“Measures of underlying inflation are currently at levels somewhat below those the committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.” The Federal Reserve Board, September 22, 2010.
Dangerous words such as these must be interpreted with caution, against the background of existing economic conditions, as interpreted from relevant economic theory. Let me explain.
The United States economy, at this point in time does not confront any significant risk of price deflation. Conventional measures of consumer and wholesale price inflation are all positive, within the 1 percent annual range and plus, as compared with the Federal Reserve’s usual goal of between 1 and 2 per cent per annum. The dollar is falling in value against all major currencies, and this places upward pressure on the dollar value of imports, injecting additional inflation into the system. Commodity prices are rising, and these will also filter into inflationary pressure, in a loose monetary environment. The monetary envionment is so loose that gold prices have surged to an historical high of $1,300 per ounce.
Recent and projected quantitative easing on the part of the Federal Reserve is not simply a process of pumping high-powered money into the economy. It is a mechanism for driving short and long-term Treasury security yields down to historic lows, without any evidence of a liquidity trap. Put bluntly, this is the road to hyper-inflation once high-powered money translates itself into leveraged money supply increases as defined by M1 or M2 criteria. Out-of-control government spending is being financed by the printing press, the classical pre- condition for such a disaster.
Let us suppose that Ben Bernanke has not lost all his little grey cells, and does not want to go down in history as ’hyper-inflation’ as well as ‘helicopter’ Ben. If we take hyper-inflation off the table, we are left with stagflation as the most likely outcome of this episode in economic policy adventurism. Let me explain in terms of the relevant economic model: Milton Friedman’s monetary theory of adaptive expectations.
According to this theory, which has not been refuted by empirical analysis, the demand for money, under near-normal times, is a stable function of several variables. The nature of the relationship is such that, over time, any additional injection of high-powered money will augment the money supply M. This augmented M will elevate V (the income velocity of circulation of money) on its route to PY (the price level times real output) on the right-hand-side of the equation. Initially, the impact may locate itself somewhat on Y (real output). With long and variable lags, however, it will impact primarily on P (the price level). The transmission route will take place through adaptive (not strictly rational) expectations driven by decreasing money illusion in the labour markets as contracts are reworked in an inflation-expectations environment.
Just as the inflationary-expectations are slow to manifest themselves, offering short-term benefits to employment as real wages fall, so they will be excruciatingly slow to retreat once (if) strong monetary medicine is applied. As real wages rise, so employment will fall. In an employment environment as bleak as the present, this process will be as painful as it will be unnecesaary.
Add to this the adverse impact of rising public expenditure and an increasing debt burden upon the rate of private investment – the crowding out hypothesis – and the lowered productivity that such increasing socialism inevitably implies, and the witches’ cauldron of stagflation will boil and it will bubble until all the poisons of the earth spill out.
Hat Tip to Maggie
Tags: Ben Bernanke stokes rising inflationary expectations, Federal reserve sets the scene for stagflation, gold prices soar as stagflation rears its ugly head
September 26, 2010 at 8:43 pm |
Inflation remains quite remote as the high level of unemployment and declining consumption remain as massive private sector debt reduction continues. David Rosnick, an economist with CEPR, has noted that, “Despite increasing import prices, core inflation is still very much in check. The real wage was nevertheless unchanged in August, high unemployment making an inflationary wage-price spiral unlikely.”
http://www.cepr.net/index.php/data-bytes/prices-bytes/prices-2010-09
He further notes the impact of the dollar’s fall on the US trade deficit;
“Since early 2002, the trend has reversed. The (dollar) price index for U.S. exports has risen 23 percent, but the real dollar has fallen 22 percent—resulting in a small decline in the price of these exports as seen by our trading partners. Each change in the value of the dollar has had a significant impact on the balance of trade. From mid-1995 to 2002, the U.S. trade deficit rose from 1.0 percent of GDP to 5.5 percent, but has since fallen to 3.7 percent.”
