Contemplating inflation

Because a previous entry has diverged into a largely unrelated conversation about inflation, it seemed best to put up a post about the latter topic and divert the related discussion here.

The questions under discussion include:

  1. What causes inflation, and to what degree can governments control it?
  2. Is mild but positive inflation (say, 2%) socially or economically beneficial?
  3. Through what political mechanism should target inflation rates be chosen?

Personally, my enthusiasm for all things economic is flagging a bit, given how long the ‘credit crunch’ has been dominating news and political commentary. That being said, I am always keen to foster discussion and, ideally, make it available in ways that third parties will find useful at later times.

Author: Milan

In the spring of 2005, I graduated from the University of British Columbia with a degree in International Relations and a general focus in the area of environmental politics. In the fall of 2005, I began reading for an M.Phil in IR at Wadham College, Oxford. Outside school, I am very interested in photography, writing, and the outdoors. I am writing this blog to keep in touch with friends and family around the world, provide a more personal view of graduate student life in Oxford, and pass on some lessons I've learned here.

213 thoughts on “Contemplating inflation”

  1. Incidentally, my general answers from the previous thread:

    1. I am not 100% sure, though the money supply and the reserve ratios of banks are probably involved. To a certain degree, sometimes.
    2. Yes, for the most part. Largely because it allows the real value of wages in some jobs to fall, while causing less strife than falling nominal wages.
    3. Central banks, because politicians cannot be trusted to run day-to-day monetary policy.
  2. 3. We seem to assume that politicians cannot be trusted to legislate monetary policy. Do we have any evidence for this? Greenspan thinks the best period of monetary policy in the U.S. was the period from the Civil War till the 1st world war, when exactly it was the role of politicians to be “trusted” with monetary policy.

    2. Fine, but then it should be passed as a tax. Lincoln paid for the Civil War, incidentally, by going off a commodity standard and printing the soldiers wages. However, after the war, sound monetary policy was restored with increased government savings enabling a return to the previous commodity standard. Lincoln did this specifically because he knew he could not get the taxation passed which he otherwise would have needed to finance the war.

    “Does being a reserve currency:

    (a) Increase your ability to control inflation domestically
    (b) Diminish your ability to control inflation domestically
    (c) Have no effect on your ability to control inflation domestically

    when compared with governments with non-reserve currencies?”

    What do you mean by “reserve currency”? Do you mean a currency which other states use as a reserve, a store of value? (i.e. the US dollar and t-bill is probably the best current example of this). This absolutely reduces your ability to control inflation because it makes your monetary policy dependent on the investment policies of other states.

    Do you mean a “full-reserve” currency, i.e. one which doesn’t use a reserve multiplier? I.e. there is no difference between Mzero and Mone?

    Do you mean a commodity-reserve currency, i.e. a partial currency exchangeable for some commodity which has value independently of it being picked as the unit of money. Gold or Silver is usual, but you could just as easily pick oil or beans or lampshades – the point is people would hold bills which entitled them to some amount of gold or beans or lampshades. In this case, you have the decision about whether to allow fractional reserve lending. If you do, there will always be the possibility of a run on the banks that the state can’t bail out (unless the state holds gold reserves outside the money supply nominally equal to Mone).

  3. 2) Inflation is a wealth tax. It redistributes money from old wealthy households to young indebted households. As such, mild inflation is both economically and socially helpful.
    Interestingly, the inflation calculus in the US has changed in recent years. The main loser from US inflation is now the Chinese government, with almost all brackets of US households being net beneficiaries. Quantitative easing here we come.

    Have a look at:
    Inflation and the Redistribution of Nominal Wealth
    M Doepke, M Schneider – Journal of Political Economy, 2006

    I’d also recommend a book I read recently: “The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy”. Not being an economist, I am sure I am easily fooled, but it seemed a persuasive account of the mechanism of crises to me. The basic thesis is that there are positive feedback effects in the economy, contrary to the efficient market hypothesis, which central banks have largely ignored of late. Hence the string of enormous bubbles.

  4. Is mild but positive inflation (say, 2%) socially or economically beneficial?

    People who signed up for thirty year mortgages certainly wouldn’t want to see the inflation target fall to zero.

    That is true for all long-term borrowers.

  5. A bit of inflation also encourages you to put your money in an interest-bearing account, instead of under your bed.

    Most of the time, at least, banks are able to use those deposits to finance productive investments elsewhere, increasing overall wealth and welfare.

  6. This reminds me of a quote from It’s a Wonderful Life:

    “You’re thinking of this place [the bank] all wrong. As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house…right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others. Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can. Now what are you going to do? Foreclose on them?…Now wait…now listen…now listen to me. I beg of you not to do this thing. If Potter gets hold of this Building and Loan there’ll never be another decent house built in this town. He’s already got charge of the bank. He’s got the bus line. He’s got the department stores. And now he’s after us. Why? Well, it’s very simple. Because we’re cutting in on his business, that’s why. And because he wants to keep you living in his slums and paying the kind of rent he decides. Joe, you lived in one of his houses, didn’t you? Well, have you forgotten? Have you forgotten what he charged you for that broken-down shack? Here, Ed. You know, you remember last year when things weren’t going so well, and you couldn’t make your payments. You didn’t lose your house, did you? Do you think Potter would have let you keep it? Can’t you understand what’s happening here? Don’t you see what’s happening? Potter isn’t selling. Potter’s buying! And why? Because we’re panicky and he’s not. That’s why. He’s picking up some bargains. Now, we can get through this thing all right. We’ve got to stick together, though. We’ve got to have faith in each other.”

  7. The main question about fractional reserve loaning, to me is, does it itself cause inflation. If it does, then banks only profit through theft.

    I honestly don’t know the answer to this. Imagine a society where the money supply is Mzero and it is illegal to loan money in exchange for interest. People will build savings, and spend when neccesary – this will lead to some amount of money circulating.

    Now, all of a sudden a law changes allowing fractional reserve lending. It is much easier to access money now, and more money begins to circulate. However, that extra circulating money is chasing the same amount of product and services. How could this not cause inflation? If it does, that would mean even the multiplier effect were in an important sense equivalent to the printing of money, i.e. counterfeiting.

  8. Mark,

    two questions

    1) Isn’t the US in a position of logical absurdity to at the same time demand China buy huge amounts of treasury bills AND complain that China is manipulating its currency (depressing it) to foster exports? Isn’t the way China depresses its currency precisely by printing Ren with which it can purchase foreign reserves on the exchange market?

    2) Can the US really expect China to keep buying debt at a high rate (China only actually holds 800 billion or so in T-bills, according to yesterdays New York Times) – if they were to buy the entire stimulus package they would double their treasury holdings.

    On the other hand, I’ve heard that Mzero in the U.S. is only about 900 billion dollars – so that means that if the Fed were to print the stimulus package, inflation would go to 100%, right?

  9. The main question about fractional reserve loaning, to me is, does it itself cause inflation. If it does, then banks only profit through theft.

    I think you are being too quick to cry ‘theft!’ To begin with, banks could plausibly make money just by charging fees. Having your money in the bank is generally safer and more convenient than having it in a cash pile in your basement. Even if they never lent anyone one thin coin, they could still have a reason for existing.

    Secondly, even if a particular banking system causes inflation, it isn’t really banks that set the rules. In some sense, the government that permits an inflationary banking system is the entity responsible for the inflation.

    Thirdly, it may well be the case that inflation is on the negative side of the ledger, but is balanced out by larger benefits. Most obviously, those would be the benefits of having capital available to those with energy and ideas, but who lack the financial means to put them to productive use.

    Now, all of a sudden a law changes allowing fractional reserve lending. It is much easier to access money now, and more money begins to circulate. However, that extra circulating money is chasing the same amount of product and services.

    I think it is wrong to say, in the medium term, that there will be the same amount of products and services to chase. Gold bricks in a bank or under your bed are fundamentally unproductive assets. If at least a few people are borrowing to invest, having a banking system should produce more goods and services for people to buy.

  10. ” If it does, then banks only profit through theft.

    I think you are being too quick to cry ‘theft!’ To begin with, banks could plausibly make money just by charging fees. ”

    Say I loan someone some gold. But, since gold is heavy, I just write them a certificate. Now, they use that certificate to buy a tractor. Then, the man who buys the tractor, deposits the certificate in my bank.

    Now, imagine I never had the gold in the first place. The impressive looking safe in the back of my bank is empty. Have I committed theft? Fraud? Either way, it’s different than making money by raising rates – it’s making money through manufacturing false beliefs.

  11. If you take out a loan secured on a false basis (for instance, against a house or business you do not own), you are probably commiting fraud. That said, if you subsequently repay the loan, it will have been a fraud that did not produce any damages. The situation is not especially comparable to that of banks. Everybody who has investigated their nature at all knows that not all the deposits they hold are available for immediate withdrawal. Knowing how banks work and still choosing to employ them means you are accepting the form of guarantee they offer (often further backed by the state, in deposit insurance).

    Saying this does not establish (a) whether banks cause inflation, (b) whether they are morally or legally culpable for doing so, or (c) whether causing that inflation is worthwhile, when overall societal welfare is considered.

  12. Most of the time, at least, banks are able to use those deposits to finance productive investments elsewhere, increasing overall wealth and welfare.

    There is definitely an important element of the relationship being established here. Savers who had no choice but to stockpile gold are in a worse position than those who are able to lend. When operating properly, an economic system that includes debt is capable of aiding both those with surplus savings and those in need of additional capital.

    Anyone with student loans, a mortgage, or retirement investments is implicitly recognizing that moneylending isn’t inherently wicked or against their interests.

  13. Are you talking about central banks or private banks (or in Canada’s case chartered banks)? This is getting very confusing.

    Tristan seems to argue that Banks control inflation by printing more or less money and that printing more money than there are goods in an economy is tantamount to theft. Even though I do not buy his argument for a variety of reasons, I assume he is talking about central banks.

    I do not think central banks invest money, hence my confusion.

  14. I think the basic question being debated is:

    Should we get rid of fractional reserve banking, because it causes inflation?

    I am not convinced, at this point, that it does cause inflation. Further, I am not convinced that it should be scrapped even in the event that it does cause inflation.

  15. Thanks for the clarification.

    I don’t see how it causes inflation either but eliminating it would probably cause a major economic slowdown.

  16. A different question, which I think is also being asked and has been somewhat conflated with the question above, is:

    Would we be better off on a gold standard?

    This is another question where I don’t feel I know enough economics to provide a good answer.

  17. There is a tremendous amount of disinformation and confusion on the internet about fractional reserve banking, fiat money and money supply management. I recently went on a major reading binge to try and understand these things more deeply, and I was amazed at how hard it was to find a reliable source. Wikipedia, normally a fine source, was a complete mess. It thought this would be a dry academic issue where I could easily find information, but it seems that currency systems are an issue for Libertarians in the same way abortion is an issue for Catholics.

    People who think a gold standard would solve our currency problems should immediately read Paul Krugman’s article “Monetary Theory and the Great Capitol Hill Baby-Sitting Co-op Crisis”. The original paper is also well worth a read. It describes a baby-sitting club where the members would take turns to mind each other’s children. To make sure that everyone did their fair share of baby-sitting, the members created their own currency of baby-sitting tokens. What could be simpler? Alas, economies are strange beasts, and woe befell the baby-sitting co-op. At some point the number of baby-sitting tokens in circulation was lower than normal. People began to hoard the now-scarce tokens. Everyone was desperate to baby-sit and refused to go out. Because no one would go out, there were few opportunities to sit babies. The number of babies sat plummeted, even though there were plenty of able parents available, and the number of nights out also declined – in short, the baby-sitting economy experienced a recession. An economist member of the co-op persuaded them to try some money supply management, and issue more tokens to each member (printing money, “inflationary”) . Miraculously, the baby sitting recession was instantly cured.
    The point is that any system of exchange, gold, fiat or baby-sitting-token, is governed by some quite non-intuitive laws, and needs careful management. Economic systems, however small, are not inherently stable, but seem to spontaneously generate recessions and booms. Frankly I think this process has deep roots in human psychology and isn’t properly captured by our best economic theories. But it’s pretty clear that currency management has a role in taming these natural instabilities. Printing money can be a crucial tool in keeping the economy as a whole healthy and functioning. There is nothing inherently preferable about a gold standard, indeed it closes off lots of useful economic management tools.

  18. I used to read all of Krugman’s Dismal Science article in Slate a long time ago (I like them much better than his current rants in the NY Times). Thanks for the link.

    It should be noted however that the bit about inflation can be found in a “sidebar” note here:

  19. “Banks control inflation by printing more or less money and that printing more money than there are goods in an economy is tantamount to theft. Even though I do not buy his argument for a variety of reasons, I assume he is talking about central banks.”

    Central banks control inflation by a) changing the rate of increase of Mzero (the rate at which debt is monetized) b) changing the reserve ratios (changes the multiplier effect – allowing banks to effectively create more dollars by lending and then taking deposits which results from those loans as assets0.

    No one thinks that regular banks print money, this of course would be illegal. The point is, they act “as if” they have more money than they do if we had a full reserve system.

  20. Tristan,

    You have asserted this position several times, but I don’t think you have adequately answered the question of whether these are the only two causes of inflation, in all cases. Nor have you made a convincing case for why inflation is ‘theft’ or why the drawbacks of low but positive inflation outweigh the advantages.

  21. Intuitively, it also seems like trade policy could affect inflation.

    Protectionism effectively bars you from being able to buy cheaper products imported from places with lower costs of production. As such, I would expect it to increase prices domestically – with no input whatsoever from the central bank, and no changes in reserve rations.

    Conversely, free trade deals and lowered tariffs and duties would make imported goods more affordable, presumably lowering the overall price level, again with no monetary prompt.

  22. Tristan, I was refering to your comment: “Isn’t the way China depresses its currency precisely by printing Ren with which it can purchase foreign reserves on the exchange market?” It was a question and your position was quite unclear.

    I also think that your focus on Mzero brings more confusion than anything to this debate. As far as I know, and I’ll admit that I don’t know much on this issue, it is only a measurement of the amount of currency in ciculation and in bank reserves. What matters here is not Mzero itself but how it can be changed, either by central banks or government policy. I also believe that if you insist addressing only money supply, you should also consider other aspects of it such as the stock market and other funds and go as far as integrating aeromiles and Canadian Tire money.

  23. Anyone who tells you “inflation is caused by prices going up” is complete imbecile. Of course prices going up begets more prices going up – people making things have to pay for things in actual, not theoretical, prices. No one in their right mind would disagree with the claim that increased prices causes inflation, but it’s exactly like saying “scoring more goals than the other team causes your team to win”. Since inflation is defined as the rise of prices, to say it is caused by the rise of prices explains nothing whatsoever.

    We say “higher energy costs cause inflation” – but this is absurd – it explains literally nothing. If we consider a limited sector of the market – energy – Higher energy costs already are inflation – what causes the higher energy costs? Don’t we still believe in supply and demand? A contraction in supply causes higher costs. Contractions in supply produce inflation. However, logically, with respect to inflation, a contraction in supply (i.e. the size of the real economy’s ability to provide services) is identical to a expansion in the money supply. If you contract supply, prices go up. If you contract the money supply, prices go down. If you reduce demand, prices go down. If you expand the money supply, prices go up. These questions aren’t even interesting – what’s interesting is in what causes do the value of products go up – and the answer seems to be only in those cases where the increased price is caused by demand (i.e. society allocates more of its wealth towards consuming that product) (or you can give Marx’s analysis, and say society is allocating more of its socially average labour time to that product. Notice Marx’s account is logically identical to the supply-demand model.)

    Magic Tofu,

    To say “Mzero” brings more confusion is just to say that we are confused by fractional reserve banking. Mzero is the number of printed bills, M-one is the number of dollars which includes printed bills and liability created assets. Learn about it? It’s pretty absurd to me that people don’t consider it their duty to understand how money works.

