How can so many economists be wrong-headed on inflation?

G. R. Steele

21 January 2011

A member of the Bank of England’s Monetary Policy Committee believes that inflation has been driven ‘by higher food and energy costs’; and the head of the European Central Bank fears that ‘global commodity prices’ will put short-term upward pressure on inflation. Similar judgments could be cited from a majority of policy-makers and economic pundits.

Such commentaries are founded upon the cost-push inflation thesis which derives from Keynesian economics. Keynes had advised that ‘an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment’; but that notion ought to have been thoroughly discredited by the experience of stagflation in the 1970s. The co-existence of high unemployment and escalating inflation together with the impotency of prices and incomes constraints were then a vindication of Milton Friedman’s prescient warnings.

The alternative demand-pull thesis warns that inflation follows if ‘too much government paper chases too few goods’. Such a description applies in varying degree in the UK, USA and across Europe. Although UK initiatives on ‘fiscal consolidation’ are right-minded, by recent, current and prospective levels of state borrowing the ratio (to GDP) of UK national debt will continue to rise. The implication is that demand-pull inflation is inevitable. Within that process, rising energy costs, commodity prices and changing currency values are but the symptoms of a monetary process.

So how can so many economists be wrong-headed? The simple explanation is that macroeconomic forecasts are based upon Keynesian models of national income determination. No other construct purports to serve that purpose. Although the ‘services’ which such models provide have all the characteristics of snake oil, this is no impediment to the economist mountebanks who continue to enjoy their comfortable living, whether as commentators or policy advisors.

Tags: Bank of England, G. R. Steele, inflation, Keynesianism, Monetary Policy

Submitted by Philip on Fri, 21/01/2011 - 18:41.

Just as bad is the Bank blaming the rise in inflation on the rise in particular prices over a sustained period of time. The Bank is supposed to target the average price level (measured by cpi). At any tme, some prices will go up and others down. If, on average, they are going up too high then the Bank should have been taking appropriate action. A one-off surprise is one thing - that can lead to a once-and-for-all rise in prices (which is not the same as inflation) but the above-target price rises have been going on for some time now.

Submitted by Tom on Sat, 22/01/2011 - 14:26.

--"the symptoms of a monetary process."-- Whilst I agree that government debt and printing of money can have dire inflationary consequences. I disagree with the assertion that it the cause for the current above target rates of inflation. Largely, it is prices of commodities that are driving up the inflation indices. Consumer goods and durables are mostly falling in price. You've failed to acknowledge the money multiplier, that Milton Friedman also heavily emphasised. Whilst banks are not lending (BBC said this week that mortgage lending was at a 9 year low) and hoarding reserves the monetary expansion is simply not feeding through. I worry that if/when it does then we will have chronic inflation. But, for now, I think it is wrong to attribute inflation to this. A good point made, but perhaps a premature one.

Submitted by Jonathan on Mon, 24/01/2011 - 01:40.

The is an additional point to add about the current rate of inflation. It has been pushed up over the last year by the two increases in VAT, the second increase of which has just taken effect and which will not cease to affect the figures until January 2012. In the short and medium term the VAT increase will depress demand, hence pushing back the nascent economic recovery and acting as a counterweight to increased consumer spending and retailers profit-taking. The excess of labour supply over demand will continue to keep wage demands in check. Commodity prices, in particular that of crude oil are also a key determinant of the latest numbers. Pressure needs to be exerted on oil producers to increase production and supply to reduce these recovery threatening price rises. Inflation is still at relatively modest levels compared to the long-term historic trends and averages; it is only slightly higher than very recent performance, that of the last decade or so, but it does not compare to the inflation highs when interest rates were still set by politicians under Margaret Thatcher, John Major, Harold Wilson, or Jim Callaghan. Recent surveys also suggest that banks may not be making the necessary finance available to small and medium sized enterprises, thus further holding back a key driver for the recovery. The Bank of England's constitutional responsibility will rightly never allow it to lose sight of the risks posed by inflation. It has an equal duty to ensure it does not snub out the nascent recovery before it happens and in so doing repeat the mistakes from the Thatcherite era and ignore the extensive damage to the economy caused by long term unemployment and prolonged social conflict. The Bank of England needs to hold its nerve for some time to come on interest rates.

Submitted by Philip on Mon, 24/01/2011 - 11:06.