A fall in the US trade deficit is a good thing since it means a lower relative level of leakage of demand from the US economy through the financing of imports as well as the boost to the economy from export growth. In a severe global downturn, it is unlikely that export growth will be very strong but any amount of growth can help boost employment.
There is clearly a liquidity trap to the extent that the Fed’s attempts to stimulate the economy through monetary easing (and clearing out the financial sector’s toxic assets) has had little effect on overall demand. Low interest rates have not produced inflation. The fact that low yields still draw investment shows that these bonds are little better than cash; they are seen as safe investments at a time when the real threat of asset deflation and a double dip recession makes any productive investment or investment in the stock market far too risky. There is clearly a liquidity trap as evidenced by these conditions.
What is clear is that the private sector is saving what the public sector could spend in order to stimulate the economy. There is no danger of a “crowding out” effect because the private sector is deleveraging at the same time the public sector is taking on debt in order to pay for various programs to sustain and stimulate the economy. Growth is the only way to reduce the deficit. Reducing the deficit will not stimulate growth and may even, paradoxically bring on inflation through the inability of the deficit to be reduced through the growth of GDP and the federal tax base that accrues from it. Stimulus has no inherent inflationary dangers. The printing of money is not now an inflationary problem either. Randall Wray puts it succinctly;
“…there is no financial constraint on the ability of a sovereign nation to deficit spend. This doesn’t mean that there are no real resource constraints on government spending, but these constraints, not financial constraints, should be the real concern. If government spending pushes the economy beyond full capacity, then there is inflation. Inflation can also result before full employment if there are bottlenecks or if firms have monopoly pricing power. Government spending can also increase current account deficits, especially if the marginal propensity to import is high. This could affect exchange rates, which could generate pass- through inflation. The alternative would be to use fiscal austerity and try to keep the economy sufficiently depressed in order to eliminate the pressure on prices or exchange rates. While we believe that this would be a mistake—the economic losses due to operating below full employment are almost certainly much higher than the losses due to inflation or currency depreciation—it is an entirely separate matter from financial constraints or insolvency, which are problems sovereign governments do not face.”
http://www.levyinstitute.org/pubs/ppb_111.pdf
The current concern is not inflation, either through deficits or pressure on exchange rates. The danger is continued recession and economic stagnation.
September 29, 2010 at 9:17 am |
You have not addressed the issue of the potential of the economy moving towards stagflation. It is as though you do not know the difference between inflation and stagflation.
It was not until the 1970s that the global economies first experienced what is known as stagflation. This is definied as high inflation, high unemployment and high interest rates. This situation was apparent by 1973. It was the first time that I had heard of the term stagflation and it was the first time that university economics lecturers addressed the situation.
In attempting to identify what caused this situation, I have found from a cursory examination of the historical period that there were some factors relating to Government expenditure, that were instrumental at least in the prolongation of stagflation from the 1970s through to the 1980s (at least in Australia). The identifiable :
1. an increase in Government expenditure under the Whitlam ALP Government;
2. the increase in demand for higher wages and shorter working hours culminating in prolonged strike action that crippled Australia at the time.
3. an increase in the interest rate for mortgages and other forms of lending due in part to the increased competition for savings available for loans.
Since the size of the pie is finite, the increased Govt expenditure led to the drying up of funds available to the private sector. The increase in taxes also had an impact.
My own observation is that the conditions that we are witnessing today are similar to the conditions of the late 1960s and early 1970s that led to the stagflation of the 1970s. In Australia’s case the increased and out of control expenditure of the Whitlam government led to the Stagflation being prolonged.
One other thing that is similar is the oil crisis that caused an increase in the price of gas at the pumps. In the 1970s the crisis was due to the situation in the Middle East, but today it is due to the impact of the GOM oil crisis including the moratorium on drilling for oil. The USA economy has not totally felt the impact of those decisions (from what I can see).
Since there are always lags in the business or economic cycles the move toward stagflation is still very much on the cards. With the changes in the basket of goods there is no way to accurately measure the level of inflation.