    Canadian tire money? Canadian tire money is not interesting. Of course some firms accept it – this is absolutely no loss to them so long as there is some employee willing to be paid partially in it, which is of no loss to him if he or she ever shops at Canadian tire anyway. Canadian tire money is only interesting insomuch as it is an example of a private currency which does not challenge the national currency – if it did, certainly some law would be passed or invoked to arrest someone. This is a serious issue, to have the freedom to circulate and trade with your own currency – whether or not you should have this right. It seems plausible that it would be limited, but only on the grounds that taxation would be too difficult.

  24. ““Isn’t the way China depresses its currency precisely by printing Ren with which it can purchase foreign reserves on the exchange market?””

    How is this question unclear. I am asking, because I might be wrong, whether or not it is both the case that (a) the United States has publically accused China of manipulating its currency, depressing it, to encourage exports AND (b) the primary way of depressing the Chinese currency is to print it and use it to purchase treasury bills from the US. Should China stop purchasing tbills from the states, the extent to which they (the US) are bankrupt would become more acute.

    I don’t understand your confusion on my position – I am asking a question? If the answer to my question is roughly, “yes”, then my position is the U.S. is speaking in contradictions – explicitly, and such that no one notices, because no one bothers to know the first thing about monetary policy. It’s still common to see the term “devaluation” used with an independent meaning from “inflation”, for example. As if devaluation is anything but a cause of inflation.

  25. When a flow becomes a flood

    Jan 22nd 2009
    From The Economist print edition
    The deep causes of the financial crisis lie in global imbalances—mainly, America’s huge current-account deficit and China’s huge surplus

    “An unsatisfying implication of the literature on the saving glut is that it paints America as a tragic victim of forces beyond its control (though some of the authors insist this is not their belief). The emerging markets’ need for insurance, in its many guises, drives them to export capital to America (and to similar places, such as Britain). America, by implication, has no choice but to make room for it.

    In fact, Asian savings may have provided the rope; but America hanged itself. The macroeconomic forces that drove the capital flows were hard to reverse. But what made them so devastating was that they were met by microeconomic failure”

  26. Tristan,

    Calling people ‘imbeciles’ for disagreeing about whether changes in M0 are the sole cause of inflation isn’t an argument.

    It does seem plausible that other factors have an effect, whether in the short term only or also in the medium and long-term. It seems to me as though demographic changes, changes in trade policy, and other factors could all have an effect on the mean level of prices.

    Further, you are completely ignoring the other questions enumerated above.

    I do agree that dollar-denominated gift certificates, such as Canadian Tire money, are not relevant to this discussion.

  27. Canadian Tire money is an absurd example because the value of Canadian Tire dollars in circulation is meaningless. However, since it acts “like” money, it has an influence on a larger understanding of the money supply than M0, at least that’s what I remember from my undergrad economic courses. This example was the one used by my prof at the time to explain us the various ways to calculate the money supply.

    As for price having an impact on inflation, it is a bit more complex than what Tristan seems to assume. In many theory (e.g. spiraling wages), it is more about feedback loops than linear logic. Similarly, a price increase due to contracting demand (e.g. OPEP actions) or increased demand (e.g. fast population growth in Fort Mc Murray) can go through multiplicating effects often linked to limits to the elasticity of market (energy is an obvious example here).

  28. You catagorically cannot say that increased prices cause inflation. Increased prices are inflation. Inflation is just the rising of prices. So you need to find a cause which is outside of the level of prices – some way to account for prices in general going up and down. Otherwise, you haven’t even started answering the problem. Saying things are “more complicated” is saying nothing at all, why are they more complicated – given what theoretical assumptions?

    Also, no one has given any defense of the dogma that “politicians cannot be trusted with monetary policy”. Does anyone have any evidence for this, at all? The former head of the federal reserve disagrees – this seems to be reason enough to think that it’s not the only possible position you could take.

  29. Ok,

    Let’s deal with this bs “spiralling wage” theory. The idea is that wages go up, which increases the cost of production, which decreases the real value of wages, which causes a need for wages to go up again. Is that right?

    Ok, imagine this spiral is happening, but the money supply is fixed. Forget fractional reserve lending because it makes things more complicated. Ok, so, wages, and everything else, is increasing in price. But, there is the same amount of money in circulation. Without easy credit, there will be no fast money to feed the spiral – there will be a pressure for wages and all prices to go up, but it will be counteracted by a lack of money to pay these higher prices. in controversial language, there will be no ability to blow up the bubble, because there is no injection of credit. No new money means there is the same amount of money to pay higher prices – so consumption will reduce, prices will stabilize.

    It’s useful to think about the math. Imagine this “spiraling inflation” is increasing wages by 1% per year, but the money supply is fixed. Do you really think that in 70 years all prices will get to the point where they are double where they were in year one? With no more liquidity introduced? I don’t think so.

    Spirally wage theory is true, only because of liquidity-inducing monetary policy. It only appears to be the cause of inflation, where again, the actual cause of inflation is just a hidden form of devaluation.

  30. Tristan, in your example inflation will happen but the economy will enter into a recession because the cost of the goods and services in this fictional economy will be higher without an increased demand for them. This does mean that in the medium to long term we will see downward pressures on prices and wages, you are totally right here. However, this does not mean that inflation cannot happen in the short term under such a scenario. Moreover, since wages and prices tend to be sticky downward (i.e. it is more difficult to reduce them then to raise them – think collective agreements, right to strike, etc. for wages) what you are likely to see is a long lasting recession and high unemployment. In this situation, you will probably agree with me that increasing the money supply is the only easy way out. The pressure on the central Banks to increase the money supply and create inflation is therefore enormous and, at least in my opinion, cannot be ignored. You are therefore right to say that in the long term they banks are more often responsible for inflation than anything else but the reasons behind their actions probably escape them more than you seem to believe.

    As for my other example (scarcity and population growth) particularly when they affect a non elastic market or the quasi entirety of an economic system (i.e. energy), their impact on inflation would exists even in the absence of central banks. Over the long term, it is probably true that even the more inelastic market tend to adjust but we still live in a finite world and I am not convinced that even on the very long term all markets can adjust… or at least not until the population decrease substantially.

  31. So, in other words, a fixed money supply means that inflation doesn’t last. Prices go up and down, there is a cycle of sorts, but people’s savings are never destroyed – and best of all, it is in principle possible for there to be net savings in the economy. Sure, maybe growth would be slower, but it’s a fair trade for stability and fairness.

    If there were no central banks, money was gold, and the producers of gold were the gold mines, so long as the gold supply increased at X% per year, there would only be inflation if the economy grew slower than X% per year.

    We think we are so clever because we have used central banks to make ourselves richer – and we have. I don’t pretend that this kind of quantitative easing doesn’t cause growth. But why is growth good, if it’s not sustainable. Growth as such isn’t sustainable – the point of the economy shouldn’t be growth – it should be fairness, reducing coercion. The only justification for growth, since it almost by definition increases inequality, is if it increases the lot of the least well off, if it increases their ability to live a meaningful life and to have projects. Otherwise, who cares? What do you want, a speedboat?

  32. The only justification for growth, since it almost by definition increases inequality, is if it increases the lot of the least well off, if it increases their ability to live a meaningful life and to have projects

    This is exactly what mild inflation achieves – it transfers money from old rich households to young indebted households, reducing inequality. Which is why I’m so surprised that you’re so strongly against it – this seems to me socially and economically useful.

  33. Tristan, savings will be lost when people will have to use them during recession. The amount of hardship a predictable low level inflation can avoid is important. The key here is to have a predictable level of inflation over the years. Most of the time investment gains are higher than loss through inflation anyway so I am not sure I understand your point.

  34. Also there is a difference between encouraging growth and avoiding recessions.

  35. “Also there is a difference between encouraging growth and avoiding recessions”

    Only if you take the zero point of growth to be of some metaphysical importance. Does something magical happen at zero? What is the grand difference between changing the rate of growth from -1.5% to -0.5%, compared to -0.5% to +0.5%?

    I’d like to challenge the spiralling theory again. We seem to assume not only that wages will push prices up, but they will push them up so far as to negate the real-wage increase. This is obviously bollucks, because not every input will require labour. Even if all labour rates go up, labour’s buying power goes up because some things, while in a certain sense they are reliant on labour, do not have labour as a large direct input.

    You might challenge that – Marx would, but usually neo-classicalists don’t have any time for the labour theory of value, because they specifically do not believe that everything has value because work was put into it.


    You might be right about the transfer of wealth from savings toward debtors – but I’m quite skeptical that any of this debt is legitimate.

  36. Avoiding recession means evening out the peaks and valleys in growth.

    As for the labour theory of value, in my opinion, is completely wrong. Spiralling wages is a theory and as such does not explain how the world works just how an idealized sub-system work. It certainly does not happen all the time because other aspect of our economy work against it. Arguing this however does not discredit in any way this theory, it simply contextualize it. For some reason I have the feeling we already have this discussion.

  37. “As for the labour theory of value, in my opinion, is completely wrong. ”

    Do you have an argument for this? According to Marx, prices are set by demand, but value has its origin in labour. Value and price are not the same thing. I don’t think most economists today even have the right parts of the brain to begin arguing about the labour theory of value – they don’t have a subtle enough notion of what it means for something to be an “origin”. Although, I suppose if you could defeat the use/exchange value distinction, that might do the same work. Any takers?

  38. In my opinion price is a measure of value but I am willing to listen to another interpretation.

  39. I’m going to retract the concession I made to Mark earlier, where I agreed with his point that “inflation is a wealth tax”.

    The least well off do not have mortgages negotiated at near prime rates. They have credit card debt. To them, the deflation of their debt is proportionally meaningless compared to the rate at which it accrues (20+%). The difference between 2 and 4 percent is large, but the difference between 20 and 22 percent is not. The math for this is simple – imagine someone holds 20,000$ in credit card debt – this debt is increasing at a rate of 20% or so – in other words, it is doubling every 2.5 years. But, lucky for them, inflation means the real value of the debt is declining at 2% – which means its value is halved every 35 years. So, value cut in half every 35 years, nominal amount doubles ever 2.5 years.

    Don’t start to argue that debt is good for the poor – this is just absurd. And don’t assume that people with mortgages are the least well off – they might be poorly off spiritually (existential dread of suburban existence), but in material terms they are no were near the worst off.

    Also, what guarentees that the wealthy won’t profit from the devaluation even more? Do wealthy people always have more savings than liabilities? This seems like a strange inference/generalization.

  40. Don’t start to argue that debt is good for the poor – this is just absurd

    Access to credit (i.e. debt) is extremely important for the poor. It is vital for getting a home, starting a business, getting an education, etc.

    This is why Mohammad Yunus got the Nobel Peace Prize.

  41. “In my opinion price is a measure of value but I am willing to listen to another interpretation.”

    Price is a certain measure of value – but in order for price to be a “measurer” of value, value must be something distinct.

    The obvious interpretation is “value” is the activity by which I desire things I want. I “value” them, I’m willing to pay for them. However, how much things cost is mediated through a complex social structure – some of the best things in life (things I value the most) are free, whereas other things I value less are expensive (i.e. things I don’t consume and wouldn’t consume even if they were much cheaper).

    In other words, value is subjective, but price is an objective social fact. However, value is also objective in the sense that we believe that when someone values something, they actually value it – objectively (it’s not just that they value it “from my persepective” – they actually do value it, this is a fact). So, value, which subjective, is also objective because we can set over against us someone valueing something and take that relation of valueing as our object of inquiry.

    Of course, this isn’t enough to prove the LTV – because at this point people will usually say that labour is just like every other input, and what people desire is not “things which have been laboured on” but just things, even things that havn’t been laboured on (trees and rocks?).

    Anyway, the problem with this is that if there is some product that people desire which requires no labour to produce, it will be worth nothing. For example, air – we all desire it, but it takes no labour to produce, so it has no value. Or, say rocks on the beach. People value them, but because it doesn’t take any labour to make them, you can’t charge for them.

    Whereas, things people like, such as diamonds, oil, etc… all take labour to extract – and because they take labour to extract you can’t just go pick it up, you need to pay people, so this creates a demand for a firm to administer its extraction.

    The other way out, would be of course to appeal to property rights. But you can’t actually use property rights to save the subjectivist theory of value, because then you end up with a story that says “things have value because things belong to people” – but obviously, people valued things before property rights. So value needs to be more primordial than property rights, which only emerge in the most recent millenia of human history.

  42. Prices arise socially, not through individual contemplation. Wages are, generally speaking, the amount of money for which a member of the population is willing to do a certain task. Prices are likewise what a member of the population is willing to pay.

    Buying decisions might be made on the basis of an individuals ‘theory of value’ – denoted in terms of whatever that person cares about. Prices, by contrast, arise from the behaviour of groups.

  43. Tristan, I’m sorry to be so neo-classical but doesn’t prices reflect demand (linked to value) and supply (linked to scarcity)? (we could also add considerations about elasticity if you want)

    I feel that labour is only one of the many factors affecting supply, but again I willing to be convinced otherwise.

    I do agree with Milan on the social nature of prices.

  44. It is easy to demonstrate that prices bear no fundamental relation to quantities of labour.

    Firstly, you can imagine two manufacturing processes for the same product: one labour intensive and one automated. They produce goods of the same value. Even if you look into the labour involved in building the automated equipment, you will often find that the automated system produces more value in product for a set amount of labour.

    Secondly, think about situations in which the prices people are willing to pay are unusually altered. In an emergency, the ability of people to pay can become much more important than their willingness. Starving people will trade Rolex watches with high value and lots of embodied labour for sacks of beans. Again, social situations establish prices.

    Thirdly, people can value things enormously which involved little of no labour. Consider, for instance, a meteorite that someone finds. Because they are scarce and interesting, people will pay a lot of money for one. In some situations, the meteor might even be worshiped as an object of veneration.

    At best, you can say that “commodities that take a lot of labour to produce generally cost more than those that do not.” Of course, saying this is just acknowledging that labour is a factor of production. You could substitute ‘land,’ ‘capital,’ ‘platinum,’ or ‘time’ in the previous sentence and it would still be accurate.

  45. “Don’t start to argue that debt is good for the poor – this is just absurd. ”

    Credit makes important investments (such as housing) possible for the poors. Being able to purchase a house through credit also mean that over the years you can build collateral which can allow you to obtain more credit for a variety of projects such as starting a business. As such, I do see credit as a mean to empower the poor. Why do you see debt as a being such a bad thing?

  46. Milan expressed an opinion very similar to mine very eloquently. The only example that I was able to think of was a bit too scatological to write down here.

  47. “It is easy to demonstrate that prices bear no fundamental relation to quantities of labour.”


    “According to Marx, prices are set by demand, but value has its origin in labour. Value and price are not the same ”

    -Tristan, several posts before.

    I can give you the citation if you want. It’s a bit more complicated than “supply and demand determines price” because Marx doesn’t believe in the reality of equilibrium. I think people who do believe in this are hilariously unscientific, but, I suppose if we think truth is just “what works”, we need to evaluate neo-classical marginalist paradigm general equilibrium theory based on whether it actually works or not.

    “It is not the sale of a given product at the price or its cost of production that constitutes the “proportional relation” of supply to demand, or the proportional quota of this product relatively to the sum total of production, it is the variations in supply and demand that show the producer what amount of a given commodity he must produce in order to receive in exchange at least the cost of production. And as these variations are continually occurring, there is also a continual movement of withdrawal and application of capital in teh different branches of industry…if M. Proudhon admis that the value of products is determined by their labour time, he should equally admit that it is the fluctuating movement alone that makes labour the measure of value”

  48. What “poor” people do you know can negotiate what you and I would call a good rate of interest on a loan? What poor people have the stability for that?

    “Being able to purchase a house through credit also mean that over the years you can build collateral which can allow you to obtain more credit for a variety of projects such as starting a business. As such, I do see credit as a mean to empower the poor.”

    What poor people can afford mortgages? Your notion of poor is not ‘the least well off’, so it’s not the one I’m interested in. What you are really talking about is the middle class, or maybe the lower middle class.

  49. Tristan – A lot of micro-finance lenders charge interest rates that would make a credit card company look charitable, and yet they are still immensely valuable to their users. It seems credit on any terms is better than no credit at all.

