Friday, January 28, 2011

INFLATION PRIMER

More and more people are getting on the inflation and hyperinflation bandwagons lately. There may be reason to worry about inflation, several, in fact. But, for the most part, the reasons that are being offered for today’s bandwagon do not justify the conclusions that people are making.

My position is this: Real inflation is a major cause of economic disturbance and the destruction of economic value. Inflation needs to be eradicated from our lives and our political system. To remove inflation from our economy would require that we understand it at it’s root and have an accurate history of its influence. Instead, what these people tend to offer is just pointing at some prices that have risen that are special to us or in the news. Even when they mouth reference to the money supply, they do nothing to relate the money supply to the price increases they are seeing. They are just adding confusion. So, I am offering another post about inflation with a slightly different focus.

First, of course, rising prices is not inflation. Rising consumer prices may be a consequence of inflation, one of them, but it is only a consequence, not a cause, and it is the cause that we want to understand clearly. It is the cause that is the actual problem. It is the cause we need to eradicate from the economy.

The Austrians (and as further explained and expanded by Ayn Rand) are the ones who identified inflation accurately. Inflation is government manipulation, read expansion, of the money supply. When more money is pushed into the economy, prices, at least some prices, will rise. There are two important points.

First, prices cannot rise without there being more, new, made-up money. Without more money, some higher prices would just mean that fewer of those products could be sold. People would still have only so many dollars to spend. Higher prices for some goods means that the standard decisions people make as to what to buy and not buy must now account for a different price structure than before. Prices are always changing. All prices could not be rising at the same time without there being more money in circulation. Stuff would be left sitting on the shelves. Consequently, if some prices rise, other prices would have to drop, or production would have to be reduced. There are only so many dollars.

Some people try to avoid the basic physics of the issue by talking about the velocity of money, suggesting that if a unit of currency changes hands faster there is the opportunity for prices to rise without more money actually being created. No attempted explanation of inflation using the velocity of money that I have seen actually lays out how that is suppose to work. I can’t figure it out. Try it. The vast majority of people get paid on a regular rotation, i.e., weekly, biweekly, or semi-monthly. How do you fit a higher velocity into that arrangement? You can’t. Higher velocity is out.

Second, the Austrians determined that the entry point for new money makes a difference, meaning that new money does not effect the entire economy the same way, but ripples out from the point of entry. Over the past twenty plus years, the entry points for new money have been limited to just a few parts of the economy. It is easy to identify those connected directly to the Federal Budget because the prices of related items have been going up rapidly and consistently for all of those years. The list connected to Federal Government spending includes medical services and related products and higher education. Recently, Federal employee salaries can be added to that list.

Besides the budget, the other main entry point of new money is by way of the activities of the Federal Reserve System. I have gone into detail how that happens in this blog, so I am not going to restate it. The consequences of the Fed expansion of the money supply normally hit asset prices first. Stock prices and housing prices are pushed by the expansion of the money supply by the Fed – sound familiar? (Constant deficits in our Balance of Payments can also only be explained by the expansion of credit.)

Okay, so that is inflation, i.e., increases in the money supply. Well, take a look. Is the money supply expanding? Ahhhh, no. It isn’t. So where is this inflation?

What the people who are declaring that inflation is upon us are pointing to are certain, specific prices. Right now the major ones are oil, food, and commodities. Certainly, these prices are going up. But, is it inflation?

I would add another sector to the list of higher prices, the U.S. stock market, which has gone up a bunch in the last couple of years. Why has it gone up? The facts about the U.S. economy don’t support that kind of optimism. The actions of the U.S. government continue to make things worse. The market is being pulled along by a ton of money sitting around. It is the same thing that happened in the late-1990’s and mid-2000’s.

So what about the prices of oil, food, and commodities. Okay. Fact one. In any economy (where individuals can make decisions at least to some extent), in any situation, for all kinds of reasons, prices will be on the move. Some prices will go up, some will go down. We do see prices going down all of the time in our world. That is especially true of high tech stuff. Prices change because people’s preferences change. Demand changes. The supply changes because of new technology, new business structure, new sources, governmental action. There are a host of different reasons. You have to look at specific industries to understand the price movements. More than that, if it is inflation that is causing consumer prices to rise, the general trend would affect the entire economy, in a ripple effect. When the price rises are confined to specific sectors of the economy, it is necessary to look closely to determine what is happening. In is not proper to just declare that it is inflation. Looking closely at medical services, oil, and commodities results in very different conclusions for each sector. That is especially true when the best data available on the money supply (admittedly government data, but not sufficiently corrupt) show that the money supply is not expanding to speak of and credit has contracted.

