Tuesday, December 14, 2010

Why the inflations expectation model is nonsense

Thanks to all who commented on my challenge. Big thanks to Nick Rowe especially.

A brief recap: economic models treat the savings decision as a case of inter-temporal substitution -- either I buy now or I buy later. The discount rate governs exactly how this decision is made, and the discount rate includes an inflation term. If inflation expectations increases, then future consumption is discounted more heavily, and inter-temporal substitution begins to favor the present. Or, as Nick says "the increase in expected inflation reduces the real interest rate for any given nominal interest rate"

I don't reject this model because it abstracts reality to illuminate a particular mechanic. That is the point of models. I reject this model because it fails to capture the essential economic dynamic at work here. The inflation expectations story is simply a weak one.

Take this scenario (slightly tweaked, as Nick, while long on generosity was a little short on imagination. Still, all is forgiven, and I do thank him for this list): You're living in Brazil, it's 1970s, you have a stash of cruzieros (your and your family's life savings!!) and you think the value of your nest egg is about to be blow to smithereens via a vicious bout of hyperinflation. In this case, Nick would:
- Buy a variety of luxuries
- Buy some financial assets tied to commodities
- Quit his job (take unpaid leave)

In case you think I'm joking, here's the list, verbatim:
1. A new, lighter weight canoe. Swift Mattawa, in carbon fusion. Better buy it now, before prices rise, rather than waiting till I'm too old to lift my heavier one. (Do you really want the exact model and manufacturer?)

2. Better cookware.

3. Many crates of Scotch.

4. A new field drain under the back yard.

5. New laptop for one daughter.

6. New stereo for the other daughter.

7. Small farm 30 minutes north.

8. shares in oil/gas drilling company.

9. equity mutual funds (have to ask my broker which).

10. One year's leisure (unpaid leave from work, since the money won't be worth as much, and it would be better to take the leisure now and retire a year later).
See, I was not kidding! I think the number of people who, on the eve of having their hard earned life savings obliterated, would blow it on kayaks and scotch is small.

Vivianne Vilar, who it seems has personal experience, nails it:

My mum (and all family) used to buy dollars. I can't tell you about 1979, because I was only born 2 years later, but that is what she did from when I was a kid until 1994, when the Plano Real was implemented.
Primarily, people save for things:
1. They cannot afford currently (and don't want to buy on credit)
2. Unexpected emergencies
3. Old age
4. Bequests for their kids

2-4 cannot be moved forward and so are not inter temporal decisions the way the models treat them. Therefore, if savings are threatened, people will substitute into other stores of value such as fx or gold. They will not move consumption forward, as they cannot. This is not about consumption.

1 is an interesting case. If there's something you cannot afford now, you will not go out and buy it because you'll be able to afford even less of it in the future. There is one big exception to this, which I'll write about in a future post.

Ultimately, you need to decide for yourself whether, if your nest egg is going to be hyper inflated away, you'll spend it on a fiber glass kayak or move your savings to another currency. Economists are betting on the kayak.



Blogger Oliver Davey said...

Yes, but savings is the part of income which isn't spent in any given period. To get a complete picture one would have to ask what happens to that other part of income that is spent and whether there is a shift in relation of one to the other that is relevant to macro outcomes for a sensible period. Is there an alteration in the consumption patterns? Could it be that the consumption of luxury goods that was PLANNED ANYWAY is moved forward? Would that change anything in inflation measured at, say the end of the year? Is binge consumption contagious? One may want to look at differences in consumption patterns between income classes to predict the effects a potential downgrade from one to another could generate. Are societies with less intricate social safety nets more prone to go into debt? Do different personal scenarios of economic advancement or descent influence ones 'prudence' and savings ratios? Not saying there's necessarily anything to be found, but only looking at what happens to that which is saved ex post and assuming it is static seems to me a bit simple.

3:41 AM  
Blogger winterspeak said...


Yes, sales of luxury goods planned anyway may be moved forward, sure. This is the mechanic that has the spotlight in Nick's story (orthodox inflations expectation).

You need to make up your own mind whether you find that believable, or if you think that someone, faced with the prospect of their life savings evaporating, might do something other than buy luxuries.

9:24 AM  
Blogger Felix said...

In my home country of Venezuela we have always had high inflation. Its difficult to speak about changing patterns when the situation is permanent. However, sometimes when theres a big surge of inflation on the horizon, as in the day before a currency devaluation, people storm the stores en masse.

4:23 PM  
Blogger winterspeak said...

Felix: Welcome!

Tell me, in Venezuela, do those who have money tend to store it as bolivares (the latest kind) or do they tend to store it in other forms?

7:18 AM  
Blogger Nick Rowe said...

But Winterspeak:

1. That list was for *me*, not some hypothetical Brazilian.

2. The whole point of buying that stuff now, rather than later, is precisely to *avoid* having my nest egg blown away by a bout of hyperinflation. I want to buy that stuff while I can still afford it. Which would you rather have: my list of 10 things (which is what you get if you spend your savings now); or nothing (which is what you get if you wait for the hyperinflation to destroy your savings)?