  50. “It seems credit on any terms is better than no credit at all.”

    You’re assuming people don’t over-discount future costs. When actually, people constantly over-discount future costs. It’s probably the main structural way in which actors are irrational. I’ve heard of studies which measures the future discount rate of toddlers using marshmellows and things, which go back to check the data against the success of the toddlers when they are 20 and 30, and the ones who don’t over-discount do far better.

  51. Tristan,

    It is extremely patronizing to say that poor people can never use credit effectively. I agree that they are more vulnerable to being abused by lenders, but that doesn’t mean that they should be denied capital altogether.

    On the matter of high interest rates: they are a rational response to a higher risk of default. They may be regrettable, but they are also somewhat akin to legal abortions. The alternative is loan sharks with even more abusive interest rates, and far harsher mechanisms for ensuring repayment.

    If you want to provide cheap credit to poor people, microfinance initiatives like Kiva (linked above) provide a mechanism.

  52. Also, does Marx think that meteorites have no ‘value,’ even though their prices are high, because they take no labour to produce?

  53. Scaling Up Housing Microfinance for Slum Upgrading

    By Sole, Regina Campa
    Publication: Housing Finance International
    Date: Friday, December 1 2006

    “To eliminate slum conditions over the next 15 years will require a sustained effort on a global scale. This is a challenging proposition since it is clear that scaling up slum improvement will require very substantial financial resources. Central and local governments will never have enough money to do the job entirely by themselves. Only by mobilizing private capital and enabling slum dwellers to improve their own housing conditions on a financially sustainable basis will it be possible to achieve such large scale results.”

  54. “For I dipt into the future, far as human eye could see,
    Saw the Vision of the world, and all the wonder that would be;
    Heard the heavens fill with shouting, and there rain’d a ghastly dew
    From the nations’ airy navies grappling in the central blue;

    Till the war-drum throbb’d no longer, and the battle flags were furl’d
    In the Parliament of Man, the Federation of the world.
    There the common sense of most shall hold a fretful realm in awe,
    And the kindly earth shall slumber, lapt in universal law.”

    Poor people, rich returns

    May 15th 2008 | NEW YORK
    From The Economist print edition
    Is it acceptable to profit from the poor?

    The hidden wealth of the poor

    Financial services are at last spreading from the rich to the developing world—and even making money, writes Tom Easton Nov 5th 2005

    Listen to audio
    Download PDF

    Doing good by doing very nicely indeed

    Jun 26th 2008
    From The Economist print edition
    In support of profiting from the poor

  55. Embedded in this debate is the question of ‘who is poor.’

    Looking at microfinance and those who are very poor by global standards is one way of sidestepping the discussion. Presumably, if debt is good for them, it is good for less poor people.

    By some standards, grad students are fairly poor. I for one am glad that a couple named Larry Page and Sergey Brin were able to get a US$100,000 loan to fund the business they were building in their garage.

  56. “Also, does Marx think that meteorites have no ‘value,’ even though their prices are high, because they take no labour to produce?”

    I think I already answered this by saying that they acquire value by analogy. But anyway, there is a better answer.

    The answer is it takes an unbelievable amount of labour to produce a meteorite. Say someone showed up at your door and tried to hire you to find meteorites. How much would they need to pay you? Presumably, meteorites can be located by human ingenuity, looking in places where there have been meteorites falling. Sounds very difficult, but possible.

    If it didn’t take any labour to produce them, then they would be immediately available – like air (which has no value).

  57. “the question of ‘who is poor.”

    There is no need to pretend that this question is difficult. If you think the state, or perhaps better your ‘sphere of influence’, is relavent, then the poor are the least well off in your state or in your sphere of influence. If you think distance, etc… are irrelavent, then the world’s least well off are the poor.

    I’m basically a statist though, like Rawls/Hegel – I think we have duties to those people who we already exist in implicit contractual and moral obligations with.

  58. the poor are the least well off in your state or in your sphere of influence

    How many of them?

    The 50% at the bottom? The 5%? The 0.05%?

  59. Regarding the meteorite, I agree that you can choose to value it using labour hours. It’s not clear why this is a more special measure than any other. At any point in time, the amount of effort required to find meteorites depends on many factors, some of them potentially much more important than the number of hours you spend looking. For instance, some sort of system for detecting incoming meteorites might reduce search times by an enormous factor.

    What does valuing things in terms of labour allow us to do, which we could not do otherwise?

  60. If it took only a few labour hours to locate a new meteorite, meteorites would cost very little. And the amount they would cost would reflect the inputs required to locate and extract and transport and distribute them. And all of those costs are reducible to a labour input, but not all labour inputs are reducible to a non-labour input.

  61. Tristan, how do you factor the fact that we live in a finite world with limited resources in a labour theory of value?

    I believe that you suggested that only private property places limit on this theory, I am right? If so, are we suggesting that it does not apply to the type of economy we live in?

  62. Tofu,

    I don’t understand the problem. The world is finite, yes. For example, you only extend a few feet in every direction. If we were infinite, we wouldn’t need to build anything because we couldn’t mix our labour with things.

    Labour theory of value deals with why things have use values that are not entirely particular, that are at least somewhat universal (universal enough to be a commodity). The LTV always seems to break down when talking about things that are not commodities. Lucky for Marx, commodity is a a priori metaphysical distinction of our age though, and not a set of attributes that things could have or not have.

  63. Tristan, is it fair to say that it does not apply very well in a world dominated by private property given that scarce resources are not equally distributed geographically and are subject to private control?

    Is it also fair that it is useless in describing historical shifts such as those where scarce resources become increasingly scarce because of population increase or simply the very use of these resource over time?

  64. Tofu,

    Stop thinking I’m talking about prices. Prices are a complex derivative of value. I’m talking about why things have value. Value is primarily use value, but in exchange use value is abstracted into a universal (exchange value). Labour is the only use value that in using it produces an exchange value. Every other use value, in using it, destroys the exchange value. For example, when I eat a choclate sunday, I can’t exchange that sunday any longer for cash. But when I pay someone to make choclate sundays, the product of that use-value (the labouring) is an exchange value (the things that labour has been put int0).

    Ok, lets take your example. A scarce resource becomes increasingly scarce – like in Nazi Germany petrol became scarce. What do we do – we start making biofuels, or from coal, I can’t remember exactly what they did. The demand was quite inelastic (i.e. war effort), so the amount of labour required to produce a unit of petrol went way up (pumping out of the ground versus all the difficulties of what they had to do instead). Here is a really simple example of where the value of a product goes up because more labour is required to produce it.

    All products have alternatives. If the price of gold were to go up beyond a certain amount because of scarcity, I’m sure we’d start using something else in our electronic devices. And the reason we’d start using something else is that the amount of labour to extract one extra unit’s worth of that other metal was less than the amount of effort required to extract another units worth of gold.

    Of course, private property distorts this, but only in a non-free market. Hoarding, i.e. Silver in the 70s, and diamonds always. Hoarding means the market is not allowed to determine the fair price of an item, which you will probably agree with. However, the only difference is the anti-marxian economists insist on defining the fair price only in terms of fair conditions of a market, rather than believing that things “really have” value and that these non-existent real-values (it’s not a marginalist equilibrum paradigm, so the “real values” are the values around which the price moves, not the point at which a price remains fixed).

  65. Two identical house, one built next to the ocean and the other one across the street. The first one benefits from a nice view and as such is generally valued at a higher level than the other one, the prices for these two houses reflects this very fact. How does it fit in a LTV model?

    In general I agree with some basic ideas, that value and price are not the same thing for instance, but I think labour is only a proxy for a more complex mechanism.

    As for hoarding, I’d say that it can be viewed as a consequence of particular contexts and individual perceptions but that it impact on the market in the same way other variable does. As for the idea of “fair price” I seems like a very fuzzy concept that has more to do with sociological factors than economic ones; in other words, a market does not and probably should not care about it… it seems to me that it should fall in the domain of politics and culture.

  66. Tofu,

    You can always try to argue against LTV by proving that things we buy are not commodities. If you could prove that, you’d succeed. Unfortunately, things we buy are commodities, and this means that they are infinitly replaceable and reproducible.

    It’s really easy to see why this house near the shore has a greater value. There are only so many road-accessible houses near the shore, so to continue to build shore houses above a point, you’d need to build more roads, ferries, etc – this all takes labour. If it didn’t take more labour to build one more house near the shore (also, the length of the commute counts as labour aswell), then it wouldn’t cost more than the one inland.

    It’s only because the cost of replacing and reproducing certain commodities is higher in labour that their “value” is said to be higher. And you are right, the shore house is more valuable – and the proof of this is society votes with its dollars, which are abstracted labour, to spend more labour on houses by the shore. This is why Britannia Beach is being filled up with subdivisions – people are willing to commute this long distance to Vancouver just to have a house with a great ocean view, even though it would be far less labour intensive to build houses somewhere uglier nearer the city.

  67. By the way,

    I’m not actually certain that everything is a commodity. I don’t think capitalism is completely all-pervasive – I actually believe that,different sets of social relations can be true at the same time. Very simple example – the donations plate which goes around at Church – this is at the same time an expression of some material relations between workers and owners, and something about God and personal commitment to the Christian project. This is a hack example, but what I mean it’s possible for something to be at the same time a commodity and something else – maybe a thing. If you want to know what I mean by “a thing” as opposed to a commodity, Heidegger wrote an essay called “The Thing” in 1950. But it is not possible to read this if you come to it with the assumption that you already know exactly what a thing is.

  68. The worst thing about this crisis may be how it has made everyone obsessed with economics.

    The subject is overwhelmingly boring.

  69. Tristan, I like to think that I am flexible enough to change my understanding of certain things and accept different definitions and ideas. However, I still don’t see much value in the LTV but that being said, I think Litty is right, we are engaged in a very boring discussion.

  70. For the next while, I will try hard to avoid posts that raise any of these issues:

    • Israel
    • The philosophy of science
    • Economics

    They are all getting very tiresome, and it doesn’t seem like debates about them produce any useful insights.

  71. Does anyone else recognize the boring-ness of various topics, such as economics, Israeli war attrocities, US support for brutal regimes, to be produced as boring “on purpose” – to make sure attention is vested elsewhere, i.e. cooking shows?

    If being a democratic citizen has anything to do with being aware of the decisions being made which impact your and other people’s lives, then it seems that economics, philosophy of science, and Israel, should be all near the top of any list of things it is a duty to know about as a democratic citizen.

    Unless you’re just happy with the elite running everything, and the white tower justifying continual immoral state actions.

    My main point – we should be extremely self-critical as to why we find these debates boring. What is it about the production of ourselves as concerned subjects makes these topics, which materially affect life a massive amount, seem boring and disconnected?

  72. The ‘debates’ are boring because they aren’t really debates, at least in the sense that any progression of ideas arises from them. They are more like a series of assertions and contradictions. The same tends to be true for other topics that soon grow boring to debate: capital punishment, drug legalization, abortion, euthanasia, etc.

  73. Milan,

    Thanks for the article. It gives what seems like a fair and balanced story of the current issues. They even admit the contradiction between asking China to appreciate its currency, and asking China to buy the stimulus package – these demands contradict each other.

    The pessimistic view sees the US as screwed either way. Either, China continues to buy more debt, and increases its leverage over the US economy. Or, it stops buying debt, allows its currency to appreciate – allowing its own citizens to consume more, and it may become less reliant on foreign markets.

    What makes China so interesting is the Mercantalism in reverse. Usually you begin with over production and solve the problem with colonies. However, in China’s case, you begin with, effectively, colonies in the form of rich foreign countries who can buy your goods on the cheap (by holding down the value of your currency), and then follow that by raising the domestic standard of living, where the logical end point is autarky.

    But then again, China always has been the middle empire. It makes sense they would want to do Hegel backwards.

  74. Some information on currencies with intentionally high inflation, intended to discourage people from saving them:

    Depreciating currencies
    The money-go-round

    Jan 22nd 2009 | MUNICH
    From The Economist print edition
    Will old-fashioned scrip make a comeback?


    Chiemgauer is the name of a REGIO community currency started on 2003 in Prien am Chiemsee, Bavaria, Germany. It is named after the Chiemgau, a famous region around the Chiemsee.

    To maintain them in circulation, every three months, you have to put on the banknotes a “scrip”, corresponding to the 2% of the banknote value. This system, called demurrage, is a sort of currency circulation tax and was invented by Silvio Gesell.

  75. If China or an oil producing nation chooses to buy up the majority of world gold production, and take that production out of the open market, any continued demand for gold would not be met by a supply – electronics would have to be built out of reserves, and the price of Gold would increase. This would be especially beneficial for China, since they could direct the gold production both towards reserves, as well as towards production of consumer goods. I don’t know what the total price would be to buy up the gold production industry would be, but could it be more than 1.5 trillion (China’s projected possession of US treasuries by next year).

  76. The worst idea ever
    By | NEW YORK

    I wonder if Mary Shelton reviewed monetary policy during the Great Depression and decided to undo one of the few things that unambiguously helped. She advocates a return to the gold standard, because as she sees it, inflation, rather than a credit crunch, is the real enemy:

    “Inflation is the enemy of capitalism, chiseling away at the foundation of free markets and the laws of supply and demand. It distorts price signals, making retailers look like profiteers and deceiving workers into thinking their wages have gone up. It pushes families into higher income tax brackets without increasing their real consumption opportunities.

    In short, inflation undermines capitalism by destroying the rationale for dedicating a portion of today’s earnings to savings. Accumulated savings provide the capital that finances projects that generate higher future returns; it’s how an economy grows, how a society reaches higher levels of prosperity. But inflation makes suckers out of savers.”

    High rates of inflation do indeed discourage saving, in cash. The best way to protect your future consumption is to invest in assets that provide a positive real return. If consumers were truly so terrified of inflation that it was undermining the foundation of capitalism you’d think there would be more demand for TIPS. Her earlier point on inflation moving people into higher tax brackets seems to suggest a move toward indexing tax brackets rather than scraping fiat money outright.

    Uncertain or excessive inflation is a problem. But a positive, relatively predictable level of inflation is the hallmark of a healthy economy. Ms Shelton’s idea gets even stranger:

    “Given that the driving force of free-market capitalism is competition, it stands to reason that the best way to improve money is through currency competition. Individuals should be able to choose whether they wish to carry out their personal economic transactions using the paper currency offered by the government, or to conduct their affairs using voluntary private contracts linked to payment in gold or silver.”

    You can not have two competing currencies, one backed by gold and one backed by faith in the American government. As long there exists even a trivial probability of a dollar collapse, everyone would simply hold the gold backed currency, which would necessarily precipitate a dollar collapse.

  77. “Fractional reserve has been around for centuries, and has nothing to do with gold-backed currency. Fractional reserve banking can and will exist as long as contracts are enforceable: if I write an IOU, I have just increased the money supply, gold standard or no.”

  78. I think gold, or some other hard-commodity backed currency, will be considered necessary by 2050.

  79. This discussion ended up steering towards questions about debt, and questions about value, which ironically where not what the post was originally about.

    I still don’t believe that we can meaningfully say wages spiraling increases are a cause of inflation, ceterus peribus, because – and I think this is a truism – if the supply of money remained constant, and the size of the real economy is growing, you will always get deflation. I don’t mean to say that wages might not go up, but wouldn’t this simply mean they would go up in relation to other commodity costs? So, if the price of an output was to remain constant, either nominally or in deflation adjusted terms, and the wages went up, other commodity inputs would have to go down in relative value. This does not mean they go down in absolute value – because price is not an absolute value, price is exchange value concretized into an object. In other words, the deflation adjusted price of non-labour inputs might remain constant while their nominal prices might decline, whereas the labour inputs might go up both in nominal, and even more so in deflation adjusted terms.