Interesting points from Tom and Jonathan, though I disagree with Jonathan. We have been talking about "one-off" factors for some time now and I think we need to be asking ourselves whether other issues are responsbible for the weak growth (one of which is the increase in commodity prices, of course). The mistake of the 1960s and 1970s was to, in general, try to deal with slow growth by expanding monetary policy - we did not immediately get to 27% inflation but that is where that approach led us. The severe disinflation of the Thatcher period was necessary and the fact that the markets did not believe it would happen contributed significantly to the pain in terms of unemployment (real wages were rising rapidly in the recession because of the unanticipated fall in inflation). The danger is to go back down that route where inflation expectations rise and become embedded. Reducing inflation from (say) 8% back to 2% in three years time may be a lot more painful and prolong the agony of the current slowdown.

Submitted by Whig on Mon, 24/01/2011 - 15:34.

I think we need a little more terminological precision. Surely 'inflation' is a decrease in the purchasing power of money 'inflation is always and everywhere a monetary phenomenon'. Given that - under the present system - the government manipulates the money supply both directly (via control of interest rates and money supply) and indirectly (via the fractional reserve system) government must be held responsible for inflation. This must be held distinct from 'price rises (or falls)' which are a consequence of a change in the value of a particular good and service according to variations in subjectively determined supply and demand. Being a good, of course, money is subject to fluctuations in supply - but again, because government distorts price signals so much a proper price mechanism for money is impossible under the present system. This is, of course, at the root of our economic problems. Price signals are a necessary part of any economy, inflation is an unpleasant consequence of government manipulation (although, of course, the price signals of many parts of the economy are heavily distorted by other forms of government interventions). The consequence, it seems to me, of government intervention is that we cannot actually tell whether we are experiencing price rises or some sort of inflation (or even deflation in some areas) resultant from changes in the money supply.

Submitted by Janis on Mon, 24/01/2011 - 20:34.

The statement “an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment” is self-contradictory. Because before the increase in the quantity of money price of labor was zero; after injection of newly counterfeited money previously idle labor now is paid at certain price. Keynes might have not meant the price of labor in the statement but the price of goods and services. And again Keynes' statement can't be valid because the price of marginal good before the increase in the quantity of money previously equaled to zero, after the increase it has certain price purchased by means of newly injected money. There can be no changes of aggregate price level only as long as the purchase by means of inflationary money is performed at the expense of those who have not received the money yet. When the fiat money reaches further fields of economy, money is distributed among more and more late receivers, only than changes in purchasing power of money becomes obvious. Till that moment inflationary money served as an indirect tax benefiting early receivers at the expense of late receivers. In the first phase it is not seen therefore it is tolerated. At the second phase it can be tolerated if change in the price of money (its purchasing power) is minimal because distributed among many market participants. It proves Keynes understood the economy. But Keynes did not consider possibility that the late receivers of inflationary money shall spend it the same as early receivers, creating bubble (surging prices) in a particular market segment.

Submitted by Jonathan on Tue, 25/01/2011 - 02:19.

Phillip You are correct to identify the big deflationary contraction in the early years of Thatcher. Equally damaging was the political quest for the elixir of the "feelgood factor"; the short term economic stimulus, usually through tax cuts for electoral gain. This repeatedly led to the inflation, overheating and subsequent downturns, which alongside the deep recessions became known in popular parlance as "boom and bust". Check the inflation numbers, the sixties were pretty benign in respect of inflation. Major's record on inflation was much better than Thatcher's, arguably due to the huge budget deficit and the need for a fiscal straightjacket in the early 1990s, after the last big recession. The other key differences between now and the 1970s economy are the related absence of major industries employing thousands of workers and the radical changes in the balance of power in collective wage bargaining, as well as external downward forces exerting pressure on wage demands from developing countries including China and India. These mean that Keynes' views on the downward pressure of unemployment on inflation will hold true during the current recovery. Whig is correct, the short term price rises, particularly in oil are affecting the published inflation numbers. Action needs to be taken to reverse the recent steep increase in crude oil prices, but not yet at least to increase interest rates. Sudden oil price spikes were a common feature of the 1970s, 2007/8 and could be again in the future. Before interest rate rises, the Bank of England could start to reverse the Quantitative Easing process, if it believes inflation is becoming problematic, especially if QE is proven as being, at least in part, the cause.

Submitted by Austrian Smith on Wed, 26/01/2011 - 10:11.

MV=PT the quantity theory of money explains the current situation as the velocity of money has collapsed. If you look at M4 it is falling very sharply as the banks start to rebuild their reserves, albeit with payment of bonuses along the way. Anyone looking at the recent money supply figures would have expected the contraction in Q4. The external factors leading to the current rise in inflation will dissipate. However, we then enter the debt deleveraging deflation vortex explained by Irving Fisher in 1933. We will enter the liquidity trap soon enough and the Bank will be under further pressure to do QEII. Unfortunately, conventional policy will compound matters as low nominal rates become deflationary. Slow and gradual increase in rates is needed not for inflation, but to allow the efficient use of resources. Raising interest rates to a real positive rate might be construed to be liquidationist, but it will lead to stronger long term growth.