However, there are other indicators (also not accurate because they are anecdotal) that are showing that the inflation rate is in fact a lot higher than what is being admitted. For example, expenditure on things like movies, ice-cream and other treats. Are these higher or lower? I have seem some anecdotal evidence that people are not buying ice-cream as often because it is no longer affordable on a regular basis.
This is the same with the unemployment rate. How do you measure the hidden unemployed? How many people have given up looking for work? The measures for unemployment only include those looking for work. They do not take into account those who have given up looking because of their age or other factors.
Other anecdotal evidence are the number of shops that have closed down, the strip malls that are now empty, small businesses closing down. There is a lot of anecdotal evidence that indicates increases in all of these things. Businesses are either going broke or they are deciding to close down rather than face the higher costs being imposed upon them.
September 26, 2010 at 8:52 pm |
So how would you explain the remarkable rate of growth in the dollar price of gold over the past several years?
September 28, 2010 at 1:55 am |
The gold market is global and effected by different types of shocks at different times. It fluctuates wildly. Yes, deficits in the US affect the price of gold in dollars and in other currencies as well. But deficits themselves are caused by many things. In the case of the US currently, the deficit is more non-discretionary than discretionary; it is caused by lost output and tax base from the recession than by discretionary spending. Most spending is non-discretionary in the form of “automatic stabilizers” which kick in when the recession occurs. Again Wray;
“These automatic stabilizers, not the bailouts or stimulus package, are the reason why the U.S. economy has not been in a free fall comparable to that of the Great Depression. When the economy slowed, the budget automatically went into a deficit, placing a floor under aggregate demand. And in spite of all the calls to rein in deficits, the truth is that deficits will not come down until the economy begins to recover. Even if we eliminated welfare payments, Medicaid, Medicare, military spending, earmarks, Social Security payments, and all programs except for entitlements; and also stopped the stimulus injections, shut down the education department, and doubled corporate taxes, the New York Times estimates that the budget deficit would still be over $400 billion. This example further demonstrates the non-discretionary nature of the budget deficit. And, of course, this example doesn’t consider how much more tax revenues would fall and transfer payments would rise if these cuts were actually undertaken. With the current automatic stabilizers in place, the budget cannot be balanced, and attempts to do so will only damage the real economy as incomes and employment fall.”
http://www.levyinstitute.org/pubs/ppb_111.pdf
It is also important to look at treasury bond yields. Despite lower and lower yields, investment is flowing to the treasury bond market because it is safe. This indicates low inflation expectations. In fact, the yield on the 10-year is now at 2.71% which shows even lower inflation expectations than a year ago when 10-year bond yields were much higher. This says as much or more than the dollar price of gold which is determined by many things beside inflation expectations. There is sufficient slack in the US economy to have rapid output growth without inflation.
http://www.businessinsider.com/krugman-if-you-believe-in-bond-viglantes-youve-lost-a-lot-of-money-2010-8
September 29, 2010 at 8:49 am |
Your explanation does not take into account the fact that the basket of goods has been altered to take out some rather critical elements relating to health care costs and other items that have been a part of the measurement over a long period of time.
Since the basket of goods has been altered this serves to hide the real rate of inflation.
Can you show me where the price of goods have in fact fallen? I thought not.
Items that clearly impact inflation include the price of gas (petrol), utilities such as electricity, etc. etc. These have not decreased but have continued to increase. As such there is a trickle down effect since it impacts upon the costs of production and hits the consumer in the hip pocket via an increase in grocery and other items.
Yet, with the changes in the basket of goods how can we be sure that the impact of government regulation for the globull warming scaremongering has been taken into account? How do we measure the impact on inflation, the cost of setting up the ineffective solar and wind farms? These are items that are not being adequately measured.
October 5, 2010 at 11:18 pm
I should have added that one other critical factor in the 1970s was the wage-price spiral that triggered out of control inflation.