3. Now, and this is the BIG problem with your response: your response violates the basic rules of accounting! For every $1 borrowed, there is $1 lent. Someone's credits must equal someone else's debits. Financial assets = financial liabilities. (This *has* to be in the accounting textbooks somewhere.)

So, for every cruziero your man in Brazil is owed, there's another cruziero that someone else owes. So, somewhere out there, there's someone else who owes your Brazilian all those cruzieros. And she's thinking "That hyperinflation is going to blow away all my debts", just as he's thinking "That hyperinflation is going to blow away all my credits".

See, that's why economists talk about "income effects" (or "wealth effects") vs. "substitution effects". Because the income effects go in opposite directions for him and her. But the substitution effects go in the same direction for both.

3:43 AM  
Blogger Nick Rowe said...

And it's a canoe, not a kayak! Both were invented and perfected in Canada, but kayaks are really bad on the portage. And it's not fibreglass, dammit! It's carbon fusion. That's so I will be able to portage it, because it's so much lighter than fibreglass.

3:51 AM  
Blogger Nick Rowe said...

And if you ask: "How is Nick going to eat, when he's spent all his savings on carbon fusion canoes?"

See that small farm? That's how. Farms produce food.

Plus there's the oil and gas shares, and the equity mutual funds, which I'm hoping will retain some or all of their real value when hyperinflation hits Canada.

Oh, and can I add one more item to my list?

11. One restaurant meal. Better buy it now, while it's cheap. They normally have specials on Wednesdays, and that's when I normally go. But if the whole of this year is a special, compared to next year, I'm going to have more restaurant meals this year and fewer next, just as I normally have more on Wednesdays and fewer Thursdays.

4:19 AM  
Blogger Felix said...

Well, people with the capacity and culture to save in Venezuela usually purchase dollars, although its difficult these days because of currency markets restrictions, and those with more money purchase properties, sometimes in other countries.

I myself bought bonds and stocks, money in the bank evaporates fast.

7:19 AM  
Blogger winterspeak said...


D'oh! You've outed me as someone who does not canoe much. Or at all.

1. And I think your list was just great, so thanks!

2. There's an option 3, which is to move my savings into vehicles that actually keep my savings savings. People save for a reason, and my Brazillian has options other than cruz so he can still meet his goals. Forex is one, other financial assets is a second. There is one consumption story that works better with the DGSE model, but it will not work in this economy. Another post on that soon.

3. I used to believe the same thing, and then I learned how credit actually worked. Borrowing is not redistributive, unlike spending. There is a different between net and gross financial assets.

The accounting textbooks, sadly, crush the economics textbooks when it comes to credit and finance. They just never think big enough (they are accountants after all -- focused on the pennies!)

But there have been many comments about this on your site and you don't buy it, which is fine. I just wanted to make sure I got the DGSE story straight, don't want to misrepresent anyone, and then people can make up their own mind.

7:51 AM  
Blogger winterspeak said...

Felix: You raise an excellent point. Economists could learn so much about behavior in inflationary times by looking at what people actually do in third world countries. (No offense -- I come from my self).

7:52 AM  
Blogger Rogue Economist said...

Nick said: "So, for every cruziero your man in Brazil is owed, there's another cruziero that someone else owes. So, somewhere out there, there's someone else who owes your Brazilian all those cruzieros."

Yes, but Nick, if the Brazilian bank is going to lend its cruziero to Nick to buy his canoes now, it's now going to lend him at the rate that incorporates the higher inflation expectations for next year. So the higher borrowing rate effectively offsets the value of buying canoes now rather than buying it at a higher price next year and just borrowing less (or not at all). There's now way to get ahead if the other side also knows what you know.

8:02 AM  
Blogger Rogue Economist said...

And if Farm sellers and oil and gas shares owners know that inflation will be higher next year, they won't sell you their farm now. Or they will sell you their shares at a price that reflects the higher inflation. You may end up not wanting to buy anymore.

8:10 AM  
Blogger Rogue Economist said...

But having the restaurant meal now will likely be your best bet to get ahead.

8:12 AM  
Blogger Nick Rowe said...


Your getting canoes and kayaks muddled is a terrible mistake!

On the DSGE thingy, have a look at my comment this morning on your previous post.

Look, you do have a valid point, though. Let me say what I think it is. A fall in real interest rates (whether dues to a fall in nominal rates or an increase in expected inflation is supposed to increase demand in New Keynesian DSGE models through 2 main channels: consumption, and investment. But they often skip the investment channel in simple models, leaving only consumption.

The general view is that investment is much more interest-sensitive. The bits of consumption that are most interest sensitive would be consumer durables, which are really investment, as much as consumption.

Most of my list of 10 were consumer durables. The canoe won't depreciate at all, if you are not paddling it. And it costs me next to nothing to store. So it has a real rate of return of about zero, while in store. (And really high psychic returns when I start paddling it!). So, if there's hyperinflation, so my cost of funds is negative, it's a good investment. So are rice and beans, if I can keep the mice off them.

