Newsgroups: sci.econ Subject: Inflation and its Causes The following is excerpted from Chapter 8, "The Need for A Rethink by Economists" in the book "The Death of Inflation" by Roger Bootle, a British economist. I know it will give heartburn to many on sci.econ, especially dedicated monetarists. I would hope that others at least give some serious thought to the ideas presented here. William F Hummel ------------------------------------------------------------------------------ The mainstream position on inflation is a mixture of monetarism -- the doctrine that inflation is always caused by increases in the money supply -- and the belief in the so-called natural rate of employment -- that there is only one level of unemployment at which inflation is stable. Both of these positions are riddled with dogma. Neither finds room for historical and institutional factors. Given any economic problem, economists feel an urge to find a single and complete answer that will apply to all circumstances, a sort of grand unifying theory. Monetarism is just such a temptation, and economists have fallen for it. It provides a link with monetary inflations of the past, and with more recent hyperinflations which always involve massive printing of money. There is no doubt that monetary expansion plays a dominant role in hyperinflation. Even so, as Philip Cagan found in a classic study of seven hyperinflations, in all cases there were substantial declines in the demand for money (in real terms) such that the rise in prices substantially exceeded the rise in the money supply. To the monetarist, creeping inflations are really the same as hyperinflations, differing only in degree. But underlying hyperinflation is almost always a huge budget deficit which the government is unwilling or unable to finance in the ordinary way by borrowing in the capital markets. Rather than cut the deficit, the government prints money or borrows it from the central bank, which amounts to the same thing. However, it is striking that mature and developed economies do not normally suffer from such inflation. When they do, there is at the root a distinctly real phenomenon - such as war, a revolution, or a sharp political change. In virtually all cases of moderate inflation in the west, the literal printing of money or government borrowing from the central bank has played a minor role. When expansion of the money supply is involved in the moderate, post-war inflation, it is due to the commercial banks lending to the private sector, and the businesses and consumers who seek to borrow money from them. And if governments and central banks are ultimately to be held responsible for this inflation, it must be from their encouragement of the lending behavior of the banks by failing to set interest rates high enough -- presumably for fear of the consequences of unemployment and lost votes. Traditional monetary theory teaches that the money supply can be thought of as an exogenous act of policy. Thus if you observe a strong link between money and income (or prices), the causation inevitably run from money to income and not the other way around. But in a modern monetary system 'the money supply' is not under the direct control of the authorities. It is determined by the lending criteria of the banks, the demand for credit in the economy as a whole, and the attractions of bank credit compared to other forms of finance. Even if you observe a strong correlation between changes in the money supply and changes in national income or the price level, this does not necessarily tell you much. You do not know whether a change in the money supply is the cause of events in the economy or a response to them. For professional economists, monetarism's simplicity and certainty enables them to believe in a fundamental law or rule of economics, which thereby lends status to the subject. It saves them from the messy world of historical analysis and institutional studies. Today, long after monetarism has passed its high-water mark, it lingers on as the conventional wisdom, partly because a whole generation of economists, journalists, bank officials, and market practitioners have been trained in Friedmanite economics. And partly because so many economists have poured so much intellectual capital into it that they cannot bear to write it off. There is no philosophers's stone that gives all the answers about inflation. However there is one all-embracing framework that has some appeal: Inflation is caused by the struggle between different groups within society over their share of national income. Classic monetary inflation fits into this framework. Governments caused inflation when they tried to secure more of the national income than they are willing or able to finance openly through taxation. In an inflation driven by private credit creation, borrowers lay claim to more resources than are currently available without other in society giving up some of their claims. The sort of inflation we have experienced in the post-war period reflects the upsurge of producer power that led to battles between producer groups for shares of the cake in which monetary factors were secondary. In the largely agricultural society of previous eras, the power of producers to affect the general price level was limited. Small units of production and poor communication made collusive behavior difficult. And when circumstances demanded that prices and wages should fall, they fell almost as easily as they rose on other occasions. Industrialization changed all this. The price of industrial output was something to be decided by the producers. Mass production technology limited the number of firms that could viably operate in an industry. The conditions of mass production favored mass organization of labor into unions, mirroring the cartelization of the employers. The tension between services and manufacturing sectors played a major role in the tendency toward rising prices. The attempt by both labor and capital employed in manufacturing to bag all the benefits of increased productivity was resisted by other groups, and the real income gains spread throughout society. Inflation will still be caused when aggregate demand runs at too high a level relative the aggregate supply. But there is no unique link between the money supply and aggregate demand or inflation. And across wide variations in the rate of unemployment there will be no systematic relation between the level of demand the rate of inflation. At present, the change in the general price level is being driven by two opposing forces. On the one hand, there is the continuing process of cost and price rises produced by the struggle for income shares, inherited from the past. On the other hand, there are the cost and