Personally, I look to what happened in Australia, but I have been learning more and more about President Richard Nixon which would suggest that the USA was experiencing similar difficulties with regard to prices and wages at the same time. One snippet of information regarded the fact that the Democrat Congress gave Nixon the ability to impose a wages and prices freeze. If prices and wages were not spiraling out of control then such a freeze would not have been needed.
I will have to look up further information, but from memory, the Whitlam Government attempted to impose price controls. It was not a freeze as such, it was something else. They introduced a Prices Justification Tribunal which was run by Professor Alan Fels from Melbourne University (yeah he was one of my professors when he took the appointment). The purpose of the tribunal was to stop monopolies, except that it did not work so well when the tribunal was constantly rubber stamping the price increases from the oil industry oligopoly.
By 1975 prices and wages were out of control, and yet we had high unemployment. As a result of Government competing for investment dollars, the interest rates were also creeping up. This is why the stagflation in the 1970s was prolonged.
When the Fraser Government came into power they had to start cleaning up the mess left by the Whitlam government, and they had to impose a wages-prices freeze. If I am remembering this correctly, the British government was doing the same thing around about this time.
So far the US economy has not had the wages inflation, but if the unions continue to be dominant, there is likely to be an outbreak of demands for higher wages. So far that does not appear to have happened. This is because there is a vast reserve of unemployed people, a number that is in fact hidden (most people have given up the search for work which reduces the statistics for unemployment).
October 8, 2010 at 12:50 am |
Aussie,
It is hard to know where exactly to begin but your post completely ignores reality as it actually exists. In the first place, Unions in the US are, and have been, a dead letter for about thirty years. Only about 12% of the US workforce even belongs to a union and most of those are public sector unions. The gap between union and non-union wages has been narrowing for years due to the weakness of union bargaining power and the growth of service sector jobs which pay much lower than manufacturing. The real annual median income in the US has declined over the past ten years from $52,388 in 1999 to $49,777 in 2009. This is no indication of the prospect of “wage inflation.” Core inflation is low; it is massive unemployment and the strength of capital that is holding down wages.
http://www.census.gov/prod/2010pubs/p60-238.pdf
Health insurance costs are running way ahead of core inflation and indeed, even ahead of actual medical costs. This is one of the great scandals of our epoch. It is not a monetary phenomenon but mostly one of greed and monopoly pricing power. There are other sectors that have similar monopoly pricing structures such as energy and food (prices are also influenced by commodity speculation). The Levin Committee in the Senate released a report on Wheat prices last year that concluded;
“Commodity index traders increased their holdings from a total of about 30,000 wheat contracts in 2004, up to 220,000 contracts in 2008. That sevenfold increase dramatically enlarged the market share of commodity index trading so that, in each year since 2006, commodity index traders held between 35% and 50% of all outstanding wheat futures contracts on the Chicago exchange.”
Clearly this impacted the price of wheat.
http://levin.senate.gov/newsroom/release.cfm?id=314947
A similar type of report for oil in 2006 was released by the same committee;
“The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil to be delivered in the future in the same manner that additional demand for the immediate delivery of a physical barrel of oil drives up the price on the spot market.”
http://levin.senate.gov/newsroom/supporting/2006/PSI.gasandoilspec.062606.pdf
Stagflation in the 1970s was partly the result of inflation due to declining output and productivity which coexisted with a credit expansion to mop up overproduced consumer durables resulting from the production competition between Germany, Japan and the US. To many dollars were chasing to few goods. It was not a monetary phenomenon. At the same time employers cut back output and employment in the face of declining demand. This created a recession and inflation simultaniously. Oil shocks contributed to the problem. Obviously, interest rates soared along with prices. This is how stagflation occured. Inflation also reduces demand at a certain point further reducing output and employment.
October 8, 2010 at 1:31 am |
Aussie,
Chronic stagnation is endemic in late capitalism. As capitalism further concentrates the economy and skews the distribution of income upward, it constrains effective consumer demand and thus the potential for sustainable growth. This is why financialization has become such a key phenomenon in the US economy; demand shocks have lessened profitable opportunities for investment in the real economy and hence financial investment takes its place. This is further enabled by the growth of finance as increased consumer and government borrowing take the place of progressive taxation and growing real middle class income. The expansion of the financial sector has led to bubbles and regular, ongoing, systematic financial crises since the early 1980s. The full deregulation of the financial sector in the 1990s worsened this tendency toward financial instability.