    It might seem I’m begging the question by holding either the price of the value of the ouput constant – why wouldn’t its price go up if the costs of the inputs are going up? Yes, of course, but like I said, if the supply of money is not growing with respect to the size of the real economy, the scarcity of currency should prevent consumers from paying the price as it attempts to inflate. Logically, this law should hold just as true as its converse – that increasing the size of the money supply with respect to the real economy will mean more dollars chasing the same goods and services, and increased prices will result – each individual dollar is worth less. You can’t have it one way without the other – either printing money doesn’t cause inflation, or it does, and if it does, then not printing money needs to prevent inflation (or cause deflation). Since this relation describes the economy at the most abstract level, all talk of wage spirals needs by definition to fall inside of it, no?

  80. Irving Fisher
    Out of Keynes’s shadow

    Feb 12th 2009 | WASHINGTON, DC
    From The Economist print edition
    Today’s crisis has given new relevance to the ideas of another great economist of the Depression era

    He was prominent among the 1,028 economists who in vain petitioned Herbert Hoover to veto the infamous Smoot-Hawley tariff of 1930. And he developed his debt-deflation theory. In 1933 in Econometrica, published by the Econometric Society, which he co-founded, he described debt deflation as a sequence of distress-selling, falling asset prices, rising real interest rates, more distress-selling, falling velocity, declining net worth, rising bankruptcies, bank runs, curtailment of credit, dumping of assets by banks, growing distrust and hoarding. Chart 1 is his: it shows how deflation increased the burden of debt.

    Fisher was adamant that ending deflation required abandoning the gold standard, and repeatedly implored Franklin Roosevelt to do so. (Keynes was of similar mind.) Roosevelt devalued the dollar soon after becoming president in 1933. The devaluation and a bank holiday marked the bottom of the Depression, though true recovery was still far off. But Fisher had at best a slight influence on Roosevelt’s decision. His reputation had fallen so far that even fellow academics ignored him.

    Contemporary critics did poke a hole in his debt-deflation hypothesis: rising real debt makes debtors worse off but creditors better off, so the net effect should be nil. Mr Bernanke plugged this in the 1980s. “Collateral facilitates credit extension,” he said in June 2007, just before the crisis began in earnest. “However, in the 1930s, declining output and falling prices (which increased real debt burdens) led to widespread financial distress among borrowers, lessening their capacity to pledge collateral…Borrowers’ cash flows and liquidity were also impaired, which likewise increased the risks to lenders.” Mr Bernanke and Mark Gertler of New York University dubbed this “the financial accelerator”.

  81. You can argue that debt deflation required abandoning the gold standard if you want, but to do so you have to ignore that the Fed actually decreased reserve ratios (i.e. reduced the money supply – less dollars in the economy per ounce of gold in the treasury) during the early depression.

    Also, you have to ignore the fact that rumours that the US would be going off the gold standard was a cause of bank-runs, which were probably the worst part of the depression. And, rightly so – I’d want to get my money out in gold before they devalued the currency as well.

    Also, you can say that deflation increases the debt burden if you want, but you have to ignore that a debt is an asset. My deposits at a bank are assets to me but debts to the bank. My loan from the bank is debt to me and asset to the bank. So, deflation or inflation both distort the contracts. If we want fair contracts, we need neither inflation nor deflation, but a constant value currency. You get this by not inflating the money supply faster than the economy is growing. It just so happens, through pure chance, that gold mining tends to increase the money supply at 2-3%, which is why it’s a stable currency for a economy in a period of stable growth.

  82. “I still don’t believe that we can meaningfully say wages spiraling increases are a cause of inflation, ceterus peribus, because – and I think this is a truism – if the supply of money remained constant, and the size of the real economy is growing, you will always get deflation.”

    The spiraling wage theory does not imply that if there is a wage increase it automatically creates inflation. It suggests that it will creates higher prices throughout the economy due to the increased cost of labour. In turn, such higher prices will push workers to ask for higher wages in order to avoid a reduction in purchasing power. When they obtain new wage increase the cycle repeats itself over and over. The idea is that this situation creates feedback effects over time.

    Now, I’m not an expert but here’s an attempt at reconciling our views on this… I wish an economist could provide us with feedbacks because this is really not my area of expertise.

    Ok, let’s try! You can, of course, look at the problem from a macro-perspective, as you did, and only assume that inflation is created by an increase in the money supply larger than the increase in the economy as a whole. In my view this is not very satisfactory because the money supply is influenced by a number of factors such as micro phenomena such as credit and even the emission of Canadian Tire money (to bring back a contentious item). It is like saying that it rains when humidity condenses in clouds without explaining where atmospheric humidity originates from nor why it is condensing.

    To get back to the wage spiral example, if employers need to pay workers more, they are likely to request more credit to do so. In turn, workers who earn more will be able to afford more credit or save more which in turns makes more credit available elsewhere in the economy. Higher prices is also an incitative for demanding more credit. Since credit necessarily increase the money supply, spiraling wages have a long term effect on inflation.

    Hope I’m not completely wrong here… I am seriously stepping out of my comfort zone…

  83. The money supply is only influenced by a large number of things because we have unsound money. If we had sound money, money would be commodity, and fractional reserve lending would be considered a form of fraud, and the money supply would be equal to the amount of money. Money would be a thing which had a use value as well as an exchange value, so you could literally hold it in your hand. You can’t hold fiat money in your hand, all you are holding is a promissory note which can’t be exchanged for anything except more promissory notes. We shouldn’t be surprised that it has created a situation of instability. Of course as soon as money is just paper and lending is based on credit and the money supply is expanded and retracted based on market confidence, of course you’ll get crazy feedback loops. But this is a product of an inherently unstable system. The laws of inflation will remain in place, but much less relevantly so because the money supply becomes impossible to precisely measure or control, and since the money supply will fluctuate relatively quickly, there is no guarantee that the actual price inflation will ever catch up to the monetary inflation – because no one ever argued that the effect of devaluation on prices was instant. In fact, you could argue that the laws of inflation are no longer empirically testable, and if that’s true, that’s just because we a crap money supply, not because there was anything wrong with the laws that describe the relation of money supply to prices.

  84. Tristan, I don’t see how credit would be made impossible in your virtual economy. Why someone could not make a deal to repay a certain amount in the future because curency is backed by a commodity?

    Also, in such a fictive economy, you would have little control over the money supply and inflation could be rampant (e.g. producing more beans in a bean based economy would have the same effect as increasing the money supply). Using a single commodity to back your currency will mean that all other goods and services will fluctuate in value in comparison with that chosen commodity… inflation and deflation still remain an issue.

  85. Unless you forbid unsecured loans between individuals, there would still be credit.

    Requiring that all loans be secured (you can only get a mortgage if you already have a house worth of gold) loses all the advantages of being able to save, lend, and borrow.

  86. A trillion dollars is about the total amount collected in income taxes by the U.S. federal government in fiscal year 2006— $1.04 trillion, if you’re curious to use the exact number. That gives me a simple rule of thumb for personalizing these numbers. If I want to know what an additional trillion dollars in government borrowing or spending will mean for me, I just imagine what it would be like to pay twice as much in federal income taxes for one year.

    So, for example, with the President’s proposed budget calling for deficits of $1.75 trillion for 2009 and an additional $1.17 trillion for 2010, after 3 years of paying twice as much as I paid in 2006, I’d have about paid off my share of the bill for the first two years of the proposal.

  87. Loan Ranger
    The way Americans pay for college is a mess. Here’s how to fix it.
    By Eliot Spitzer
    Posted Wednesday, March 4, 2009, at 6:57 AM ET

    The long-term economic strength of the United States depends on our ability to compete in the world of intellectual capital. Indeed, that is perhaps the last remaining arena where we can hope to win, since we ceded pure wage competition long ago, capital is now as mobile as an e-mail, and scale, which we once had, is no longer our friend. The Chinese middle class already numbers in the hundreds of millions, and last month, more cars were sold in China than in the United States, the first time that has ever happened.

    If we are going to improve American intellectual capital, we need to fix how Americans pay for higher education.

    Marketed under the decidedly unappealing name of “income-contingent loans”—how about we call them “smart loans” instead?—the concept is simple: Instead of paying upfront or taking loans with repayment schedules unrelated to income, students would accept an obligation to pay a fixed percentage of their income for a specified period of time, regardless of the income level achieved.

  88. Food-backed Local Money
    Posted by Jason Bradford on March 4, 2009 – 6:24pm in The Oil Drum: Campfire

    The money I had printed was created with all the above-mentioned issues in mind: wide income disparity, lack of practical self-reliance, unsustainable agriculture, resource depletion, climate change, a fragile just-in-time delivery system, a failing money system, and rising unemployment. When I said that “Ben Bernanke doesn’t make money as good as this” I meant that today’s dominant money actually creates or exacerbates those troubles, whereas Mendo Credits can be part of their solution.

    Along with several other people, I am working with Patty Bruder and Cyndee Logan of a local non-profit called North Coast Opportunities (NCO). NCO mainly provides social services, such as running preschools, senior support, and managing community gardens. Mendo Credits is a new food-backed local currency project partly funded by a grant from the California Endowment. The overall goals of the project are to improve community health, economic vitality and environmental sustainability through local food system development. For as long as I have known Patty and Cyndee they have been thinking about the importance of system change and practical self-reliance. They’d prefer to develop a community garden where low income families can grow their own food rather than hand out meal money.

    Mendo Credits are 100% backed by specific quantities of pinto beans, triticale, and white and brown rice.

  89. Chinese prices record rare fall

    Chinese consumer prices showed an annual fall in February for the first time since 2002, figures have shown.

    The consumer price index fell 1.6% from a year earlier, dragged down by falls in food prices but officials downplayed the threat of a deflationary spiral.

  90. Should creation of money stay in private hands?

    By woodblock100 on banking

    Professor and economist Richard Werner proposes a solution for the current banking crisis, under which “… national debt and interest liabilities will not increase, but credit creation will.”
    He begins by giving a rather novel perspective on some basics: “It is a little-known fact that there is no such thing as a ‘bank loan.’ Banks do not lend money. ‘Lending’ refers to transferring control of the lent object to the borrower. If I lend you my car, I can’t at the same time drive in it. That’s not what banks do when they issue a ‘bank loan.’ Instead, they are allowed by the current regulatory framework to create new money out of nothing–which is called ‘credit creation.’ The collective decisions of commercial bank staff thus determine how much money is created, who gets the newly created money and for what purpose.”

    His proposal involves the issuance of ‘United States Notes’, such as the ones President John F. Kennedy authorized to be issued in 1963.

  91. Fed to Buy $1 Trillion in Securities to Aid Economy

    Published: March 18, 2009

    As expected, the Fed kept its benchmark interest rate at virtually zero. But in a surprise, it dramatically increased the amount of money it will create out of thin air to thaw out the still-frozen credit markets that have cramped lending to consumers and businesses alike.

  92. A trillion?

    Everyone who owns american $, buy something real now. A trillion will double the US money supply. Double.

    That means prices will have to, in the long run, double.

    On the bright side (if you can call it that) this will allow home prices to ‘stabalize’, by having their nominal values remain the same as all other prices rise.

  93. But, doesn’t this mean, that as soon as the credit crunch ends, we’re in for massive inflation?

    Also, who gets to spend this trillion dollars exactly? Are they going to divide it up equally among citizens? If they don’t it’s a tax on the public imposed by a private company.

  94. Yes and yes, more or less. I think everyone is now expecting high inflation when this whole thing blows over. I suppose in theory it might be avoided if credit supply never reaches the levels it was at before the crash, or if savings behaviour permanently changes. Neither of which I would bet on.

    Not sure if the Fed counts as a private company, but either way, the second part is true too. (As an aside, dividing it equally among citizens would still be a tax. To be “fair” they would have to divide it equally among dollar-holders, which means giving a big chunk of it to the Chinese.)

    All that said, at this point the Fed’s actions are probably the least-worst thing to do.

  95. “Neither of which I would bet on.”

    Isn’t this exactly what everyone who continues to hold any savings in cash is precisely betting on? If people don’t make this bet, doesn’t that mean the collapse of the dollar? Doesn’t the continued strength of the US dollar precisely require people to “bet” that inflation will not rise above their rate of return on savings invested in cash based domestic securities?

  96. Right. I guess the market, in its wisdom, doesn’t agree with our analysis. Or maybe it’s a timing thing. Lots of people expect short-term deflation, long term inflation. So under this scenario, the best approach would be to sit in cash for a while and then run. So maybe an avalanche is around the corner.

  97. Wouldn’t a severe recession with a constant money supply also cause inflation?

    After all, a constant number of dollars would be ‘chasing’ a smaller number of goods and services.

  98. World economy ‘to shrink in 2009’

    By Steve Schifferes
    Economics reporter, BBC News

    The world economy is set to shrink by between 0.5% and 1.0% in 2009, the first global contraction in 60 years.

    In its gloomiest forecast yet, the International Monetary Fund (IMF) says that developed countries will suffer a “deep recession”.

    The global economic body says “the prolonged financial crisis has battered global economic activity beyond what was previously anticipated”.

  99. This is pretty absurd – that we’re all going to starve because we stand on producing 1% less wealth than last year. It just shows who disproportionally is affected by tiny overall changes. I don’t think I know a single person who would be adversely psychologically affected by the news that they stood to earn one percent less, in real terms, than they did last year. Anyone who’s job does not come with consistent raises experiences a two percent reducing in real wages every year already.

    The system is crap.

  100. In the emerging world the pattern will be different, but the outcome more painful. As trade shrinks, millions of workers are losing their foothold on the bottom rungs of the global supply chain. Poverty will rise as they sink into informal work or move back to the land. The World Bank expects some 53m people to fall below the level of extreme poverty this year.

    The global crisis and the poor
    The toxins trickle downward

    Mar 12th 2009 | DAR-ES-SALAAM
    From The Economist print edition
    A downturn that began in the rich world is hurting those who can least afford it

  101. Printing money is a treacherously horrendous activity engaged in by states in times of crisis to protect the elite.

    However, it’s quite useful in further destabalizing an unjust system.

  102. Do you believe that printing money will not help prevent a worldwide economic depression, or do you think that outcome is less bad than an increased rate of inflation?

    Would 5% inflation for a decade have been worse than the Great Depression? What about 10% inflation?

  103. The depression is caused by the market realizing that there is a lot less wealth in it than is represented in “wealth” i.e. paper, stocks, bonds, etc…

    The idea that you can prevent a depression by increasing the oversupply of “wealth” with respect to wealth, seems like a bad idea to me.

    The solution is a system in which the speculative “wealth” of nations is not allowed to vary so wildly around its actual wealth. However, since we live under the dogma of general equilibrium, no one is willing to acknowledge the objective relations which our empirical data is flailing wildly around.

  104. The solution here seems simple enough (and it isn’t ignoring the crisis and refusing to print money).

    Governments with failing bank sectors should nationalize the banks that cannot meet their obligations. They should fire whoever was managing the banks when they failed, and set up future contracts so that bankers lose their pensions if their successes prove short-term in retrospect. They should write off the loans that will never be paid and unwind the consolidated debt obligations and credit default swaps. Then, they should break the banks into small pieces and sell them back into the private sector.

    From that point on, the government should refuse to let any bank get big enough to threaten the financial system, and refuse to bail out any bank that fails. It should also tightly regulate new financial instruments like CDOs.

  105. This ignores the fact the banks were acting rationally – risky lending was how to make money after the fed reduced lending rates in response to the nasdaq crunch associated with the dot-com bust. We shouldn’t punish banks for acting rationally. We should punish the Fed for setting up circumstances in which individuals acting rationally increased systemic risk. We need a system that internalizes systemic risk into the cost of doing business. You do this not by outlawing crazy financial instruments but by not setting the conditions in which these bad ideas become profitable.

    For one, let the market set the lending rates. All of them.

    For two, take away the right from any bank to print money out of thin air. Make money a commodity. Make failure to repay money in commodity an offense equivalent to theft.

    Third, restrict the reserve rates, and keep them constant – so as to prevent the blowing up of bubbles.

  106. China suggests switch from dollar

    China’s central bank has called for a new global reserve currency run by the International Monetary Fund to replace the US dollar.

