what would be the consequences today?

Its obvious that it would lead to hoarding of products(that are storable, which you misleading examples dont mention) and investment in the supply of other ones(to profit by selling later). Otherwise you are arguing that capitalistic economies wont take advantage of low risk arbitrages

Think about how futures market work

4:44 AM  
Blogger winterspeak said...

Fernando: I have buddies who are actual futures traders, so you really don't want me to think too much about how futures markets work in practice. I can read a text book as well as you can, so I know how they are imagined to work in academic circles.

If everyone in the US thought we would have 1000% increase in CPI, they would load up on canned goods and ammunition, as it means the state is dissolving. If they thought the US would have a more reasonable 10%-20% CPI increase per year (which happens in third world countries) they would probably do exactly what folks in the third world do every day.

And no, it is not stock up on canned goods.

There is so much reality all around you Fernando -- you just need to close your textbook, walk out of the classroom, and see it.

1:23 PM  
Blogger Digger said...

Speaking of 1933, you may find Marriner S. Eccles's Congressional testimony of interest. Maybe even enlightening.

This was just before he became Chairman of the Federal Reserve 1934-1948. One can only wish we had someone with his comprehension at the helm today.

I am guessing he would have liked The Nature of Wealth book,now out of print, but recently made available online.

5:42 PM  
Blogger ds said...

Higher inflation expectations serve to erode the liquidity premium placed on money. The prospect of higher inflation can't force you to pre-eat a year's worth of meals, but it might motivate you to buy a car or to buy a house. In addition, it might make conditions more favorable to real investment, since higher inflation erodes the value of debt.

I see what you mean -- the channel of lower rates to higher inflation expectations to an increase in real output is weak, especially in our current state. But it isn't altogether irrelevant either.

12:43 AM  
Blogger Fernando said...

Are you saying that inflation expectations shocks dont lead inflation?Because I dont believe the empirical evidence will be very kind to your case

Furthermore, you mention EM. I live in one and the brazilian hyperinflation ended not when the central bank stopped printing money(that had been tried a few times) but when a plan to control inflation expectations was created(Plano Real, a fake currency was created for a while)

2:04 AM  
Blogger winterspeak said...

Fernando: very good. Say you are brazilian in 1979. You see inflation coming over the next ten years. You live in a modest san paolo apartment you own outright, and have a large bank balance at your local bank (in Cruzeiros). What do you do?

8:40 AM  
Blogger Fernando said...

Decrease my cash balances. But you dodged the question, are you claiming that inflation expectations shocks dont lead actual inflation?

2:51 AM  
Blogger winterspeak said...

Fernando: Please add some detail. Do you take your Cruzeiros out and burn them?

I am happy to answer your question about what inflation expectation shocks may or may not do, and would like to use our Sao Paolo resident circa 1979 as the example.

4:43 AM  
Blogger Fernando said...

What I would do is not necessarily representative of other people because I know more about investing than them. But I would buy commodities and demand a rise in my salary

But thats not important, what matters is what the data says and the veredict is pretty clear

So I showed that the fed can raise M at will(Indeed QE1 put about $700b out there outside the Fed excess reserves system, QE is quite likely to raise M2 as well).

They can also raise V(also called money demand, which goes down when inflation expectations rise, this means people try to get rid of cash). Both are leading indicators of inflation and they all happened when 'balance sheets are constrained' which I believe is irrelevant to highly committed central bank(as opposed to the fools in the BOJ). If balance sheets mattered M and V would not have risen but they did

The question now is, will you be humble enough to admit that your views arent quite supported by the data

3:37 AM  
Blogger Fernando said...

Also, I'd point out that since the QE2 rally started commodities have gone through the roof, so actual inflation has already been affected by the 'expectations', yet it all happened when 'balance sheets were constrained'

3:51 AM  
Blogger winterspeak said...

Fernando: The Mishkin article is the typical nonsense you get from economists who do not understand basic accounting, and therefore how the financial system works. Please do not waste my time with these.

Also, I'm going to keep asking you for more details on how you would act based on increased inflation expectations. Now you say you would "buy commodities". Again -- please give actual details. Would you buy actual bushels of wheat to store in your modest san paolo apartment? And you say you are not representative -- that's fine, what would someone more representative actually do?

8:32 AM  

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