As price adjustments, under conditions of monopoly capitalism, fail to equilibriate the economy, capitalists compete through cost cutting and downsizing. This results in unemployment and further aggravates the problem of low demand and stagnant growth. Overcapacity quickly developes and acts as a further obsticle to productive investment. John Bellamy Foster explains the problem of late capitalist stagnation in an analysis of the business cycle;
“The central trait of [late capitalism] was a tendency for surplus (value) to rise—a phenomenon made possible by the effective banning of genuine price competition in mature, monopolistic industries, together with continually rising productivity. Under these conditions, the main economic constraint was no longer the generation of surplus, but rather its absorption, i.e., a chronic lack of effective demand…corporations normally refrain from carrying out net investment if expected profits on new investment are weak. Such expectations are affected by the existing level of capacity utilization in industry; the presence of idle plant and equipment deters business from investing in still more capacity. Since a rising surplus tendency, moreover, generally means that real wages are rising less than productivity (i.e., workers are more exploited), wage-based consumption is chronically weak relative to society’s capacity to produce, resulting in increasing excess capacity, and the atrophy of net investment. Under monopoly capital the long-term growth trend is therefore sluggish, characterized by a wide, and even widening, underemployment gap. The economy, in other words, falls far short of its potential growth rate, with underutilization of labor and capital goods. Hence, the normal state of the monopoly capitalist economy [is]… stagnation or an underlying trend of slow growth.”
http://www.monthlyreview.org/100201foster.php
Currently, the US economy is suffering from massive overcapacity. According to the Federal Reserve, capacity utilization in the entire US economy was 74.7% as of August 2010, an increase of about four percentage points over August 2009. The output capacity of the US economy shrank by 0.5% during the course of the recession, however. Capacity utilization in manufacturing has made impressive increases over the past year from 67.6% to 72.2% from Aug. 2009 to Aug. 2010. These increases in output is mostly due to the fiscal stimulus program.
http://www.federalreserve.gov/releases/g17/current/default.htm
However, utilization capacity remains at near historic lows and shows little sign of recovery despite rapid growth in corporate profits, investment, stock market value and dividend payments to shareholders. Corporate profits are up while job growth still suffers;
“Total profits of U.S. corporations, as compiled by the Commerce Department’s Bureau of Economic Analysis, were at $1.50 trillion in the fourth quarter of 2007 and reached $1.59 trillion in the first quarter of 2010. Over that same period, the country lost 8.2 million jobs, or 5.9% of the job base.”
http://www.epi.org/economic_snapshots/entry/corporate_profits_have_recovered_but_job_market_still_depressed/
Corporations aren’t earning high profits through increased output and sales but cost cutting and refinancing of high interest debt;
“Most of the money that large corporations are holding stems from “tremendous cost-cutting and shedding employees,” says Ken Goldstein, economist at The Conference Board, a business research group…Many corporations have been shoring up their balance sheets further by refinancing older, higher-interest debt with new, lower-rate debt”
http://www.usatoday.com/money/economy/2010-08-31-1Anationaldebt31_CV_N.htm
Stock dividends have been increasing since as early as the second quarter of last year and have continued to the present time;
“…70 companies in the Standard & Poor’s 500-stock index have either started to pay dividends or boosted them so far in 2009. That exceeds the number of companies (59) that have trimmed or eliminated dividends.”
http://seekingalpha.com/article/138127-dividends-survive-despite-recession
Economic uncertainty has hurt workers more than capitalists who are thriving. The global economy is also more important than simply the domestic US economy for more and more US corporations. Unemployment will continue without massive public investment in job creation, increased working and middle class real incomes and a redistribution of income from the top down to spur effective demand. Sadly, this agenda is off the table.