Midnight Thought for Sensible Economics

This is the Burning the Midnight Oil Midnight Thought for tonight … which will be found in Burning the Midnight Oil for Sensible Economics … but not until later tonight (Wednesday).

Posted here because … well, Docudharma blogs the future. Yeah, normally further ahead in the future than three or four hours, but if I didn’t already have this part in the draft diary queue, ready to go, I’d have no idea what I was going to say.

And, yes, the two most important parts of the Midnight Oil are, first, the commentary that follows and, second, the diary roll, so what I’m giving you here is a Bronze Medal … that is, the Midnight Oil clip and snippet from the lyrics. And then, of course, the Midnight Thought which finishes, as they say in Oz, “just outside the medals”.

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Midnight Thought

The time has come to talk about … Inflation.

Oh, c’mon, wake up! You, there in the back, I see you dropping off to sleep. Yeah, its late for some of your, get a cup of coffee or tea or something. This is serious. Start talking about economics and people just {mutter mutter mutter}

Is there any question that we are facing a threat of inflation? No, of course not.

The question is, which inflation are we facing?

Inflation is a price spiral. One side of the spiral goes:

• An increase in the average prices of goods and services,
• Automatically means less purchasing power for given wages and salaries
• So those people might push for higher wages and salaries to make up lost ground
• And if they do, they might succeed
• And then the increase in average pay per hour
• minus the increase in productivity per hour
• is an increase in the cost of production.

The second leg of the spiral goes:

• An increase in the cost of production
• Reduces profits for given prices and effective demand
• So those businesses might try to increase their prices, if they think it won’t just hand business to their competitors
• And if they do try and do succeed, then there is an increase in the average prices of goods and services.

So its a loop, so prices keep going up and up and up … and ongoing increases in the average price level, that’s inflation.

But what makes for an increase in how fast prices are increasing? That is, what make inflation accelerate?

Well, go back to that loop. Its either something pushing up prices of products, or something pushing up costs of production.

What pushes up prices of products? Most businesses would like to increase prices “if they could” … so its competition – general competition with all other businesses for the consumer’s dollar, and specific competition with other producers in the same market – that puts a check on that desire.

Suppose that business Abstract Example Corporation (AEC) is selling all they can make … AEC is at maximum output. Or else their direct competitors are selling all they can make, and can’t take advantage if AEC pushes up prices. Then in the face of customers lining up to buy when they can sell no more … at least some business will come up with the idea of sorting out their customers by who will be willing to cough up more dough.

OK, then if enough businesses are doing that … so its the whole economy coming closer to our national capacity to produce … there is the increase in the average prices of goods and services … and in those conditions, businesses are also fighting for workers, which makes for a stronger kick around of the price increases.

That’s “demand pull” inflation.

But costs of production can go up on their own. The dollar can drop in value, pushing up costs of imported oil and material and components … or the price of some vital input (like oil) can increase. So the price spike does not always come from the demand side … sometimes it comes from the supply side.

That is “cost push” inflation.

OK, sorry about that, but I had to step through it.

Now, when you hear “inflation”, the next thing you hear is “interest rate rise”. And, for one kind of inflation, that makes sense. But only for one kind. So it is real important to sort out which kind of inflation we are facing.

Fighting Demand-Pull Inflation

If the inflation is in large part demand-driven, then it becomes necessary to reduce effective demand, because there is bidding war for the real product of our economy. And the government bears a substantial burden in that respect, since government spending rules the roost … the government is the monopoly provider of fiat currency (cash is Federal Reserve notes, and the Federal Reserve makes sure Treasury checks never bounce), so the government can always outbid any private party bidding with fiat currency.

Of course, in monetary policy, the policy intervention for demand-driven inflation is to accompany the reduction in government spending with increased interest rates to reduce effective demand in the private sector and ration investment projects to those with the most certain or strongest expected returns.

Fighting Cost-Push Inflation

If the inflation is in a large part cost-push then reducing effective demand simply shifts the burden of the reduction in real income from people with wealth to people employed in demand-sensitive labor markets.

What does cost-push inflation really mean, after all? It represents a increase in the real cost of the product of our economy and/or imports in terms of an average hour’s productivity. That is, no matter whether wages or salaries are stable, the amount of stuff to share around has dropped.

If inflation spikes, that reduces the purchasing power of financial wealth. So cost-push inflation makes the wealthy shoulder a larger share of the reduction in national income.

Suppose we suppress that increase in prices, by pushing demand down, even though the economy was not actually overheating to start with. That means we are responding to a fall in our total purchasing power … by putting people out of work and making fewer goods and services, so that the unemployed people and demand-sensitive businesses are the ones who get to carry the can. They don’t have income so they are the ones “not buying the stuff” we can no longer afford, as a nation, to buy.

And the demand-pull monetary policy? Raising interest rates is evidently the wrong policy when faced with inflation that is mostly cost-push inflation.

Increasing interest rates when facing pure cost-push inflation … that is, when there is real spare productive capacity in the economy … reduces real investment in our productive capacity. But what is needed is an increase in real investment (not Wall Street, but machines and factories and such) so we can increase productivity per hour, to recover the lost ground.

After all, a 7% cost push is only a 4% inflationary impulse if it is combined with a 3% productivity gain. And a 4% inflationary impulse is nothing to worry about. But a 7% cost push is a 6% inflationary impulse if we only have a 1% productivity gain.

The other demand side effects of an increase in interest rates is to reduce consumer side effective demand … and that also reduces the incentive to invest in productive capacity.

So a low and stable interest rate is the preferable monetary policy in the face of cost-push inflation.

It should be a companion to a government spending policy that focuses on shifting from government consumption spending to government investment spending that is complementary to private sector productivity.

Which Kind of Inflation Is It?

Oh, what are the driving factors? Well overall CPI inflation is 4.3% compared to a year ago. However, “core” inflation is only 2.5%. “Core inflation” excluded food and fuel, ‘because they are volatile’ … that is, they are more driven by supply side factors, for food, and by international prices, for fuel.

Hmmm … “core” inflation is 2.5%, but overall inflation in terms of the actual cost of living is 4.3%. That sure as hell sounds like Cost-Push inflation to me. Oh, and plus, we are heading into a recession, or are already there (timing will vary slightly from one region of the country to another) … and, yeah, its just silly to think we can have a recession and demand-driven inflation side by side.

And how do “markets” (that is, Wall Street) expect the Federal Reserve to react? From Bloomberg, via Cracks Emerging in the Treasury Market Rally? (Bonddad blog):

Treasuries fell, pushing the 10-year note’s yield to the highest level in more than a month, on speculation accelerating inflation will prompt the Federal Reserve to be less aggressive in cutting borrowing costs.

So at least Wall Street “expects” the Fed to act like we have a mix of a recession and demand-driven inflation, and to try to find a “balance” between cutting interest rates and raising them.

But that’s balance between the right policy to pave the way out of the recession, and the wrong policy to fight cost-push inflation.

Does that make sense? Remember what I said above: for cost-push inflation, reducing effective demand shifts the burden from the wealthy to the workforce. So, no, its not economic policy for the good of the economy … but it sure as hell “makes sense”.