    Central bank governor Zhou Xiaochuan did not explicitly mention the dollar, but said the crisis showed the dangers of relying on one currency.

  107. A New Way Forward

    Nationalize. Reorganize. Decentralize. wants you to organize a protest on April 11th to express your frustration and disapproval with how our elected officials have handled the economic crisis.

  108. Budget watchdog predicts 8.5% drop in GDP

    The Canadian Press

    March 25, 2009 at 4:33 PM EDT

    OTTAWA — Canada’s budget watchdog says the federal government is likely to fall about $9-billion further into the hole over the next two years than the budget projected in January.

    Parliamentary budget officer Kevin Page told a Commons committee Wednesday that the economy has deteriorated so much since the January budget that any stimulus from increased government spending will have been swamped by lower growth.

    Mr. Page says Ottawa will record a deficit of about $38-billion this fiscal year and $35-billion in 2010-11, about $9-billion more over the two years than Ottawa projected.

    As well, he says 385,000 jobs will vanish in the first half of this year.

  109. Who are the contemporary marxist economics scholars that I should be reading?

    Chris Dillow

    Yes, inflation will fall

    Yesterday’s rise in inflation (pdf) has led several people to claim that our problem is inflation, not deflation. I disagree. Insofar as we can be sure of anything in economic forecasting, inflation will fall. I say so for three reasons.

    1) A big chunk of inflation is the legacy of last spring’s rise in utility bills…

    2) Some of the stubbornness of inflation reflects a rise in import prices as a result of sterling’s fall in the autumn…

    3) As I’ve been saying for some time in my day job, the first effect of recession can be to raise inflation by reducing firms’ willingness to cut prices…

  110. It’s kind of funny how pervasive the idea of thinking about inflation as rising prices is. Especially since, what it means to explain something is to explain its causes, that can’t possibly count as an explanation – just by the mere concept of what an explanation is.

  111. Your assertion that money supply = inflation has yet to be adequately justified.

    Not all economists are of the Austrian School, and the Austrian School isn’t necessarily correct.

  112. I didn’t say money supply is inflation. What I said was, inflation=increasing prices is not an explanation. It’s just a description. Since it doesn’t even attempt to describe the causes, it doesn’t count as an explication of the happening.

    It’s like saying the reason why the frog is green is because it exhibits light at some frequency. Sure, its true – but it doesn’t begin to answer the question.

  113. So inflation is the same thing as rising prices?

    Apparently, the causes are a separate area of discussion.

  114. Tristan, saying that an increase in money supply at a level greater than the increase in the size of a given economy is not an explanation either. It is simply stating the same type of tautological assertion but this time from the other side of the lenses.

    In any case, you also have to admit that the concept of the money supply is a very abstract one and that no-one can measure it accurately (we have a great variety of measurements but all have their limitations and flaws) or control it entirely (particularly if anyone writing an IOU has the power to increase the money supply). As a corollary to this, central banks can act on the money supply but do not control it.

    Finally, as I tried to explain earlier, whether the chicken or the egg came first is not always important. In any complex system, positive or negative feedbacks can sustain a phenomenon regardless of the initial cause. There are probably a great number of causes to inflation and some of them might come as side-effects of other economic processes.

  115. Actually, saying inflation is caused by the difference in the rates of the increase of the money supply and the increased size of the real economy DOES count as an explanation, because it’s a description of an event which might be “behind” the rise of prices. That’s why it’s a possible explanation.

    That does not mean it’s the correct explanation, or that it’s “actually” the cause of inflation. But, at least it has the right form for an explanation.

    Lots of other things have the correct “form” for an explanation. You could say “God”, or “because elephants have flat feet” – these all have the correct form for an explanation of inflation. Strictly speaking, everything has the correct form EXCEPT just describing what inflation is, because everything other than that explication is a possible reason “behind” it which might account for it.

    You say “whether the chicken or the egg came first is not always important”. You can say this if you want, and in a certain sense its true, but not in the sense of what we’re asking for when we’re asking for explanations. Now, you might say you don’t want an explanation for inflation, you want an explanation about how to avoid it, or control it – that is a potentially completely other matter. You might not give a hoot what causes it. That kind of willed ignorance would be entirely appropriate to our age.

  116. “you also have to admit that the concept of the money supply is a very abstract one and that no-one can measure it accurately ”

    Alright, so, “abstract” has a dual meaning. On the one hand, it can mean “that which you can’t grasp, can’t get a handle on, can’t understand”, on the other hand, abstracting is what we do to understand any situation – you can’t understand anything in its absolute particularity, without some abstraction, some generalization, you can’t make any claims at all.

    So, taking into account the inner tension in the notion of ‘abstraction’, we can ask is the notion of a money supply ‘abstract’? Intuitively, it does not sound very abstract. The money supply is just the supply of money. To say it is abstract is like saying the supply of potatoes is abstract. Money is just like any other commodity, so why is its ‘supply’ more abstract than the supply of any other commodity.

    If the price of any other commodity goes up, we say immediately “supply and demand”. But, because of some strange inculcation, we are prevented from saying the same obvious truth when it comes to the supply and demand for money.

  117. “Actually, saying inflation is caused by the difference in the rates of the increase of the money supply and the increased size of the real economy DOES count as an explanation, because it’s a description of an event which might be “behind” the rise of prices. That’s why it’s a possible explanation.”

    The problem I see with this explanation is that it does not provide us with a mechanism but solely a formula which states that inflation is due to changes in the ratio between the money supply and the size of the economy. In other word, its a macroeconomic definition of inflation while increased price = inflation is a microeconomic definition. Either way, no mechanism has been identified. Now you can argue that inflation is caused by government, via central banks, are causing inflation through their action on the money supply (which I believe is true although I also believe that it is only one factor among many)… but it is the action of the government (e.g. printing money or legislating bank activities) not the money supply itself which cause inflation. I believe we can agree on this very basic point.

    “You say “whether the chicken or the egg came first is not always important”. You can say this if you want, and in a certain sense its true, but not in the sense of what we’re asking for when we’re asking for explanations. Now, you might say you don’t want an explanation for inflation, you want an explanation about how to avoid it, or control it – that is a potentially completely other matter. You might not give a hoot what causes it. That kind of willed ignorance would be entirely appropriate to our age.”

    My chicken and egg comment reflect the discussion we had about the spiraling wage theory. Sorry for the confusion; I was not trying to imply that the causes of inflation do not matter. Although, when thinking about it, I am sure a lot of central banks actions on the economy are taken in the absence of knowledge about root causes… the economy is, after all, a very complex system on which we only have a small window through certain indicators.

    “Alright, so, “abstract” has a dual meaning. On the one hand, it can mean “that which you can’t grasp, can’t get a handle on, can’t understand”, on the other hand, abstracting is what we do to understand any situation – you can’t understand anything in its absolute particularity, without some abstraction, some generalization, you can’t make any claims at all.”

    In case it was not clear, I was using the word abstract in the first sense: “that which you can’t grasp, can’t get a handle on, can’t understand”. As such, you’ll probably also understand that I do not agree with your point of view that the money supply is not abstract. The very fact that no-one can measure accurately the money supply and that our different estimates (M0, M1, M2…) are so immensely different in scale is, I believe, a good witness to the complexity of the concept. Money is a problematic concept here because it takes many forms, to be relevant to our discussion it has to be much more than printed bills.

    That being said, the concept of supply in itself is also very abstract and is almost impossible to calculate. Supply and demand are abstractions (to use the second meaning of the term) to help us understand larger issues but these are very difficult to apply to real world situations.

  118. Ya, you’re right. Obviously prices, in capitalism, in the real world, have no relation to supply and demand.

  119. One rhetorical point: sarcasm is almost never convincing. It may amuse people who already agree with you, but it is quite unlikely to make those who disagree re-think their positions.

  120. I know you are joking Tristan but that is not what I was trying to express at all. What I was trying to say is that supply and demand are ad-hoc explanations. Supply and demands are generally inferred from looking at product quantities and price. While theoretically prices are set through the interaction of supply and demand, in practice our understanding of demand and supply are determined by our (often incomplete) observations of price and quantities.

    That being said, we should probably talk about money quantity rather than money supply in most cases.

  121. Supply and demand are ad-hoc explanations? Ideas determined after the fact?

    So, if I want to know why the price of oil is going up, and I know that the supply has been reduced but demand has stayed constant, this is just an “ad hoc” way of me understanding it?

    Do you not believe in real relations at all?

  122. “That being said, we should probably talk about money quantity rather than money supply in most cases.”

    Why? Who cares how much of something there is if there is no supply of it? Supply is a flow, quantity is just a bare fact. There might be a large quantity of oil, but if there is no supply of it, the price will go up.

    This would seem to have a real effect on the price of money. If there is a lot of money in the economy, but people are not willing to spend it – how is this different from say, suppliers of some commodity possessing a lot of it but refusing to supply it at the current price?

    And isn’t that exactly what the toxic assets are? Assets that the banks refuse to supply at the market rate? And that obviously affects their price! If they would just clear them, the market would instantly set prices (low ones) and swallow them up, so we could get on with things.

  123. Tristan, about your first question, how can you know that supply was reduced and that demand stayed constant? What you can know is that the quantity of oil on the market is lower (i.e. because of a major well closure), that some producers decided to act on supply (i.e. OPEC) and that you are not aware of anything having an impact on demand and are therefore led to believe that it remains constant.

    The shape of the demand and supply functions however remain uncertain and this very fact prevents you from knowing exactly how high the price of oil will go. Your theoretical tools allows you to guess, probably very accurately, that the price of oil will go up but not much more than that.

    About the quantity of money vs. money supply debate, I think it probably suffice to say that our usual measurements (M0, M1, M2…) reflect quantity and not supply. Conventionally however we still call this money supply.

  124. ” If there is a lot of money in the economy, but people are not willing to spend it”

    I believe this affects more the velocity of money than the money supply but I am not too sure about this. One thing for sure, if people were doing that you’ll get deflation ;-)

  125. “how can you know that supply was reduced and that demand stayed constant? What you can know is that the quantity of oil on the market is lower”

    Why do you care what you can know? I’m talking about the objective relations, not whether I can know about how those relations are playing out.

    If you make epistemology the standard for ontology, you’ll have no ontology at all. And yet, every true statement supposes a true thing behind it, so to make the existence of the true thing dependent on you being able to know its truth, turns all truth into a mere subjective feeling.

  126. I don’t think the money supply, the quantity of money, or the velocity of money can be thought without each other. To say we should talk about one rather than the other two, that would seem like a mistake.

    Just thinking analogously, even though now “supply and demand” have become contentious, we would certainly (naively perhaps), imagine that when both the quantity, supply, and velocity of a commodity is part of the “supply” of that commodity.

  127. Tristan, I think we are complicating the issues needlessly.

    Do you disagree with my assertion that the money supply is not tangible the way prices are?

    Do you disagree with my other point that equating inflation with a change in ratio between the size of a given economy with the size of the money supply is not an explanation as it does not provide an explaining mechanism?

    Finally, I don’t understand your last comment at all and your reference to the “velocity of a commodity” is very puzzling. Could you explain?

  128. Things that are tangible are the least objective, the most contingent, the most random, the least knowable. So for example, if you want to know what you can know, the thing you can know the least is something like your immediate experience, and the thing you can know the most is there are a priori conditions that make your experience possible. In other words, the most real things are the most abstract.

    So ya, of course prices are tangible – but this should be an immediate warning against trying to ground a theory on them. Prices fluctuate randomly – as Marx argued in Capital 3, prices vary around an equilibrium that the necessarily never stabilize on, and the reason you need the labour theory of value is that no where in the money economy do we find the stable value which the ever wild and unstable equilibrium is chasing.

    If you want to “know” anything about the economy, it can’t be some random price fluctuation. It has be something analogous to the a priori conditions for experience at all – that’s the only way it could be lawlike, and not just some random “empirical” universality, i.e. something that has been true up to now but we have no reason for thinking it will be true next time.

  129. “velocity of a commodity”

    MagicTofu, you already used this distinction:

    “believe this affects more the velocity of money than the money supply”

    Money is a commodity like any other. So, if money has a “velocity”, all commodities will have velocities.

    I’m just throwing this out there – but when we say the “supply” of a commodity, don’t we mean some combination of its quantity and velocity?

  130. “Do you disagree with my other point that equating inflation with a change in ratio between the size of a given economy with the size of the money supply is not an explanation as it does not provide an explaining mechanism?”

    Of course I disagree. You misinterpret if you think that the monetary inflation explanation means “equating inflation with a change in ratio…”. What you mean here, presumably, is that people like me are saying “Inflation, and by this I mean the increase in prices, is the same as inflation, and by this I mean monetary inflation”. No, they are not the same – but one is posited as the hidden cause of the other.

    The explanatory mechanism, firstly, is not required, and secondly, is obvious. We don’t give an “explanatory mechanism” when we explain some physical event by some scientific law – we simply say “it is that way because of the law”. However, if you want an explanatory mechanism, it’s perfectly obvious and we’ve already discussed it here – supply and demand. The more money supplied, the lower the price of money.

  131. On your first point about tangibility, I think our positions are not reconcilable. In my opinion, prices are one of the most important window we have to understand how economics works. It allows us to test hypotheses and discover new relationships.

    About the money being a commodity like any other, our position are equally irreconcilable. I don’t see money as a commodity, or at least not a commodity like any other.

    Af for velocity having anything to do with supply, again I think our understanding are in very sharp conflict. We might not be talking about the same thing.

    As for what inflation means, I can agree with you that an expansion in the money supply causes price increase. Most of the definition of inflation that I have read equate inflation with an increase in prices. Other definitions argues that it is an increased in the money supply against the size of an economy. I think both definition are correct but simply reflect different point of views, one from a microeconomic point of view, the other from a macroeconomic point of view… at the end however they are saying exactly the same thing. One says the money supply is inflated, the other says prices are inflated… but when you look at it closely, you realize that it is pretty much the same thing: if prices are inflated, it means that more money is chasing the same amount of goods.

    As I argued earlier, these are definitions and they don’t provide explanation. If you don’t explain why more money is chasing the same amount of goods, you are not explaining inflation, you are merely defining it. It probably does not matter that much at this point considering the gap between our views on the topic.

    If you see a point in continuing this discussion I will continue but we could also simply agree to disagree and move to something else.

  132. If you really feel the need to remain a pre-critical empiricist, feel free. You have most of the 20th century on your side. It’s going to make dismissing Kuhn really easy as well.

    But, if you want to take a philosophical position that didn’t become outdated in 1781, you might want to reconsider.

  133. Does size matter?
    Posted by: | WASHINGTON

    THE conventional wisdom at the moment is that banks are too large, and that the banking system should be regulated such that no bank becomes too big to fail. I’m not sure when this became the conventional wisdom; even as we were all realising that (relatively) small financial institutions could threaten financial systems, the American government was actively encouraging and abetting consolidation. But conventional wisdom it has become. Big banks can’t be allowed to fail, and they know it. They’re difficult to monitor, internally and externally. And they don’t seem to be providing much in the way of scale economies, given the systemic risk they present. So break them up, right?

  134. Tristan, you might be seeking a fight but I’ll abstain this time. Good luck with your attempt to understand and fight inflation.

  135. What do you think a commodity is anyway? How could money not be a commodity? Everything is a commodity.

  136. Why size matters

    Kevin Drum has nicely posed the question of whether it really is important to break up big banks. After all, he argues, even small-ish banks have proven to be too leveraged and interconnected to be permitted to really fail. He argues that maybe it’s the banking industry, rather than individual banks, whose size and reach we need to constrain.

  137. For once, a positive parallel to the 1930s
    By | NEW YORK

    IN THE prelude to the G-20 meeting, many commenters, including this newspaper, worried of a repeat of the London Conference of 1933. Franklin Roosevelt is often accused of wrecking it with his refusal to return to the gold standard. The resulting disarray, it is said, deepened the Depression.