I have already discussed the constant rise in the prices of medical services, which is a direct consequence of government spending. Let’s try oil. The price of oil is an international price. For its price rises to be a consequence of inflation, it would be necessary for there to be inflation of significant amounts in many countries. But, there are more obvious and immediate explanations as to why the price of oil has gone up, and may continue to rise. Two explanations, actually. First, as a result of the anti-industrial movement (which includes the ecology movement), the production of oil has been forcefully reduced nearly worldwide. In a few countries, the production is kept lower than those countries are capable of for the reason of attempting to influence the price (OPEC, of course). We all know that the supply of oil is less than a free market is capable of providing. Second, we have a couple large countries, very large countries, that have finally begun to open their economies up sufficiently that they have produced a modicum of wealth. These countries are now also buying oil in larger quantities than they have in the past. Just a little increase from these very large countries has a significant impact on the price of oil. So, we have a supply that is less than possible and a significant increase in demand, and, surprise, oil prices rise. Standard stuff. Inflation is not necessary to explain the price of oil. To the extent that there is inflation, the increase in the price of oil will be worse. If a specific country has inflation, its currency will tend to buy less internationally over time, and the price of oil in that country will rise faster.

The second half of the analysis of the oil price applies to commodities, including food. There is more international demand. Higher demand means higher prices for basic, auction-derived prices such as commodities. China and India are buying more than they did a few years ago. If there is the possibility of greater production, the higher prices will attract more supply and the price may go down, but that does not happen overnight.

Food prices, especially within a large country like the U.S., is more dependent on local factors. I have not seen sufficient reports to make a well-founded conclusion as to why prices have begun to move upward. International grain prices have moved upward, but really have only a minor impact on the prices of consumer goods in the U.S. The cost of wheat in a loaf of bread in the U.S. is only a small fraction of the price at the store. Transportation, i.e., oil prices might be more important. Weather is important. The important point is that the factors causing our food prices to rise are not an increase in the money supply and are somewhat different that the reasons why oil and other prices are rising.

Then there is the issue of inflation here vs. inflation there, in the present day case: inflation the US vs. inflation in China. China is experiencing inflation, both asset and consumer price inflation. It is also experiencing sufficient growth that allows people and businesses to buy basic materials on the world market that they couldn’t before. Both of these factors make up the fact that China is a major reason why international prices are increasing. To fully understand what the impact of China’s rise (as well as India’s) means, it is necessary, as always, to gain perspective. Don’t just focus on selected markets that fit with a particular expectation or world-view. Look at the big picture.

What is my suggested perspective maker? French wine! The prices of good French wine have gone through the roof, up maybe as much as 3 or 4 times what they were a couple years ago. The reason is that a very small percentage of China’s 2,000,000,000 people have discovered the good stuff and have the money to start buying. They have bid up the prices. The Chinese are bidding up the prices of many things right now. The world has been rolling along with a few industrial countries and a lot of undeveloped ones as the status quo. Imagine the situation if many countries were to open up their economies to individual efforts and wealth. The demand for basic commodities would skyrocket! The old, restricted level of production would not be able to respond, shortages would ensue, and prices would rise. That scenario is pretty much what we are seeing. Newly freed countries would mean periods of economic adjustment as changes in distribution patterns developed. Ultimately, either we would see greater production, and thus higher standards of living all around, or we would see massive shortages and breakdowns in the world economy. In this respect, the emergence of China and India as economic powers will be good for all of us. Countries that refuse to deregulate, like the Europeans are blindly doing, will be faced with falling standards of living and fiscal nightmares, as is happening. For those who have tied their thinking to the dominance of the U.S. in the world economy, there will be confusion. In a world that is free and prosperous, the U.S. would be a great competitor, but not the richest nation. It is not the biggest country. But it would be incomparably richer than it is now. Higher productivity and creativity worldwide would mean greater wealth for all, and we would benefit.

But, back to the point of this post, greater demand for commodities, or anything, and subsequent rises in prices is not inflation. Only increases in the money supply by government action is inflation. Keep your causes straight.

13 comments:

  1. "Is the money supply expanding? Ahhhh, no. It isn’t."

    http://research.stlouisfed.org/fred2/series/M2?cid=29

    http://research.stlouisfed.org/fred2/series/MZM?cid=30

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  2. Annoymous, now you have me confused. The two indicators you offered are not consistent with each other. One shows a stead increace (M2) and the other even shows a decline over the last two years (MZM). Other indicators that you might look at, say bank loans, show significant declines. The evidence since the the meltdown in 2008 does not support the conclusion that we are seeing an expansion of the money supply. Not that the Fed hasn't tried to expand it.