price reductions originating from technological advances, the organizational revolution within companies, the development of new producers world-wide, and the intensification of the competitive climate. This is an unequal struggle. The former is dissipating while the latter is burgeoning. It now appears the problem of perpetual inflation is yesterday's story. - mason clark wrote: > What is the relation between interest rates and inflation? It is true that > excessive interest rates can crash the economy and cause deflation, but > that is an inadequate answer to the question. Hi, If you see that excessive interest rates are deflationary, is it hard to believe that inadequate interest rates are inflationary? Opposites are opposite? -- ,,,,,,, _______________ooo___(_O O_)___ooo_______________ (_) jim blair (jeblair@facstaff.wisc.edu) For a good time call http://www.geocities.com/capitolhill/4834 Inflation and Interest Rates pjmcgurk@gate.net wrote: > Why is the response to [price-inflation to increase interest rates ? Doesn't > that *raise* the cost of capital, and consequently the costs of goods > produced using capital ? Hi, I think this is best explained in terms of the money supply (when the economy is based on fiat money, as today). Expansion of the money supply faster than the economy can expand goods and services is inflationary. I see the situation like this: if interest rates are "high" fewer people want to borrow money and more people put money into the bank as saving. This reduces the money in circulation and is deflationary. If interest rates are "low", more people want to borrow money and fewer want to keep money in the bank. If more people want to take money from the bank than want to put money into the bank, where does the bank get the extra money to loan out? It can't just loan out the reserves in the vault, it must borrow from the Federal Reserve. This increases the money supply. If this happens faster than the output of goods and services (maybe because of worker shortages? Or the failure of productivity to keep pace?), the result will be higher prices. Unfortunately money supply (M) is not the whole story, there is also the rate at which the money exchanges: V in the classic monetary equation MV = PT For more details, see: http://www.geocities.com/capitolhill/4834/cpi.htm -- ,,,,,,, _______________ooo___(_O O_)___ooo_______________ (_) jim blair (jeblair@facstaff.wisc.edu) For a good time call http://www.geocities.com/capitolhill/4834 On 8 Aug 2000 22:28:13 GMT, William F Hummel says in: http://wfhummel.cnchost.com/inflation.html (of cheap credit) When economic growth is achieved, it should normally occur without significant price inflation up to the point of nearly full employment. Thereafter the effects of cheap credit will lead to higher prices, .... Hi, So we agree that interest rates which are "too low" result in "higher prices" (aka inflation), and especially if unemployment is "nearly full" (as it is today). So the difference is not in what happens, but in the way we explain it. Hummel: I think the deflationary scenario is much more complex than this. As interest rates rise, producer costs also rise for those who depend on borrowed money. That can lead to higher prices, not lower prices, particularly on those goods and services that consumers cannot easily do without. A small increase in interest rates and prices is going to have very little effect on consumer spending or saving. Thus a slow Greenspan-style increase in rates can actually result in higher prices. Rates must rise sharply to have the opposite effect. Consumer's will then be inclined (or forced) to put off spending, which puts a damper on business income. Business will also have a problem rolling over short term debt due to higher cost of borrowing. Both of these act to cause tough times for business, and probably a lowering of prices due to a recessionary environment. > >If interest rates are low, more people want to borrow money and fewer want to >keep money in the bank. If more people want to take money from the bank than >want to put money into the bank, where does the bank get the extra money to >loan out? It can't just loan out the reserves in the vault, it must borrow >from the Federal Reserve. This increases the money supply. If this happens >faster than the output of goods and services (maybe because of worker >shortages? Or the failure of productivity to keep pace?), the result will be >higher prices. > I agree with this except for two points. It is the demand for credit that causes the money supply to increase, not the Fed lending or supplying money to banks. The Fed only reacts to the demand. Also most of the additional reserves will come from the Fed monetizing the debt, i.e. buying Treasury securities from the public. Only a small fraction of reserves come from borrowing at the Fed's discount window. William F Hummel AND: On 10 Aug 2000 01:31:33 GMT, djr80@aol.com2 (DJR80) wrote: >>I think the deflationary scenario is much more complex than this. >>As interest rates rise, producer costs also rise for those who >>depend on borrowed money. That can lead to higher prices, not >>lower prices djr80: >I thought most firms were net savers/lenders, as witnessed by their growth via >retained earnings and the fact that they pay dividends, so if anything higher >interest rates should encourage them to save more by cutting other costs. Yes, cutting fat is appropriate. However after a firm has cut into muscle far enough, its survival may be as questionable as its ability to restructure its debt. > >> It is the demand for >>credit that causes the money supply to increase, not the Fed >>lending or supplying money to banks. The Fed only reacts to the >>demand. > >So when the Fed lowers the discount rate or fed funds rate, it has no effect on >the quantity demanded? The amount of credit created ultimately depends on the decision of banks to lend, the willingness of customers to borrow at the going rate, and their preference for bank loans versus non-bank loans. The Fed has no choice but to supply whatever reserves are required by the banking system. If the Fed failed to do so, it would lose control of the Fed funds rate. As a minimum the Fed must provide overdraft facilities (loans) to any solvent bank that lacks sufficient reserves to cover its liabilities. Otherwise the banking system itself would be imperiled. The Fed attempts to control the demand for credit through its selection and control of the Fed funds rate. That is rough control at best, and typically involves a time lag of many months. The banking system must clear every day. William F Hummel AND Dan in Philly: > >So when the Fed lowers the discount rate or fed funds rate, it has >no effect on the quantity demanded?