"3. I used to believe the same thing, and then I learned how credit actually worked."

That's what i would like to see you expand on.

Rogue: yep. If the central bank of Brazil cuts the money supply and raises nominal interest rates point-for-point with the increase in expected inflation, everything I said is wrong. All nominal interest rates will rise in tandem. There will be no effect on demand and the CPI today. And that's why inflation-targeting central banks *do* respond like that, other things equal. It's the "Yaylor Principle".

9:53 AM  
Blogger Nick Rowe said...

That should be "Taylor Principle"

9:55 AM  
Blogger Nick Rowe said...


Following on from your other post.

Suppose the financial assets are freshly printed banknotes. Where's the offsetting liability?

Good question. I like this one. I used to be good on this one, in the olden days. It's the old question "Is money net wealth?" Willem Buiter is good on this one too. He did a paper "helicopter money" about this question. Very wonky.

Gurley and Shaw gave one answer. They said that "outside money" (like central bank money) is net wealth, because it's irredeemable so there is no offsetting liability (even though the Bank of Canada's accountants insist that they record bank notes as a liability, just so the books balance, because accountants freak out if the books don't balance). But (according to G&S) "inside money" (commercial bank money) is not net wealth, because it is redeemable, and has an offsetting liability on the bank's books.

Pesek and Saving said that G&S were wrong. P&S said there is "monopoly money" (stop laughing, Winterspeak), where the issuer has some monopoly power, and so earns a stream of monopoly profits from issuing money. And there is "competitive money" where the issuer has no monopoly power, and so earns no monopoly profits from issuing money. Money is net wealth if and only if it is monopoly money.

I agree with P&S.

The Bank of Canada has a monopoly. It currently earns about $2billion per year, which it gives to the Canadian government. (My guess is that it's about $40billion for the Fed, on average).

The size of those monopoly profits is the product of 2 things: the real money supply M/P; and the growth rate of the real money supply Mdot/M. But there's a Laffer curve in the inflation tax, just like all taxes. The bigger is the tax rate (Mdot/M), the higher is the inflation tax, and the lower is M/P. At lower inflation rates, an increase in the money growth rate Mdot/M and inflation will increase the seigniorage monopoly profits. But when you get to Zimbawean levels of inflation, you are over the top of the Laffer curve, and so seigniorage falls.

So, does the increase in expected inflation in Brazil increase or decrease expected net wealth? It depends. Which side of the Laffer curve is the Banco de Brazil on?

10:18 AM  
Blogger winterspeak said...

Nick: The only investment you will get with a sharp drop in consumption is inventory. Investment is sensitive to interest rates, but it is more sensitive to forecast demand (at least the kind of investment you're talking about and is pertinent to our discussion).

There is one big exception that proves the rule here, which I've been promising a post on for a while. I will get to it eventually -- I promise!

Here's a teaser on your freshly printed bank note question -- those aren't financial assets at all.

2:59 PM  
Blogger Nick Rowe said...

Winterspeak: "Investment is sensitive to interest rates, but it is more sensitive to forecast demand (at least the kind of investment you're talking about and is pertinent to our discussion)."

Agreed. Investment is sensitive to both. (It's a bit harder to argue about which it is *more* sensitive to, because they don't really have the same units, so we are trying to compare apples and....err...haircuts?)

But, if forecast demand is itself sensitive to (forecast) interest rates, you can get a lot more action that way.

And, one of the weaknesses of much New Keynesian macro, IMHO, is how it handles that question. It uses Rational Expectations, and I'm not convinced it's an appropriate use of RE. I prefer some sort of learning mechanism.

"Here's a teaser on your freshly printed bank note question -- those aren't financial assets at all."

Aha! Well, I agree they are certainly a very weird sort of financial asset. Irredeemable notes anyway. And they (at least in Canada) promise to pay a real interest rate of *minus* 2% (the Bank of Canada promises 2% inflation), which is less than the growth rate of the economy, and yet people willingly hold them. They are rather like Mr Ponzi's "financial asset", except, nobody is being lied to or fooled, and yet people are perfectly willing to hold them, and it's a *sustainable* Ponzi scheme.

And if you want to say that makes them *so* weird, as financial assets, that they are not really financial assets at all, I'm already halfway convinced.

But don't forget the implied wealth of government seigniorage revenues.

6:42 PM  
Blogger winterspeak said...

Nick: I do not believe that forecast demand is particularly sensitive to forecast interest rates. I have written several posts on this topic recently explaining exactly why, although I do owe you one more on the big exception.

The reason I don't believe folding money is a financial asset has nothing to do with Ponzi, and everything to do with the definition of a financial asset vs real asset.

Also, the term "seigniorage" is meaningless for true fiat monetary system for obvious reasons.

7:30 PM  
Blogger Adam P said...

It's kind of funny Winterspeak, for the most part you're correct that most people would react not by spending the money but instead by shifting into another currency.

Yet you're still wrong that the model is nonesense. Ironic huh?

11:51 AM  

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