    What your comment has suggested to me is that it would be beneficial to write a post about measuring the money supply and related issues. Thank you for that.

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  3. I hope "Annoymous" was a typo, I did not mean to be annoying.

    I am also confused by two things:

    1) You say that the M2 and MZM data are inconsistent. I see MZM declining since about mid-2009 till about mid 2010, and then rising, to currently about $200B above the mid-2009 peak. But even if the two were diverging, as you say, that could easily have been explained - the difference between the two aggregates is that MZM includes all money market funds in lieu of time deposits less than $100,000 and money-market deposit accounts for individuals. Thus, the different patterns are just a migration of money from institutional money market funds into time deposits less the $100K. What caused this, we can only guess. However, both aggregates are at all time highs. You mention bank loans - true, down a good bit, but hardly surprising, since it is profitable and safe for banks to borrow money at 0% and invest it in Treasuries. Since the big banks were trying desperately to recapitalize, I am not sure it's smart to look at bank loans for indications of inflation.

    2) The arguments of inflationistas (I am somewhat sympathetic to them, have to admit) are not so much that money supply is up as it is, even though it is. They are that there is pent-up potential money supply that may be unleashed on the economy without the Fed being able to soak it up. With velocity low as it is (http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=MZMV&s[1][range]=5yrs), if it does pick up, what is the Fed going to do? Sell Treasuries? But it is buying Treasuries. If it does begin to sell them, with the Treasury also trying to sell massive amounts, and the Chinese less willing to buy, yields can skyrocket. If the Fed does not tango with the Treasury, it's the Fed that will be cut at the knees, not the Treasury. The promises to soak up the money through repos do not seem to be convincing anyone. To sum up, the argument is that we have an inflation bomb ticking, with the Fed unwilling and/or unable to do much when it does go off.

    I do agree with a lot of your observations, and wish you the best - keep up the good work.

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  4. Yes, I did a typo. I should have written in Word first for the spellcheck. Sorry.

    I am looking at bank loans because credit expansion via the banks is the tool the Fed uses to expand the money supply. As long as banks are not expanding their loans and businesses are not expanding borrowing, the Fed’s efforts are not effective. Without credit expansion within the U.S., the primary means of increasing the money supply is borrowing back created dollars from overseas, i.e., the result of out trade deficit, which is financed by credit expansion (thus loans for international trade are continuing, but domestic business loans are not). When pointing at money supply figures, it is important to identify where the “money” is coming from. It makes a difference. It means, for example, the rise of the stock indexes is being financed by past inflation and not new money. It means that international commodity prices have some relation to U.S. money supply expansion, but there are other factors as well. (There is one set of hyperinflationists who blame every price rise in the world on the U.S. Federal Reserve Board. I am willing to consider that there are other idiots in the world, especially in communist China. Also, prices of items can rise for other reasons than inflation.) I am not suggesting that the Fed isn’t trying very hard to create inflation, or that the Fed is capable of “sopping up” the “excess liquidity” without major damage to the economy (we are guaranteed of their failure), or that the combination of the Fed and the Obama Administration isn’t going to send us into depression. My point is that to clearly understand what is happening you have to connect all of the dots. I definitely agree with your suggestion that the Fed cannot long control interest rates. If you look at my post on the debt, you will see that I think it is a bigger problem than inflation.

    Thank you for your comments, Anonymous.

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  5. I'll take the liberty, much as I despise Bill Gross for his cheerleading of this disaster, to provide this link: http://www.pimco.com/Pages/Two-Bits-Four-Bits-Six-Bits-a-Dollar.aspx . Here he seems to have come to his sense - of course, after TARP, TALP, and various QE's bailed his (and all other fixed income investors') sorry derriere from getting the sandblasting they so richly deserved. Skip the tripe about his family antics, and go 2/3 of the page down, starting two paragraphs above the pie charts. Who will be buying when the Fed stops? Or should it be "if the Fed stops"?

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  6. Great minds seem to think alike, and at the same time.

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  7. Unfortunately, great minds don’t seem to be getting the attention they deserve. I mean, look at a recent poll regarding the deficit, read the two items at the top of the second page: http://www.politico.com/static/PPM191_poll.html.

