Thursday, 21 March 2013

INFLATION OR DEFLATION; REFRESHING MACRO, PART 3


INTRODUCTION

As a part of my on-going series on Macro-economics and what I understand of it, here is my take on a subject that was quite popular a couple of years ago, inflation (and deflation).

I think this is still relevant because like austerity versus deficit, the debate still heats up from time to time.

As with any good introduction, I will give you my conclusion straight out. The truth is that they are several types of inflation (I count three) and deflation (I count two). And those differences are important because they (ought to) determine our macro-policies rather than simply stating inflation above 2% is baaad and deflation (anything below 0%) is also very very baaad...

1- THE THREE TYPES OF INFLATION

I think there are three distinct sources of inflation (feel free to add to the list in the comments if you can think of other types of inflation) and each means different things.

1A- OUPUT GAP

This is when Demand exceeds Supply. As per Microeconomics 101, if Demand increases faster than Supply, the result is rising prices. That's, obviously, inflation.

The solutions to a over-heating economies are well-known and, while they've screwed up recently with the housing bubble (and with bubbles in general), authorities are not too bad at dealing with this case. Raising interest rates is usually enough but a whole host of other measures can be deployed to constrain bank lending.

The only thing I would personally do different from our recent past authorities (apart from raising interest rates faster in booming years) is being less timid about raising taxes and especially non-stealth taxes. Raising VAT is probably efficient but I do not like it - it's a regressive tax and it's something governments abuse on the pretext that it's less visible. I'd prefer taxing income directly, however unpopular that might be at the time. In general, I think governments should try and sell to the voting public the idea that tax rates ought to vary with economic conditions.

Of course, restraining government spending in good times (beyond the fact that the automatic stabilisers are costing less) is another obvious technique, though, to be fair to fiscal conservative types, few governments are that way inclined and that is definitely an issue.

Needless to say, this type of inflation is not a problem in our present-day situation.


1B- SUPPLY SHOCK


Instead of Demand exceeding Supply, this is the case of Supply becoming, for whatever reason, scarcer. The consequence, rising prices, might be the same than in 1A but the solutions ought to be drastically different.


Let's take the case of rising oil prices. As a key input cost rises, manufacturers have  mostly two choices. Either they accept that their profit margins have to fall or they try and pass on the cost increase onto consumers. Obviously, a combination of both is possible. A third possibility would be to reduce costs elsewhere, notably salary cuts. I don't think it's a common reaction but it's worth mentioning it. 


Either way, as an input cost rises, someone down the chain is going to have to lose. It can be the manufacturer/capital owner, the consumer or even the worker but there's no magic.

However, this is only a one-time inflation hit, not the type of runaway inflation we saw in the 70s. For that to occur, you need not only the manufacturers to elect to rise prices in response to a shock but consumers refusing to accept the loss of purchasing power and, as workers, bargaining and getting pay rises to compensate. This is the mechanism of a wage-price inflation spiral and the conditions that made it possible in the 70s - a workforce with strong bargaining power - are long gone.


I am on the record for saying that I'd like unions to get some of their old powers back. But it is certain that unchecked union power is just as bad as limitless corporate power. In the face of a supply shock, cooperation and an agreement to 'share the pain' across Labour and Capital (and Government too - temporarily lowering taxes and/or switching to debt financing for some of the government expenses ought to help in response to a supply shock) is the way to go.


Oil shocks are not the only supply shocks we can experience. Clearly, the destruction of supply capacity (wars, earthquakes etc) can have the same effect but subtler is the artificial constriction of supply, stopping it from adjusting to high prices.


Here, I have the specific case of health care in the USA in mind. Health care costs are so high in the USA because prices are high. And, given the impact of health care costs/health care inflation on future US budgets, I think it deserves a mention in a paragraph on supply shocks. A true solution to health care inflation lies in removing some of the barriers to entry in the sector.


1C - MONETARY INFLATION


This is the kind of inflation people who say we're about to unleash hyperinflation in the western world have in mind. It's often supposed to come from monetizing deficits.


For those fearing that hyper-inflation is around the corner, it's easy to point out to a graph similar to the one below and bemoan the growth of the Fed's balance sheet. Then they scream "money printing!", "debasement!"





Slightly more sophisticated, the reasoning can go: "The Fed buys Treasuries thus artificially supporting government spending and, through either 'crowding out' or 'guns & butter' excess demand, inflation will occur.


In reality, the Federal Reserve does not buy Treasuries directly from the Treasury but from banks. It will credit those banks' accounts to reflect those purchases i.e. bank reserves will rise. The graph below shows this happening.





Now, bank reserves are not yet 'money'. For it to become 'money', banks need to lend. In our present circumstances, this is not happening, partly because severely burned banks have tighten their lending standards and partly because severely burned customers are in no hurry to take on more debt.


For more on the subject, especially on the potential risks of such monetization, one could do worse than read Dylan Grice, formerly of Societe Generale and now at Edelweiss.

Bottom line, though: Monetary inflation is a real issue, potentially. But it does require a series of steps to actually happen. In our present situation, a few vital links are missing for the Fed Treasury purchases to translate into inflation. As I've said before, the various QE programs have had little real-world impact, whatever Ben Bernanke says. Maybe some banks got their asses saved. Nationalisation or forced recapitalisation would have achieved the same thing. Maybe the stock market or commodity prices went up. Either way, it's not doing much good to Main Street. 


Conclusion on Inflation: Inflation can be caused by three distinct mechanisms, each calling for different macro-policies but, at the present time, none of these mechanisms look likely to spring into action.



2- THE TWO TYPES OF DEFLATION


After having reviewed potential sources of inflation, I'd like to turn to deflation. Since Central Banks are unlikely to willingly engineer an outright deflation (i.e. there is no deflationary counter-part to monetary inflation), I think there are only two real sources of deflation.