Submitted by Jonathan Harris on Wed, 26/01/2011 - 18:30.

Would we still say that the Bank of England still needs to raise interest rates after yesterday's UK GDP number?

Submitted by Whig on Wed, 26/01/2011 - 19:34.

I'd say that the Bank of England needs to be abolished altogether and a system of free banking introduced!

Submitted by Terrence von Holstein on Wed, 26/01/2011 - 19:44.

They have to much to lose if they admit this, imagine you are one of them, living with a good wage and high bonuses. And an army of staff at your disposal, and you suddenly said to the government that we should just let the market decide, and then they would lose everything. The prestige, the money, the staff. Would you do it?

Submitted by Whig on Thu, 27/01/2011 - 10:57.

That merely demonstrates the vested interests inherent in the status quo, to paraphrase a famous satire.

Submitted by Quentin Langley on Thu, 10/02/2011 - 11:49.

Price rises caused by an imbalance in supply and demand for particular goods and services can't cause inflation - which is a monetary phenomenon - but it is possible that they can cause a rise in a price index which purports to measure inflation. It is important to bear in mind the distinction between the two. RPI, CPI, etc. are only approximate measures of inflation. The narrower the basket the more it can be impacted by imbalances in one component - say food. The contents of the basket and the weighting of its components are set by politicians, and can be rigged for political purposes.

Submitted by Rodney Atkinson on Thu, 10/02/2011 - 13:25.

Inflation is the debasement of the currency. The political choice of so called "inflation indices" makes the measurement of inflation impossible - just as the distorted and ludicrous brief to the MPC to "take account" of economic activity and the role of the Treasury in the appointment of MPC members makes their control of inflation impossible. The inclusion in RPI/CPI of more and more mass produced,high tech products which are inherently declining in unit cost and less and less the kind of goods and services which are essential (especially to the old) is the most cynical aspect of the political rigging of "inflation". The MPC must become REALLY independent with a long appointment for the Governor who should appoint 2 others t his committee of 3 and do no more than control inflation - measured as THEY decide - through monetary policy. We saw what MPs do when they control their own expenses. We now see the farce of their deciding what "inflation" is and who should "control" it. The State will never control its fiscal deficits until the Bank of England, through tight monetary policy, makes them pay the political price of trying to "inflate their way out of debt" - that price being high interest rates and loss of votes!

Submitted by Dudley Horscroft on Thu, 10/02/2011 - 14:01.

Tom said "Largely, it is prices of commodities that are driving up the inflation indices." True, and therein lies the problem. People accept that inflation is measured by changes in the CPI, etc. It is not. Inflation is measured by the quantity of money. It can be disguised if the 'velocity of circulation' changes, but there is, somewhere a 'normal' volocity of circulation. So if V decreases, and the quantity of money is increased to compensate (to keep MV constant and hence PT constant) when V returns to 'normal' the result will be that PT has increased and so prices will suddenly shoot up (the volume of transactions remaining near constant). Austrian Smith is right in this. To adjust the interest rate to try to contain inflation is foolhardy, especially if 'inflation' is measured by an increase in the CPI. Here in Australia the Reserve Bank decided that inflation was increasing and raised the interest rate, time and time again, even against the advice of the Treasurer. The result was that Australia nearly entered a recession, and then the RBA very quickly reduced interest rates. The Labor Government then quickly threw money around on building school halls, libraries, etc, whether they were needed or not, and also on insulating homes. This kept the change in measured GDP positive, +0.1%! Saved!! Had the RBA not pushed interest rates up mistaking it as a cure for inflation, there would have been no need to waste money to keep GDP positive. And why are economists wrong headed on inflation? Because for their degrees, in addition to microeconomics they are taught macroeconomics, which someone correctly described as "nonsense on stilts". And Keynes and his disciples still reign supreme there.

Submitted by David on Fri, 01/04/2011 - 10:38.

Friedman was talking about averages. The average rate of inflation determined by the average rate of money growth net of average real output growth. Averages are about the longer term. I do not think he suggested that the variance of inflation would be zero if the authorities had a fixed rate of monetary growth. From the perspective of the UK economy there are shocks that hit the economy, energy costs, bad harvests etc. So it is correct for the Bank to mention these in relation to overshooting of its inflation target. If the price of oil doubles tomorrow do we really want the Bank to put interest rates up? Finally depicting the Macroeconomic forecasting model of the Bank as Keynesian is also wide of the mark. see https://www.bankofengland.co.uk/publications/other/beqm/beqmfull.pdf

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