    Yet one could argue that in its failure to return the world to gold, the 1933 conference was a success. Markets greeted Roosevelt’s July bombshell “enthusiastically”, notes economic historian Allan Meltzer. They correctly anticipated “reflation, rising output, and a vigorous policy of domestic expansion.” As Barry Eichengreen has demonstrated, the gold standard was a monetary straitjacket that transmitted deflation between countries; each country’s recovery is highly correlated with when it abandoned gold.

    On this front, I see a parallel (though perhaps a tortured one) with the G20’s decision to boost the IMF’s lending resources from $250 billion to $1 trillion. Of the increase, $500 billion will come through an expanded line of credit with its major members, and $250 billion through the creation of new special drawing rights, or SDRs, the IMF’s unique currency. This latter is essentially the printing of new money. As Dominique Strauss-Kahn, the IMF’s managing director, says, “it’s the beginning of increasing the role of the IMF, not only as a lender of last resort, not only as a forecaster, not only as an advisor in economic policy and its old traditional role, but also in providing liquidity to the world, which is the role finally and in the end, of a financial institution like ours.”

    In other words, it is a step closer to turning the IMF into a world central bank.

  138. World Wad
    What would a new global reserve currency look like?
    By Christopher Beam
    Posted Friday, April 3, 2009, at 3:22 PM ET

    At Wednesday’s G20 summit, Russian President Dmitry Medvedev suggested creating “a new reserve currency” to replace the dollar. In a paper published March 23, Chinese central bank governor Zhou Xiaochuan also proposed a new reserve currency, one “disconnected from individual nations.” Even Treasury Secretary Timothy Geithner has said he’s “open” to the idea. What would a new currency look like?

    Lots of other currencies combined. Medvedev, the Chinese economic minister, and other would-be reformers want to create an accounting unit based on a “basket” of other currencies—a sort of hybrid. Instead of countries holding billions of U.S. dollars in their reserves—which makes them vulnerable if the dollar drops suddenly—they would hold a new unit, composed of, say, the dollar, the pound, and the Euro. The value of each component currency might fluctuate, but if one drops, the others can serve as “hedges.”

  139. Am I going to look like less of an idiot when Bretton Woods 2 collapses? Or is there going to be some reason why despite my predictions coming true, I was still wrong?

  140. Velocity of money
    From Wikipedia, the free encyclopedia

    The velocity of money is the average frequency with which a unit of money is spent in a specific period of time. Velocity associates the amount of economic activity associated with a given money supply. When the period is understood, the velocity may be present as a pure number; otherwise it should be given as a pure number over time. In the equation of exchange, velocity of money is one of the key variables determining inflation.

  141. Swissie fit

    Mar 19th 2009
    From The Economist print edition
    The terrible temptation to depreciate

    IT IS not easy being Swiss. Every other country complains about your bank-secrecy laws. If you live in Zurich, the nice houses by the lake are taken by rich foreigners and you have to put up with something more modest and farther out.

    Worse still, in a crisis, everyone buys your currency, in effect tightening your monetary policy. UBS excepted, Switzerland did not indulge in an Anglo-Saxon-style speculative boom over the past decade. But it is suffering nevertheless. The Swiss National Bank thinks the economy will contract by between 2.5% and 3% this year. Consumer prices are expected to fall by 0.5% in 2009; in other words, the economy is suffering from deflation.

    But now, to recall the movie “Network” (featuring a different UBS), the Swiss are mad as hell and they are not going to take it any more. In February residents of the Zurich canton voted to stop foreigners from having the right to pay tax as a lump sum related to the value of their property, rather than having their income and wealth properly assessed in the same way as Swiss citizens do.

    The bigger move, however, came on March 12th. The national bank vowed to intervene in the currency markets in order to prevent the Swiss franc from appreciating further against the euro. That made the Swiss the first big economy in the crisis to opt for explicit depreciation. The Swiss have tried before to discourage the use of the franc as a haven currency. Back in the 1970s they charged foreigners a fee for having a bank account, in effect imposing a negative interest rate.

  142. Money’s muddled message

    Mar 19th 2009
    From The Economist print edition
    Today’s fattened central-bank balance-sheets evoke fears of inflation. Deflation is the bigger worry

    This is scary stuff to those who swear by Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon.” But the role of the money supply in creating inflation is less obvious than monetarism suggests.

    The quantity theory of money holds that the money supply, multiplied by the rate at which it circulates (called velocity), equals nominal income. Nominal income in turn is the product of real output and prices. But does money supply directly boost nominal income, or does nominal income affect velocity and the demand for money? The mechanism is murky.

    Central banks control the narrowest measure of the money supply, called the monetary base—typically, currency plus the reserves that commercial banks hold with the central bank. But the relationships between the monetary base, broader monetary aggregates and nominal income is highly unstable.

  143. Should we also rethink the hallowed goal of small, predictable inflation? Paul Volcker reckons so. The Wall Street Journal reports on an exchange between Mr Volcker and Donald Kohn, the Federal Reserve’s vice-chairman, over the Fed’s insistence that a 2% inflation rate is appropriate for the American economy in the long run.

    Mr. Volcker, who led the Fed in conquering double-digit inflation in the 1980s, questioned how the Fed can talk about both 2% inflation and price stability. “I don’t get it,” Mr. Volcker said, leading to a lively back-and-forth between the two central-bank heavyweights at a conference Saturday at Vanderbilt University.

    By setting 2% as an inflation objective, the Fed is “telling people in a generation they’re going to be losing half their purchasing power,” Mr. Volcker said.

    Mr. Kohn, who worked as a staffer to Mr. Volcker in the 1980s, replied that aiming at 2% inflation gives the Fed “a little more room…to react to an adverse shock to the economy” because it is easier to get its key short-term interest rate below the inflation rate, the usual remedy for recession. “Your problem is [2%] becomes three becomes four,” Mr. Kohn told Mr. Volcker. But other central banks with a roughly 2% target haven’t had that problem, he said.

  144. The world economy
    A glimmer of hope?

    Apr 23rd 2009
    From The Economist print edition
    The worst thing for the world economy would be to assume the worst is over

    Thanks to massive–and unsustainable–fiscal and monetary transfusions, output will eventually stabilise. But in many ways, darker days lie ahead. Despite the scale of the slump, no conventional recovery is in sight. Growth, when it comes, will be too feeble to stop unemployment rising and idle capacity swelling. And for years most of the world’s economies will depend on their governments.

    Consider what that means. Much of the rich world will see jobless rates that reach double-digits, and then stay there. Deflation–a devastating disease in debt-laden economies–could set in as record economic slack pushes down prices and wages, particularly since headline inflation has already plunged thanks to sinking fuel costs. Public debt will soar because of weak growth, prolonged stimulus spending and the growing costs of cleaning up the financial mess. The OECD’s member countries began the crisis with debt stocks, on average, at 75% of GDP; by 2010 they will reach 100%. One analysis suggests persistent weakness could push the biggest economies’ debt ratios to 140% by 2014. Continuing joblessness, years of weak investment and higher public-debt burdens, in turn, will dent economies’ underlying potential. Although there is no sign that the world economy will return to its trend rate of growth any time soon, it is already clear that this speed limit will be lower than before the crisis hit.

  145. Deflation in America
    The greater of two evils

    May 7th 2009
    From The Economist print edition
    Inflation is bad, but deflation is worse

    MERLE HAZARD, an unusually satirical country and western crooner, has captured monetary confusion better than anyone else. “Inflation or deflation,” he warbles, “tell me if you can: will we become Zimbabwe or will we be Japan?”

    How do you guard against both the deflationary forces of America’s worst recession since the 1930s and the vigorous response of the Federal Reserve, which has in effect cut interest rates to zero and rapidly expanded its balance-sheet? On May 4th Paul Krugman, a Nobel laureate in economics, gave warning that Japan-style deflation loomed, even as Allan Meltzer, an eminent Fed historian, foresaw a repeat of 1970s inflation—both on the same page of the New York Times.

    There is something to both fears. But inflation is distant and containable, while deflation is at hand and pernicious.

  146. Should America fear inflation or deflation?
    By | NEW YORK

    HOW worried should we be about inflation or deflation? If half of the economists worry about deflation and the other half worry about inflation, shouldn’t they cancel each other out and we needn’t worry at all?

    According to our leader this week, deflation is the current and more troubling worry. Modern monetary policy is ill-equipped to deal with it and it signals a very sick economy. But will the extraordinary actions policymakers are taking to fight deflation leave us with rampant inflation in the future? Even if central banks have the tools to fight inflation, will they dare use them and risk shaking us out of what may be an anaemic recovery?

    Scott Sumner doubts it will come to that. He has ten reasons why excessive inflation is not keeping him up nights. Between TIPS yields, commodity prices and consensus forecasts, it does not appear the market anticipates high inflation. The economic forecasts rarely take a strong stand on what inflation will be far into the future (they often just go with the inflation target).

  147. Our own little inflation mini-blog! Quite a useful resource at this stage. Curious to know if Google sends much traffic here Milan?

  148. This is not an especially popular page. Since creation, it has only been viewed 385 times, by 206 different machines.

    Of those, 164 came through Google. 35 came from GMail.

    By comparison, the most popular post from the past year is on non-alcoholic beer. It has been viewed 4,029 times, from 3,587 machines.

    Of those, 3,466 came through Google.

  149. Central banks
    The monetary-policy maze

    Apr 23rd 2009 | WASHINGTON, DC
    From The Economist print edition
    The simple rules by which central banks lived have crumbled. A messier, more political future awaits

    IN THE world that existed before the financial crisis, central bankers were triumphant. They had defeated inflation and tamed the business cycle. And they had developed a powerful intellectual consensus on how to do their job, summarised recently by David Blanchflower, a member of the Bank of England’s monetary policy committee, as “one tool, one target”. The tool was the short-term interest rate, the target was price stability.

    This minimalist formula fitted the laissez-faire temper of the times. A growing array of financial markets could price risk and allocate credit efficiently. Central bankers had merely to calibrate their interest-rate tools and all other markets would automatically adjust. Central banks still cared about financial stability and full employment, but could argue these were best served by stabilising prices—without, if you please, interference from politicians.

    Central banks may not just have to rethink their tools. They may also have to rethink their goals. Governments and central banks had come to agree that they should focus only on achieving low and stable inflation. The Fed by law must emphasise employment and inflation equally, but in practice it, too, targets inflation. This consensus was forged in central banks’ research departments and universities, and its adoption paralleled a rise by academics to the top ranks of central banks: among the leading lights are not only Ben Bernanke, chairman of the Fed, and Mr King but also Lucas Papademos, vice-president of the ECB, and Lars Svensson, a deputy governor of Sweden’s Riksbank.

  150. Brazen Tunneling and Inflation

    What does any of this have to do with inflation? If you want to the Fed ever to be able to tighten, you need a healthy enough financial sector – i.e., given what we now know about policymakers’ preferences, banks in the “too big to fail” category better not be close to failing.

  151. 17:09 GMT +00:00
    A few words on “hyperinflation”

    Posted by: | WASHINGTON

    At any rate, Mr Blodget’s fears seem to be misplaced. He refers to rapid growth in the supply of money as reason for concern, and indeed, in normal times it would be. But these are not normal times, and most of the increase is due to a rise in bank reserves which are simply sitting there, doing not very much. If the money isn’t doing anything, then it’s not inflationary. But the money might start doing something eventually, mightn’t it? Certainly, but that would indicate that banks were finding lots of profitable loan opportunities, which would in turn indicate that recovery was well underway, which would in turn indicate that the Federal Reserve would have scope to rein in supply.

    The bottom line is this—markets aren’t perfect, but they’re not oblivious either. If there were even the remote possibility of sustained, very high inflation, the 30-year interest rate would be soaring, and it is definitely not soaring. It’s up off the extremely low levels sustained during the depths of the financial crisis, but that’s not saying much.

  152. Like many long-standing economic relationships, “wage stickiness” is being tested by the savagery of the recession. Ordinarily, when unemployment shoots up wages do not tend to fall: they simply grow more slowly. Why the price of labour responds less to demand than that of other commodities is a bit of a puzzle. In the 1990s Truman Bewley of Yale University interviewed hundreds of employers and discovered that, faced with a slump in demand, they would rather lay some workers off than cut the pay or hours of everybody. The sackings devastated those directly affected, but broad cuts to pay and hours hurt everybody’s morale. “The main drawback of pay cuts is that they fill the air with disappointment and an impression of breach of promise, which dissolve the glue holding the organisation together,” he wrote in 1997.

  153. ONE consequence of the worst economic crisis in 80 years is that dismal scientists everywhere have had to gen up on the Depression in order to contribute to the policy debate. Most have by now picked up the stylised fact that a rigid adherence to the gold standard made a bad slump worse. Countries that cut the link to gold quickly and allowed their currencies to fluctuate endured shallower recessions and recovered more quickly than those that stuck with it. Freed from the need to uphold a gold-price parity, these countries could lower interest rates and so stimulate spending. By devaluing against gold, their money also became cheaper against currencies that kept their gold parity, giving domestic producers a cost advantage over many foreign firms.

  154. Decoding money-supply data
    Narrow success, broad concerns

    Sep 3rd 2009
    From The Economist print edition
    Unorthodox monetary policies have mixed effects on the money supply

    “INFLATION is always and everywhere a monetary phenomenon,” said Milton Friedman. So when central banks started pursuing unorthodox monetary policies, including the purchase by central banks of government debt, to boost their economies, some commentators started muttering about the possibility of a descent into Weimar-style hyperinflation. Others took a different view. They looked at the repeated attempts by the Bank of Japan to pull its economy out of a deflationary mindset and concluded that other central banks might prove equally impotent.

    A look at money-supply data in leading economies provides both sides with ammunition. There has been fairly rapid growth in the most narrow measures of money, those closest to cash. Ideally, there would be a “multiplier” effect as growth in narrow money led to increased lending. But broader measures of money are more sluggish. Growth in these measures and growth in credit are what count for economic activity.

    In America, for example, M1, which includes banknotes, current accounts and overnight deposits, grew by 17.4% in the 12 months to July, while M2, which also includes savings accounts, rose by just 8.1% over the same period. The difference between the two was even starker over the past three months. In the euro zone the growth rate of M1 rose to 12.2% in the year to July from 9.4% in June. Yet the growth rate of bank lending to non-financial corporations fell to 1.6% in July, and loans to households were flat year-on-year.

    None of this sounds like Zimbabwe. For those kind of eye-popping figures, you have to delve into the minutiae of the data. For example, Britain used to publish a number for M0, a very narrow measure of money supply consisting of notes and coins in circulation plus reserves held by commercial banks at the central bank. Between July 2008 and July 2009, M0 more than doubled. But this is not really a sign that the printing presses have been working overtime. Virtually all the jump is due to an increase in bank reserves, following the decision by the Bank of England in March to implement a policy of creating money to purchase assets, or “quantitative easing” (QE). In the three months to July reserves held at the central bank rose at an annualised rate of 1,968%.

  155. Hyperinflation in Zimbabwe wasn’t all it appeared to be
    September 22, 2009 9:58 AM

    First Zimbabwe formally abandoned their currency, then received assistance from The IMF, and now now we’re seeing inflation in that nation easing to an acceptable rate of 0.04% per month. So it’s fair to ask, is hyperinflation in Zimbabwe is a thing of the past?

    No, it wasn’t imprudent monetary policy, nor was it unwise fiscal policy, it was something more base and easily understood.

    Hyperinflation in Zimbabwe was mostly caused by corruption, government officials and insiders enriching themselves at the cost of others.

  156. Sorry, gold bugs, but the facts just don’t add up

    Boyd Erman
    Last updated on Tuesday, Sep. 22, 2009 07:35AM EDT

    It seems a shame to trash the party just when it’s finally becoming fun to be a gold bug.

    Bullion is flirting with $1,000 (U.S.) an ounce and hoarding the metal is no longer just a pursuit for Eric Sprott and assorted conspiracy theorists with caches of canned food. Even the guy behind the bar at dinner the other night was long gold and happy to expound on why.