2A - OUTPUT GAP


This is the mirror image of 1A. For whatever reason, there's a failure of Aggregated Demand and thus Supply is over-abundant. Microeconomics 101, prices tend to go lower. However, while lower prices are supposed to trigger more Demand thus restoring balance to the Force... err... to the markets, there's been enough practical cases where this did not occur.


Indeed, an initial lack of AD translating into deflation can lead to yet more AD destruction as people start anticipating that "prices will be lower tomorrow" and thus start delaying their purchases.


Related, the Paradox of Thrift states that, in response to a recession, an agent might be individually rational in deciding to save more ("putting money asides for a rainy day") but if all agents follow the same rationale, the result will be a deeper recession and thus less total savings.


I will not spend a lot of time on detailing the political measures that can be taken to sustain AD after a shock. In short, either the government spends the money directly or it gives people/corporations more money to spend or, alternatively, good reasons to spend more.


I would like to spend a bit more time on some refutations we sometimes see of the consequences of AD destruction and the resulting deflation.


For a criticism of the idea of a deflationary spiral, I think the Von Mises Institute, via Robert Blumen, has a punchier than normal refutation"Why should a price having fallen indicate that it will continue to fall? That is only one of three possible future trends. Why should past trends continue indefinitely?"

In truth, past trends don't have to continue indefinitely. It is simply an observable truth that people behave as if the recent past was the best predictor for the near future (as it happens, it often is the best predictor) and that many economic behaviours are self-fulfilling. If everybody delays purchases in the expectation of lower prices, prices will have a tendency to go lower, thus confirming everybody's anticipations and re-inforcing them.

With regards to the Paradox of Thrift, criticisms include variations of Say's Law or related ideas i.e lower prices will trigger more demand. I think that's just too naive an economic model at the macro-economic level. Just as higher prices may generate more, not less, demand, lower prices need not trigger more demand, on the contrary.

A second criticism is that savings are just funds available for lending and thus the source of future investments and expenditures and thus people increasing their savings will simply lower interest rates and thus stimulate such investments. In reality, low interest rates are likely to indicate or correlate with a bad macro-economic situation i.e. a period where people are reluctant to invest, no matter how low the interest rates. Indeed, this is the essence of the Zero Lower Bound (ZLB) issue: Interest rates stand as close as humanely possible to zero and people are still refusing to borrow!

The Austrian school seems, to me, to be a variation on these two themes: An increase in savings leads to a lower cost of capital thus a lower cost of production which preserves profit margins and purchasing power, despite the possible drop in prices and thus increased savings do not result in lower economic activity.

I think the Great Depression, today's experience etc ought to have killed all of these criticisms. Simple explanations work best. We will see in a later blog-post that I think companies target revenue growth rather than profit margins. In a world of shrinking sales and high unemployment, low interest rates, whether they're low because there's a glut of savings or because a Central Bank arbitrarily fix interest rates low, are not enough to create the investment and spending needed to close the output gap.


The economic system is solid, probably does have a tendency to revert to the mean but, if jarred sufficiently strongly from his prior 'equilibrium'/settled state, this ability to revert to the mean may well be destroyed and a recessionary spiral may well suck out all the life out of the economic system until... someone does something drastic.

2B- TECHNOLOGICAL PROGRESS


This is somewhat the counter-part of a Supply shock. I will let Matt Yglesias describes the phenomenon in an article I've criticised here for other reasons:


"To raise real wages across the economy rather than for some favored group of insiders, what you need to do is make things cheaper. And that generally entails an accumulated series of events that make selected groups of people's nominal incomes lower.

If everyone could be chauffeured around cheaply by autonomous cars, then the people who currently earn a living driving cabs and buses and trucks will lose out. If computers take over routine diagnostic work, then doctors will lose out. If online courses that serve tens of thousands of students displace community colleges, then community college instructors will lose out. The Internet, as best as I can tell, has been a total disaster for the relative earnings of journalists. But by the same token, in a small way the widespread availability of free online content has raised the real wages of everyone else. Newspaper and magazine subscriptions just weren't ever a very large part of anyone's consumption bundles.

But the way to raise real incomes across the board is for that same wave of technological change that's transformed the media to start transforming the health care, education sectors, and transportation sectors. Cheaper health care and college and better transportation is a raise for every janitor, short-order cook, yoga instructor, and nurse in America".

What is being described here is productivity gains. Technology can and does make things cheaper. It is not automatic by any means - Productivity gains can translate into fatter profit margins, higher salaries, lower amount of hours worked etc but often some of it does find its way into lower prices.


Now, this is GOOD deflation. This is deflation that doesn't destroy economic growth but indeed might well spur it further by stroking demand.

Arguably, the argument is not settled yet.

Matt Yglesias, him again, just wrote something on the subject: "Susanto Basu, John Fernald and [Miles Kimball] showed that, historically, technology improvements have led to short-run reductions in investment and employment that were enough to prevent any short-run boost to GDP, despite improved productivity".

But the Fed doesn't seem to fully agree. These authors, Yongsung Chang and Jay H. Hong, find increases in employment following a permanent TFP shock.

Still, I think that the first post by Matt got the essential truth of it: Technological improvements, when they translate into reduced prices, do far more good than bad.

CONCLUSION

Just as they are several types of inflation, so there are at least two types of deflation. Inflation tends to always be an issue as it is distorting the price signal. Deflation may or may not be an issue - Deflation due to the destruction of Aggregated Demand is tautologically bad - because AD destruction is bad. Technological improvements leading to cheaper goods and services is not. It is one of the way we all get 'wealthier'.