    At the risk of maybe saying something unnecessary in our conversation:

    I’m not sure it matters who buys. Either the money comes from actual savings within the country, which is very harmful, or it comes from made-up money from the Fed or made-up dollars floating around overseas, either of which are harmful. The problem is the debt itself. It really doesn’t matter if interest rates go up, which I expect they will (but I have been expecting interest rates to go up for over a decade). We can expect the debt to continue to grow because of the expectation of a better economy than we could possibly have, plus the lack of willingness to actually cut spending, plus the guaranteed expansion of “entitlement” spending. Higher interest rates will just make it worse. Without sanity in the Federal Budget process and/or release of the economy from restrictions and regulation, we will see an economic depression in the not too distant future.

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  8. Fully agree. I did not expect we had real differences of opinion, just seemed to me we were interpreting data differently. Since you are familiar with Hayek, I'll assume you have seen the wonderful Keynes vs Hayek video, but will share it nonetheless for the benefit of your readers - pardon the repetition if it has already come up: http://econstories.tv/2010/06/22/fear-the-boom-and-bust/ . If you have not seen it, you'll love it, even if you dislike rap as I do. It's pure genius.

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  9. Sorry, my friend. I am not a fan of Hayek. He moved from the l-f of his predecessors toward some government interference in the economy. But, compared to Keynes, he is good, yes. Lots of people have referred to the video you offered. Have fun.

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  10. This post seems to ignore the fact that there *is* much monetary inflation worldwide as a result of various countries pegging their currencies to the U.S. dollar (which is still the world's reserve currency). As the U.S. Fed prints more money, even if it isn't lent out immediately, countries who have pegged their currencies to the U.S. dollar have to inflate their currencies in order keep their value equivalent to that of the U.S. dollar. And if those countries *use* their newly printed money to buy commodities, the prices of commodities increase. The U.S., in other words, has been exporting inflation.

    As I understand, the Chinese Yuan has been pegged to the U.S. dollar for a while, though recently the Chinese government unpegged it, but are permitting it appreciate slowly, which means it is inflating the Yuan at a slower rate. (The reason for the slow rate? Apparently it is to get as much from their loans to the U.S. as possible.) So while the Chinese government (and other governments) deserve blame for inflating their currencies, the U.S. Fed, inflating the world's reserve currency, deserves a significant amount of the blame.

    The increase in gas and food prices in the U.S. must at least partly be the result of inflation exported from the U.S. now being imported. (Food production and distribution in the U.S. depends heavily on oil, much of which has to be imported.) And now, it seems U.S. banks *are* starting to lend newly printed money from QE2 (which means we should soon be seeing greater spikes in U.S. commodity prices).

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  11. So, I am ignoring “the fact that there *is* much monetary inflation worldwide as a result of various countries pegging their currencies to the U.S. dollar”. Now how does that work, exactly? I mean, if you look at my various posts, you will see that I present detail as to how economic events are causally related. Please provide the details as to how pegging a currency to the dollar causes inflation worldwide? I have not seen that claim and don’t know how it is suppose to work.

    The U.S. does export inflation, but very directly, by sending made-up dollars overseas by way of our continuous balance of payments deficit. There is some element of inflation internationally from that, but still, compared to all the non-dollar money floating around in the other major countries, the balance of payments deficit is minor in its effect on worldwide inflation. There aren’t enough new, made-up dollars there to account for the rise of commodity prices over the last year, or during 2008, either.

    Just reading the papers would tell you that the Chinese are experiencing a much higher rate of inflation than we are. If the U.S. Government is underreporting the inflation rate, you can be sure that the Chinese are as well. The rate of inflation in China, and the problems in the residential real estate market, are much more severe than ours. Anon, why aren’t you willing to admit that a bunch of communists trying to emulate Helicopter Ben are capable of doing a bang up job all by themselves? Every country has their own Ben Bernanke screwing things up. He isn’t doing it all by himself.

    Frankly, what I see is that people are upset with me that I don’t blame every economic event they don’t like on the government. Someone online just asked for help talking to people who blamed the oil price rise on the oil companies, which is a very common predice. There are many who blame any financial problem on the banks. And then there are the international secret conspiracies to consider. Really. Come on. You actually have to have reasons connected to facts to have a accurate description of what is happening.

    In the case of oil and many commodities no doubt manipulations of currencies by governments, including the Fed, account for some of the rise in prices. But we also have the equivalent of the addition of an entire nation larger than Japan of new demand. People, you can’t pretend that it isn’t happening.

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  12. FYI, the Anonymous at March 8, 2011 4:35 PM is not the Anonymous from the previous posts - that would be me.

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