    It’s all about inflation they say, and gold as a store of value. Except for one thing: The facts don’t back it. (Unless you’re an American buying bullion because you’re worried about the inexorable decline of your dollar. In that case, you should be worried.)

    Almost every real measure of actual inflation pressure – as opposed to the inflation paranoia inherent in the gold price – shows little in the pipeline. One of the best long-term indicators of inflation expectations for the next decade, the price premium built into inflation-protected U.S. Treasury bonds, is indicating that prices will rise 1.75 per cent a year.

    Yet the bullion pushers forge ahead. After 20 years of being wrong when gold was stuck around $350 an ounce through the 1980s and 1990s, they are nothing if not persistent.

  157. “Modern Central Bankers are well armed to wage war against inflation; high interest rates effectively slows the circulation of money, extinguishing inflation as the United States did by raising the Fed Funds rate to a record 20% in 1981.” (from metafilter)

    This is pretty funny. Anyone who thinks the US economy could stand that kind of interest rate hike must have failed to make the connection between interest rates, over-valued property, and foreclosure rates.

  158. What do you mean by ‘being able to stand’ an interest rate? Raising rates that high would probably deepen the ongoing recession, but it’s not something that it would be impossible for the state to do if inflation got out of hand.

    There is frequently a short-term trade-off between unemployment and inflation.

  159. Don’t you know that the recession was set off (basically) when it was discovered that complex financial derivatives made up of risky loans were based on the assumption that the foreclosure rate would not rise above 10%? Now it’s predicted the rate might be closer to 50%. If interest rates rise, it will go a lot higher than that.

    A huge amount of effort has been spent trying to make these “toxic assets” be worth something. Raising interest rates drastically would make them all worthless overnight.

    It’s more than just property, however. The whole economy is based on debt. Getting people into debt, and keeping them slaving away to pay it off. If interest rates rise, many more people will declare bankruptcy. If enough of this happens at once, if enough people get angry enough at the current system at the same time – that’s how the revolution starts. And that isn’t good for anybody.

  160. The global economy is complex. As such, the explanation of the credit crunch that economists generally believe in ten or twenty years may be very different from what they think now. Indeed, the 10-year theory and the 20-year theory may differ significantly.

    Obviously, structured mortgage products were involved. Other factors included low interest rates, trade balance issues, banks being too big and poorly regulated, insurance-like instruments not being treated as such, ratings agencies having conflicts of interest, and (quite possibly) the spike in the oil and commodity prices.

    All I am saying is that financial crises aren’t the kind of thing that can usually be fully explained by one hypothesis. They are too complex and chaotic for that, like political revolutions.

    Personally, I would be quite happy with much higher interest rates. I could then beat inflation just keeping money in ING savings accounts, and not have to look for yield in things like GICs or index tracking funds.

  161. I didn’t mean to imply that the crisis was started by only one thing. What I’m saying is that the over-valuation of property is a serious problem, one which will probably be solved by inflation (so nominal prices don’t have to go down). The central banks have to be careful about raising interest rates before property values have stabilized with the rest of the economy because it does no good to put a huge amount of borrowers underwater – this just creates a glut in the market and pushes prices down even farther.

    The Canadian government is still trying to prop up housing prices, right now through the renovation tax credit (this is a regressive program, but of all the ways they could prop up housing prices it is probably the best option).

  162. Just look at all the explanations of the causes of the Great Depression and the ways in which they go in and out of vogue. You see similar historiographical patterns when it comes to things like the origins of WWI and whether Hitler could have been successfully appeased.

    Pushing borrowers ‘underwater’ certainly has some undesirable consequences.

    What I wonder about most now is whether there is any way to make sure that most of the costs of all this bailing out end up being borne by those who behaved irresponsibly to begin with. The answer is ‘probably not’ since governments hesitate to target specific groups that might retaliate, and are always happy to pass along costs to innocent members of future generations.

  163. While naked short-selling was the weapon used to bring down both Bear and Lehman, it would be preposterous to argue that the practice caused the financial crisis. The most serious problems in this economy were the result of other, broader classes of financial misdeed: corruption of the ratings agencies, the use of smoke-and-mirrors like derivatives, an epidemic tulipomania called the housing boom and the overall decline of American industry, which pushed Wall Street to synthesize growth where none existed.”

  164. “Although America’s fiscal mess will last for years, it is not acute. Inflation will not soar suddenly. With neither the euro nor the yuan yet ready to usurp it, the dollar will not quickly lose its reserve-currency status. The lesson of the past year is that it is still a currency to flee to, not from. None of this absolves American policymakers from hard choices. But a dangerous collapse in the greenback is unlikely.”

  165. America’s public debt
    Tomorrow’s burden

    Oct 22nd 2009 | WASHINGTON, DC
    From The Economist print edition
    America’s debt crisis will be chronic, not acute

    But inflation is harder to create than you think. It would require the economy to grow so rapidly that unemployment plummeted and businesses returned to full capacity. Even the most optimistic forecasts say that is years away. Inflation could rise more quickly if the public came to expect higher inflation. But Donald Kohn, vice-chairman of the Fed, recently predicted that both inflation and inflation expectations were more likely to drop than to rise.

  166. “A gold standard clearly protects the interest of creditors since it ties the value of money to a scarce resource. A government cannot create new gold. But the law of volatility applies. If you fix one part of the economic system, trouble has to show up elsewhere. When countries on the gold standard suffered a shock they had to let the real economy, rather than their currencies, take the strain.

    The Depression showed the problem with this approach. In theory businesses and workers should quickly adjust to a deflationary shock, by slashing their prices and wages. In practice they were slow to adjust and the results were bankruptcies and mass unemployment. Democratically elected governments proved reluctant to stand by and let this happen. By going off the gold standard and allowing their currencies to fluctuate, they protected the interests of the bulk of their populations at the expense of creditors.

    Dropping gold did work. A recent paper*= by Barry Eichengreen of the University of California, Berkeley, and Douglas Irwin of Dartmouth College found that countries that abandoned gold not only had shorter recessions but were also less inclined to raise tariffs than those countries that retained the link.

    Given the Depression it is hard to see governments ever wanting to tie their countries to a gold standard again. But the result is that foreign creditors have a right to be more suspicious of debtor countries. Even if they do not resort to outright default, they can always achieve partial default through currency depreciation.”

  167. Economics focus
    Systems failure

    Nov 26th 2009
    From The Economist print edition
    Two new papers explore how to regulate the financial system as a whole

    BANKS mimic other banks. They expose themselves to similar risks by making the same sorts of loans. Each bank’s appetite for lending rises and falls in sync. What is safe for one institution becomes dangerous if they all do the same, which is often how financial trouble starts. The scope for nasty spillovers is increased by direct linkages. Banks lend to each other as well as to customers, so one firm’s failure can quickly cause others to fall over, too.

    Because of these connections, rules to ensure the soundness of each bank are not enough to keep the banking system safe. Hence the calls for “macroprudential” regulation to prevent failures of the financial system as a whole. Although there is wide agreement that macroprudential policy is needed to limit systemic risk, there has been very little detail about how it might work. Two new reports help fill this gap. One is a discussion paper from the Bank of England, which sketches out the elements of a macroprudential regime and identifies what needs to be decided before it is put into practice*. The other paper, by the Warwick Commission, a group of academics and experts on finance from around the world, advocates specific reforms**.

    The first step is to decide an objective for macroprudential policy. A broad aim is to keep the financial system working well at all times. The bank’s report suggests a more precise goal: to limit the chance of bank failure to its “social optimum”. Tempering the boom-bust credit cycle and taking some air out of asset-price bubbles may be necessary to meet these aims, but both reports agree that should not be the main purpose of regulation. Making finance safer is ambitious enough.

  168. “Gold prices (GC-FT1,119.90-6.30-0.56%) hit a four-week low of $1,109.10 (U.S.) an ounce Friday, reversing initial gains as upbeat U.S. economic data bolstered the dollar and sent bullion investors racing to cut positions.”

    “a source at the Russian state repository Gokhran said on Friday it was likely to sell 30 tonnes of gold to the country’s central bank next week. Traders say central bank interest in gold as a reserve asset is growing.”

  169. “Canada’s debt-to-income ratio had climbed to a new high of 142% as of the end of June, in part because consumers are rushing to take advantage of low borrowing costs to buy up assets. Nowhere is this more evident than in the housing market, where the average price of an existing home is up 21% from a year ago while sales volume has climbed 41%.

    But in taking on new debt, consumers may be failing to account for higher interest rates in the foreseeable future, leaving households “increasingly vulnerable” to any economic shocks, the central bank indicated.”

  170. Inflation within central bank comfort zone

    Tavia Grant

    Globe and Mail Update Published on Wednesday, Jan. 20, 2010 7:10AM EST Last updated on Wednesday, Jan. 20, 2010 10:17AM EST

    Inflation in Canada remains tame, giving the country’s central bank little reason to budge on its commitment to keep interest rates low until mid-year.

    Consumer prices rose a less-than-expected 1.3 per cent in December from a year earlier after a 1-per-cent pace in November. Less volatile core prices, which the Bank of Canada monitors as a guide to future inflationary trends, stayed at 1.5 per cent, Statistics Canada said Wednesday.

  171. “The move to fiat money (paper not backed by gold) created the huge expansion in global money supply that the pessimists had predicted. According to Mr Duncan, under Bretton Woods global foreign-exchange reserves grew by 55% between 1949 and 1969. They then grew by almost 2,000% between 1969 and 2000. This extra money was used to push up asset, rather than consumer, prices.

    It is no mystery why developed countries abandoned fixed rates. By anchoring the currency, governments forced the real economy to absorb shocks. This implied wage cuts or higher unemployment, all for the benefit of creditors. But in a democracy the votes of debtors tend to overwhelm the interests of creditors.

  172. The Fed Has a Shiny New Inflation-Fighting Weapon and Isn’t Afraid To Use It

    By Paul Smalera
    Posted Tuesday, February 9, 2010 – 3:20am

    The Federal Reserve is undertaking a “fraught exercise,” says the Washington Post, by withdrawing trillions of dollars of economic support while trying not to damage the economy those dollars have been propping up in the process. “Fed Chairman Ben S. Bernanke is betting that if the central bank is open about how it will phase out its expansive initiatives to prop up the economy, it will provide faith that the Fed will not allow inflation to flare down the road,” according to the story. A key new tool going forward is the ability of the Fed to pay interest on money that the banks “park” at the institution: “The Fed has been able to pay interest on reserves only since the power was included as a little-noticed part of the law that created the $700 billion federal bailout, known as the Troubled Assets Relief Program, in October 2008. But now, Fed officials view this authority as a key element in the central bank’s tool kit for managing the economy.” The Obama administration hopes that, “If inflation became a threat, the Fed could raise the interest rate, giving banks an incentive to park even more cash rather than lending it.” The administration also hopes that by being so open about the strategy going forward, it can avoid shocking the economy at a still very fragile moment in time.

  173. “The initial firecracker came on February 12th, with an analysis of the lessons of the financial crisis for macroeconomic policy, led by Olivier Blanchard, the IMF’s chief economist. The report called for several bold innovations. The most radical of these is that central banks should raise their inflation targets—perhaps to 4% from the standard 2% or so.

    Yet the biggest problem with Mr Blanchard’s idea is that central banks are not starting from scratch. They have spent two decades convincing the public that they are committed to price stability and, rightly or wrongly, have equated this with inflation of around 2%. The stabilisation of expectations has been remarkably successful—and it allowed policymakers to cut rates as fiercely as they did. But it cannot be taken for granted, especially when some rich countries’ budget deficits are so vast. It would disappear fast if central bankers suddenly said that inflation of 4% was just fine after all. How could they convince investors that the change was intended to make policy more flexible, rather than to inflate away the state’s debts? With their credibility undermined, the next crisis would be much harder to fight. As an intellectual exercise, Mr Blanchard’s idea is intriguing. As a policy proposal, it is reckless. “

  174. A Closer Look At Inflation

    As the chart shows, at the height of the financial panic, the Fed injected a large amount of liquidity into the system. But, as the chart also shows, that number is also now decreasing at a substantial rate.

    The bottom line is clear: inflation is not an issue right now.

  175. Economics focus
    The inflation solution
    The merits of inflation as a solution to the rich world’s problems are easily overstated

    Mar 11th 2010 | From The Economist print edition

    IT HAS long been considered a scourge, an obstacle to investment and a tax on the thrifty. It seems strange, then, that inflation is now touted as a solution to the rich world’s economic troubles. At first sight the case seems compelling. If central banks had a higher target for inflation, that would allow for bigger cuts in real interest rates in a recession. Faster inflation makes it easier to restore cost-competitiveness in depressed industries and regions. And it would help reduce the private and public debt burdens that weigh on the rich world’s economies. In practice, however, allowing prices to rise more quickly has costs as well as benefits.

    The orthodoxy on inflation is certainly shifting. A recent IMF paper* co-authored by the fund’s chief economist suggests that very low inflation may do more harm than good. Empirical research is far clearer about the harmful effects on output once inflation is in double digits. So a 4% inflation target might be better than a goal of 2% as it would allow for monetary policy to respond more aggressively to economic “shocks”. If the expected inflation rate rose by a notch or two, wages and interest rates would shift up to match it. The higher rates required in normal times would create the space for bigger cuts during slumps.

  176. “Mr King argues that one reason for the failure is that central banks did not take seriously enough the distortions to prices and wages stemming from the emerging world. When the Fed cuts rates, the central banks of emerging countries tend to follow suit since they have tied their currencies to the dollar. This boosted demand in the emerging world and thus commodity prices. It also pushed up foreign exchange reserves in the countries concerned, which were duly reinvested in western government bonds; the resulting low yields helped fuel the housing bubble.

    As Mr King points out, inflation can go up and down for non-monetary reasons (such as a productivity improvement stemming from China) and a monetary response may neither be necessary or desirable. All the Western authorities have achieved is to create asset bubbles and excessive accumulation of debts. Most independent commentators (but not yet all central bankers) seem to accept now that central banks should take asset markets into account when setting interest rates.

    But inflation may also drop down the list of policy priorities. Governments may now have to focus either on eliminating deficits or on boosting growth (and the latter will of course help the former). Or indeed on preserving living standards in the face of the west’s declining economic predominance.”

  177. Economics focus
    A winding path to inflation
    Even if governments could create inflation, they may not want to

    Jun 3rd 2010

    IN THE short run inflation is an economic phenomenon. In the long run it is a political one. This week The Economist asked a group of leading economists whether they reckoned inflation or deflation was the greater threat; this was our inaugural question in “Economics by invitation”, an online forum of more than 50 eminent economists. The rough consensus was that in the near term, as Western economies struggle to recover, the bigger worry there is deflation. But as the time horizon lengthened, more experts cited inflation, because it seems the most plausible exit strategy for governments trying to deal with crushing debts. “Deflation is not a lasting threat,” wrote Arminio Fraga, a former president of Brazil’s central bank. “The more interesting question is whether they can manage to keep inflation down over time under the regime of fiscal irresponsibility now prevailing almost everywhere.”

    Creating more inflation is harder than it sounds—even if rich-world governments were tempted to try, as a solution to their fiscal problems. It requires aggregate demand to return to, and exceed, potential output. Measuring the output gap (the shortfall of actual demand compared with potential GDP) is notoriously tricky. The OECD reckons for its members it will be about 4% this year, down from about 5% last year. It has revised that estimate down since November in recognition of better-than-expected growth, especially in America. Still, the revised gap is larger than at any time since at least 1970. America’s gap was larger in 1982, but inflation today is much lower. Indeed, the OECD estimates that in each of the G7 countries, inflation will be less than 2% through to the end of next year. The process could be hurried up if inflation expectations rise. But with underlying inflation below central banks’ targets in many countries, and dropping, expectations could move down instead.

  178. “Backing paper currencies with gold at a fixed rate, as its countries had done before the war, seemed to offer Europe a return to prosperity. By the mid-1920s Britain was back on the gold standard at its pre-war parity, despite inflation and rapid growth in the money supply in the interim. A new German currency was pegged to gold at its pre-war rate. France joined later but at a lower rate; high inflation had made the pre-war rate unrealistic.

