Friday, August 25, 2006

What is Inflation?

I’m not sure what combination of carelessness, ignorance, malice, and/or rhetorical convenience causes Arthur Laffer to mischaracterize the Phillips curve, but…maybe I should be nicer, since I actually agree with Laffer’s main point.

Laffer is countering a view recently expressed several times on the same Opinion page (including by the Journal’s editors). Essentially, the argument he is rebutting goes something like this: “Prices are rising. Thus by definition we have inflation. The Fed should keep tightening in order to get rid of this inflation, before it becomes embedded in the system. The Fed has stopped tightening only because it sees (or expects) a slowdown, and because it believes in the Phillips curve, which says that a slowdown will reduce inflation. But we all know that the Phillips curve is a bunch of crap.”

Laffer begins his response by saying, in my broad paraphrase, “Ah, yes, we all do know that the Phillips curve is a bunch of crap, but…” He gets to the point by the end of the second paragraph (now I’m quoting literally):
…to confuse an increase in commodity prices with general inflation is a serious mistake, one which often seduces otherwise clear-thinking economists.

(I guess by “clear-thinking economists” he means those top-of-the-duffle-bag folks who don’t believe in such nonsense as the Phillips curve – a category which, as Donald Luskin points out, excludes the current Fed chairman. But I think a few of my fellow bottom-of-the-bag Keynesians might be confused as well.) I don’t agree with everything Laffer says subsequently (for example, why are “further declines in the dollar…not very likely,” considering that, after all, the “U.S. global capital surplus” that occasioned the decline has only gotten bigger?), but I take his main point to be about the definition of inflation.

The word “inflation” is essentially a metaphor: pushing money into the economy to produce higher prices is like blowing air into a balloon; it doesn’t add to the substance, but it makes the balloon look bigger. As a Keynesian, I do believe there are a lot of subtleties in the process: for example, the money doesn’t have to be pushed by the Fed or even by the banking system; it could be an increase in “velocity” occasioned by changes in preferences or “animal spirits.” And the economy doesn’t work quite like a balloon, because pushing money can in some cases increase the substance (because of sticky prices and wages). Thus I don’t think that growth in the monetary base, which Laffer charts, is a sufficient indicator of whether or not the Fed’s policy is inflationary.

But let me return to the metaphor. If the prices of volatile commodities are rising, and the prices of finished goods and services are rising at a slower rate than would be warranted by their commodity content (which is to say, the price of value added above those component commodities is not rising, at least not any faster than is considered normal), how does this resemble a balloon blowing up? Most of the balloon is not expanding. And if you examine the role of money, the flattening of the monetary base at the top of Laffer’s chart has actually had the effect of raising prices, by putting upward pressure on rental costs. It’s a very odd balloon that expands when you let the air out! It seems that, if we interpret the word “inflation” in keeping with this metaphorical etymology, it surely does not describe what is happening today.

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19 Comments:

Anonymous happyjuggler0 said...

Well, if you believe that inflation is everywhere and always a monetary phenomenon, then it is silly to say that rising prices for some things causes inflation.

The issue really is: Are prices rising due to money expansion and/or an increase in velocity, or is it a case of things becoming more expensive in real terms?

Prices of "everything" can rise during a time of noninflation if quantities bought fall. There is a difference between newly expensive with falling overall purchases, and a new higher price level for "everything" without lesser spending.

Commodities are boom/bust industries, with periods of high prices leading to high investment and low demand, leading to higher supply from the investment. This reduces prices with a huge capacity overhang. It then take many years for that capacity overhang to work itself out into rising prices again. It then takes a lot of time for new capacity to come online again, and so on. The key is noting that neither supply nor demand for commodities is elastic (for the most part). It takes time to find and open up a mining operation or oil field, and it takes time for gas guzzlers to finally die and be replaced with higher mpg cars. Etc.

Thus rising global commodities prices are not likely a monetary phenomenon so long as they are part of the normal drawdown of oversupply and rising demand.

This describes the world today. There had been a very real lack of new spending on new mines and oil fields etc. prior to 1998 (and later) while at the same time more and more of the world's most populous countries had growing GDP's, and thus increased global commodity demand.

This doesn't mean that rising commodities prices can't be coincidental with inflation, witness the 70's. But the 70's were a period of time when inflation was deliberately created by central banks so they could have lower unemployment. Instead we of course got stagflation as practically only Milton Friedman predicted at the start of the 70's when it was something that never happened before.

The real threat it seems to me is that rising commodites prices appears inflationary, thus increasing desire to unload currency in favor of something real....

If the combination of monetary expansion and velocity are noninflationary, then higher commodities prices will result in less spending elsewhere due to the inelasticity of commodity demand. In a commodities user country, this implies less GDP growth than otherwise would occur. Unless of course velocity increases due to rising commodity prices, or rises for a non-correlated reason for that matter.

Fri Aug 25, 01:13:00 PM EDT  
Blogger Gabriel Mihalache said...

I like very much where this is going... we've finally getting to the theoretical roots of the issues in question.

Fri Aug 25, 01:35:00 PM EDT  
Blogger Mark Thoma said...

As you know, I'd also like to see economists be more careful in describing changes in inflation from monetary phenomena, movements to a higher price level over time, and changes in relative prices.

Fri Aug 25, 06:30:00 PM EDT  
Anonymous 2slugbaits said...

It's a Friday night and I'm feeling sophomoric, so what the hell...

I've always thought that the way economists talk about inflation reminded me of the old arguments in philosophy about noumenal and phenomenal objects. Economists talk about inflation as though it were some transcendental "thing-in-itself" with an essential nature. Economists try valiantly to define inflation, but inevitably they end up defining it in terms of some measurable (i.e., phenomenal) index. But not just one index...hundreds of indices. Do we have inflation in its pure form when the CPI increases but the GDP Deflator and PPI decrease? Attempts to substitute terms like "price level" aren't really satisfying either. So where are we? Maybe economists should just junk the whole idea of trying to define the essence of inflation as a thing-in-itself. I suspect the profession would be better off just adopting a purely empirical approach by focusing on lags across changes in different price indices rather than trying to nail down a philosophically satisfying definition. Thinking about inflation as a purely empirical phenomenon rather than a noumenon would be more rewarding. And one consequence of looking at inflation as phenomenal would be that economists start looking at the effects of inflation as epiphenomenal events.

Okay, back to the real world.

Fri Aug 25, 08:48:00 PM EDT  
Blogger spencerengland said...

One thing you might want to look at while we are talking about money supply is that monetary velocity is starting to rise.

I use mzm velocity (personal income/ zero maturity money) but
m2 velocity is also starting to rise.

Historically, velocity is inverserly related to real interest rates. If you use the bond market forecast used by Laffer
real rates are not falling. But if you use almost any other measue of inflation or inflation expectations real bond yields are falling so rising velocity is
what you would expect.

You also might want to look at the tight fit between monetary velocity and nominal bond yields.

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