    This set the stage for a period of wide trade imbalances and for the Depression that followed. America’s export prowess meant that by the end of the 1920s it held almost two-fifths of the world’s gold reserves. A cheaper currency gave French exports a lift and France built up its gold holdings rapidly. The deficit countries in this constellation were Britain and Germany. Britain’s exports struggled against an overvalued currency. The economy was further held back by the high interest rates needed to retain scarce gold reserves. Britain, like Germany, found cutting wages to make exports competitive was made harder by trade unions.

    When recession came it was made worse by the strictures of the gold standard. An “unexceptional downturn then was converted into the Great Depression by the actions of central banks and governments,” say the authors. Central banks kept interest rates high to counter fears that their currencies would be devalued and to attract gold deposits. A banking crisis that had spread from Austria and Germany finally forced Britain to abandon its gold peg in September 1931. The following month the Federal Reserve raised interest rates sharply to show America’s commitment to gold. Indeed, America and France shrank their money supplies by more than was strictly necessary by liquidating gold-backed currencies from their reserves. That only increased the deflationary pressures at home and abroad.”

  179. Given that you’re investing to spend 40 or 50 years from now, what is the best strategy for protecting against inflation? Stock ownership provides excellent inflation protection. It is impossible to say whether $1 million will have any significant value 40 years from now, but a one percent ownership interest in General Electric, for example, would make you a rich person now and should make you a rich person in 40 years. Blind investment in stock indices, or “public equities”, were a great road to wealth from World War II right through 2000. This kind of investment is problematic right now due to two factors. First, everyone else has figured out how great stocks are and bid up the prices to the point where returns are unlikely ever to reach the heights of the past. Second, corporate managers are taking an ever-greater percentage of corporate profits out as personal salary, either with bonuses or stock options.

  180. So the Fed is turning to a policy known as “quantitative easing.” Essentially, the Fed is using its license to print money. (Technically, it doesn’t have a license, but it knows someone who does.) On Nov. 3, the markets expect the Fed to announce that it has decided to create somewhere between $500 billion and $1.2 trillion that it will then spend to help goose economic growth. Rather than buying space in office parks or forklifts, though, the Fed—which purchases only government-backed assets, like bonds—will probably pick up long-term Treasury debt. The strategy has been termed “QE2” because it is the second time the Fed has used this arcane monetary policy tool. The Fed makes money ex nihilo, pulling it out of thin air rather than taking it from its coffers. Then, it pushes the money into the economy by buying up assets from banks.

    The problem is that the strategy is indirect. The Fed cannot just buy up goods and services, so it is trying to convince investors to invest and banks to lend more, creating more economic activity. And many prominent economists, ranging from the wonks at the libertarian Cato Institute to liberal Nobel-winner Joe Stiglitz, are skeptical. Even Fed Chairman Ben Bernanke sounds uncertain. “Monetary policymaking in an era of low inflation has not proved to be entirely straightforward,” he sighed in a speech earlier this month.

    QE largely succeeded the first time the Fed used it, Bernanke says. From late 2008 through 2009, the Fed created about $1.7 trillion and used the funds to purchase debt in housing-finance firms like Fannie Mae, Treasury bonds, and a whole lot of mortgage-backed securities—tripling the size of its balance sheet to $2.3 trillion. That helped clean some bad assets from the banks’ books and reassured spooked markets. But in 2009, the government was trading cash for mortgage-related assets nobody wanted. In 2010, it wants to try to trade cash for an asset that is essentially as safe as cash. If QE2 is to work, it will have to work differently than QE did—and probably won’t work as well.

  181. Investors at Monday’s auction paid $105.50 for a $100 five-year bond with a 0.5 percent coupon. All things being equal, the investors overpaid—hence the negative yield. But that just means that they expect inflation to be positive for the next five years. Crunching the numbers, annual inflation for the next five years needs to be somewhere north of about 1.55 percent for the investors to break even. Any more inflation than that, and they make money.

    So why do so many investors think that inflation might head upward? Because next week, the Federal Reserve is expected to announce a new round of quantitative easing—printing money, and possibly stoking inflation. Of course, not everyone believes the Fed’s policy will have that effect. In that case, these negative-yield bonds will be true to their name.

  182. But let’s entertain the possibility: Say the United States decided to peg the dollar to the price of gold. What would happen?

    First, the government would have to decide what the price of gold is. That’s a lot harder than it sounds. In theory, there’s an ideal rate at which to peg currency against gold. We just don’t know what it is. Gold is notoriously volatile—its price has doubled over the last two years. If the Federal Reserve were to simply fix the dollar to the price of gold on a given day, and demand for gold changed drastically, it would wreak havoc on the economy. If the Fed pegs the rate too high, for example, people would want to trade their dollars for gold, forcing the Fed to raise interest rates in order to make dollars more attractive. Even if the Fed were to pick the rate correctly, it would still have to make adjustments based on the economies of the United States’ trading partners. If the dollar is growing in value, but another country’s currency is decreasing in value, yet both currencies are pegged to gold, something has to give—either one of the currencies has to inflate or deflate, or the exchange rate has to be adjusted.

    Once the Fed set the price of gold, it would then have to keep the currency fixed, leaving the economy subject to the vicissitudes of the gold index. If the price of gold goes up, the United States would have to raise interest rates, which could lead to tighter credit. Which might be OK, except that gold is a primary indicator of economic uncertainty: When the economy is bad, the price of gold goes up. So the Fed would be tightening credit just when people need it most. The result: a deflationary spiral that drives the economy even deeper into recession.

  183. US inflation moves closer to zero

    Inflation in the US slowed further in October, with “core” inflation – which excludes volatile food and fuel prices – up only 0.6% on a year ago.

    It is the lowest year-on-year increase on record, with core prices remaining unchanged for three months running.

    The core inflation measure is closely watched by the Federal Reserve as a measure of price momentum.

    The all-items consumer prices index (CPI) rose 0.2% in October, bringing its year-on-year rise to 1.2%.

    The higher overall CPI rate was mainly due to petrol prices, which are excluded from the core measure, and which jumped 4.6% from September, according to the US Department for Labor.

  184. Inflated fears

    Inflation in China is a problem for the country but not for the world

    IN JANUARY 1992 Deng Xiaoping, then China’s paramount leader, arrived in Shenzhen for the start of his month-long “Southern tour”. He extolled the success of the coastal special economic zones, lambasted his reactionary opponents in Beijing and ushered in a torrid economic boom that forced inflation above 25%.

    China has not suffered from double-digit inflation since. But the episode did lasting harm to the credibility of its macroeconomic stewardship. According to Jonathan Anderson of UBS, many outsiders see “the monetary authorities as unreconstructed relics of the socialist planning era without much grasp of market tools.” They fear that the economy is ‘“beyond control”, prone to speculative excesses followed by clumsy crackdowns.

    China is once again stirring their fears. In the year to November consumer prices rose by 5.1%, the fastest increase for 28 months and a striking turnaround from the deflation of the year before (see chart). Higher prices are now percolating through the economy: last month Starbucks bumped up the price of a whipped-cream Frappuccino by about 6%.

    Betting big on bonds

    An economist advises investors to expect deflation

    THE debt crisis has presented investors with an extremely awkward dilemma. Debt ratios, relative to GDP, are so high that it seems unlikely that most developed economies can grow their way out of the mess. That leaves the unappealing options of default, Japanese-style stagnation or rapid inflation to erode the real value of the debt burden.

    Selecting the right portfolio to take advantage of these different scenarios is very difficult. An inflationary outcome would encourage investors to buy commodities and sell Treasury bonds; a deflationary outcome would suggest the reverse. Equities might perform better than government bonds in the event of inflation, but might still deliver negative real returns as they did for much of the 1970s. Cash may provide security but offers virtually nothing in yield.

    In a new book “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation”*, Gary Shilling, an economist, argues for the deflationary outcome. He expects American GDP growth to average only 2% over the next decade as the economy struggles to deal with the debt burden.

  185. Economics focus
    Learning to like inflation
    Higher inflation could help to rebalance China’s economy

    Feb 17th 2011 | from the print edition

    CHINA’S inflation rate has become one of the world’s most closely watched numbers. This week’s release showed that inflation rose to 4.9% in January, up from 1.5% a year earlier. The increase was smaller than expected, but has not quelled fears that as inflation creeps up the government will need to slam on the economic brakes. Some economists, however, believe that China should welcome higher inflation as a more effective way to rebalance its economy than a currency appreciation.

    The recent surge in Chinese inflation has been driven mainly by food prices, but non-food inflation has also risen to 2.6%, its highest rate since the series began in 2001. Wages are increasing at a faster rate. For many years China’s large pool of surplus labour held average pay rises below the rate of productivity growth. But as fewer young people enter the workforce, wages are now rising faster than productivity. Arthur Kroeber of Dragonomics, a Beijing-based research firm, argues that if higher inflation reflects faster wage growth, this will help China, not hurt it.

  186. Worthless cash

    SIR – You suggested that the supply of Somali shillings is fairly fixed despite a number of forgeries (“Hard to kill”, March 31st). In fact, it was the introduction of forged notes that ultimately removed the incentive to increase the supply of shillings in circulation.

    The 1,000 shillings note exchanged for roughly $0.13 when General Muhammad Aideed employed a printing firm to reproduce the note in 1996. As the number of notes in circulation grew, the exchange value fell to just $0.03, which is the cost of producing an additional note. Since the exchange value equals the cost of production, forgers can no longer profit by increasing the supply. Today, the Somali shilling is a commodity money. Its supply is governed by the cost of ink and paper required to produce a note.

    William Luther
    Fairfax, Virginia

  187. Inflation may help determine how fast labour markets recover from recession

    The change in the real wage is simply the change in the nominal wage—the one listed in the contract or on the payslip—adjusted for inflation. Since the end of 2007, nominal wages in Britain have risen by about 1.6% a year on average. But annual inflation of more than 3% over that period generated a cumulative decline in real wages of 7.8%. British workers became cheaper relative to the prices of goods and services (see chart 2).

    Moderately high British inflation may therefore have been the difference between a jobless recovery and a job-filled one. Studies suggest that nominal wages are generally “sticky”: it is hard to make existing workers take a pay cut in hard times, due to contract requirements, issues of worker morale, and other complications. Moderate inflation rates can restore wage flexibility by eroding the real purchasing power of a given wage rate. Messrs Martin and Rowthorn reckon that lower real wages encouraged firms to use more labour and less capital in production. That caused productivity to fall but propped up employment.

  188. Much criticism of the West’s central bankers rests on the myth that they are wholly responsible for rock-bottom rates. In fact, they seek the highest rates the economy can bear, but no higher. When the economy is at full strength, they want a “neutral” (or natural) rate that keeps inflation steady, neither stimulating the economy nor slowing it. When the economy is overheating, they want a rate above neutral. And when the economy is weak, they want one below it. The neutral rate (r* in economists’ algebra) thus provides a vital reference point for their policy. As such, it exercises considerable influence over central bankers. But they, importantly, exercise precious little influence over it.

    According to economic theory, the neutral rate reconciles the eagerness to invest and the willingness to save when the economy is in full bloom. As such, it reflects the productivity of capital, the promise of technology and the prudence of households, none of which are variables chosen by monetary officials. The neutral rate cannot be observed directly. But Mr Williams and a Fed colleague reckon it has fallen persistently: r-star (as he calls it) is close to zero, or about two percentage points lower than it was in 2004.

    Such a rate would be only about two percentage points lower than Mr Williams’s estimate of the neutral rate. Raising the inflation target to 4%, say, would allow real interest rates to drop about four percentage points below neutral if necessary. (This is not the only reform idea. Another is targeting the trajectory of nominal GDP, which reflects both economic growth and price inflation; that might result in higher inflation when growth was weak and low inflation when growth was strong.)

    But even if a 4% target is desirable, would it be feasible? The Fed has struggled to reach its current target quickly or consistently. What makes anyone think it could hit a higher one? One answer is that a higher target would free the central bank from a “timidity trap”, as Paul Krugman of the New York Times calls it. In such a trap the central bank sets its goals too low, and paradoxically falls short of them. A credible central bank might cut rates to zero and promise 2% inflation. If it is believed, inflation expectations will rise and the anticipated real cost of borrowing will fall to minus 2%. But if the economy actually needs a real rate of minus 4% to revive, spending will remain too weak, economic slack will persist and inflation will ebb, falling under target. Conversely, if the central bank promises 4% inflation, its pledges will be both believed and fulfilled.

  189. The implication? For a central bank to keep unemployment below the natural rate, it must keep outdoing itself, delivering inflation surprise after inflation surprise. Hence, Friedman reasoned, Keynesians were wrong to pin a low rate of unemployment to a given, high rate of inflation. To sustain unemployment even a little below the natural rate, inflation would need to accelerate year in, year out. Friedman’s and Phelps’s natural rate became known as the “non-accelerating inflation rate of unemployment” (NAIRU).

    No society could tolerate endlessly rising, or falling, inflation. Phillips had observed a correlation in the data, but it was not one that policymakers could exploit in the long run. “There is always a temporary trade-off between inflation and unemployment,” Friedman said. “There is no permanent trade-off.” Nearly 50 years on, that remains the premise on which rich-world central banks operate. When officials talk about the Phillips curve, they mean Friedman’s temporary trade-off. In the long run, they believe, unemployment will come to rest at the natural rate.

    Inflation has behaved strangely over the past decade. The recession that followed the financial crisis of 2007-08 sent American unemployment soaring to 10%. But underlying inflation fell below 1% only briefly—nothing like the fall that models predicted. Because the only way economists can estimate the natural rate is by watching how inflation and unemployment move in reality, they assumed that the natural rate had risen (an estimate in 2013 by Robert Gordon, of Northwestern University, put it at 6.5%). Yet as labour markets have tightened—unemployment was 4.3% in July—inflation has remained quiescent. Estimates of the natural rate have been revised back down.

    Such volatility in estimates of the natural rate limits its usefulness to policymakers. Some argue that the wrong data are being used, because the unemployment rate excludes those who have stopped looking for work. Others say that the short-term Phillips curve has flattened as inflation expectations have become ever more firmly anchored. The question is: how long will they remain so? So long as low unemployment fails to generate enough inflation, central banks will face pressure to keep applying stimulus. Their officials worry that if inflation suddenly surges, they might lose their hard-won credibility and end up back in 1980, having to create a recession to get inflation back down again.

    This recent experience has led some to doubt the very existence of the natural rate of unemployment. But to reject the natural rate entirely, you would need to believe one of two things. Either central banks cannot influence the rate of unemployment even in the short term, or they can peg unemployment as low as they like—zero, even—without sparking inflation. Neither claim is credible. The natural rate of unemployment surely exists. Whether it is knowable is another matter.

  190. If it happens on a sufficiently large scale, the practice of tweaking quality in lieu of price could play havoc with essential economic data. Statistical agencies do their best to account for changing product quality, but if adjustments are unexpectedly common or subtle then muted inflation figures could easily be concealing a more turbulent economic picture. Central banks watching for big swings in inflation or wage growth as a sign of trouble could be reacting to figures that bear far less relation to business conditions than they used to.

    What’s more, the substitution of quality for price as firms’ main way of responding to changing market conditions weakens the case for keeping inflation low and stable. Inflation makes relative prices less informative, economists reckon, making it harder to decide what to buy and how to spend. Rather than clarity, low inflation has brought a different sort of confusion: one of shrinking chocolate bars and lost holidays.

  191. Shortfalls in inflation, combined with very low interest rates, are causing another rethink today. In 2020 the Federal Reserve will report on a review of its targets and tools. The ecb is searching for new ways to fight low inflation in the euro area. Meanwhile economists are increasingly willing to question the dictum set out by Milton Friedman in 1963 that inflation is a monetary phenomenon. A decade of below-target inflation suggests that “what was previously treated as axiomatic is in fact false,” according to Larry Summers and Anna Stansbury of Harvard University. “Central banks cannot always set inflation rates through monetary policy.”

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