Date: Sat, 3 Dec 94 17:05:45 CST From: "jim blair" To: alt-politics-economics@cs.utexas.edu,skosh@atlanta.com,mel@xmission.com Cc: BCc: Subject: INFLATION, INTEREST RATES, & DUMB QUESTIONS INFLATION, INTEREST RATES, & DUMB QUESTIONS Judy Cohen (cohen@prof.slh.wisc.edu) asked what causes inflation. This generated a variety of responses including the suggestion that it is a dumb question since the answer is in a textbook. I taught college for 15 years, and often heard the view that there is no such thing as a "dumb question". But I don't believe it. There are. But this was a GOOD question, and here is why: If everyone knows the answer and they agree, then it was a dumb question. But if everyone knows the answer and they have DIFFERENT answers, it was a good question. There are different theories about what inflation is and thus different ideas about the cause and effect. I will review and criticize some of the ones that were presented in the discussion and end by re-posting my view (aka THE TRUTH). Michael Coburn suggested that inflation hurts only the rich, since they have the money that is losing value. This would be true if they kept their money as cash stuffed in the mattress. My experience has been that those who know how to make money (the rich) are better than the average at knowing how to protect their assets from inflation. The economy of Germany did continue to keep up output during the inflation of the 1920's, but this is a "short run" situation. Things keep up until the machines wear out or become obsolete. Since it makes no sense to save in such a situation, there is no money for new capital goods: that is when everyone suffers. Mike Novosel (and others) attribute inflation to a rise in the price of some raw material that is then passed on to the consumers. Petroleum is a good example since it affects so much else through energy and transportation costs. According to monetary theory (MT) this is not inflation since it a rise in the price of energy intensive products relative to other things. In places where gasoline is expensive either because they have no domestic source (Japan) or because they tax it (Europe), the economy adjusts by using less. Mass transit and trains rather than cars and trucks. Local products rather than distant ones. Less packaging, etc. Remember a few years ago when there was talk of an "energy tax"? One of the most interesting responses was from the trucking industry who claimed that such a tax would lead to "unfair competition" from trains since they need so much less fuel to haul the goods the same distance. MEL@xmission.com suggested that the interest on money is a cost that raises prices and contributes to inflation. Thus by raising the discount rate (and thus borrowing rates) the Federal Reserve was adding to rather than combating inflation! (This is a theory that I heard in the late 1970's when interest rates were raised). Strange as this sounds from the MT viewpoint, this idea has often shaped the thinking of "experts". Since there is a connection between interest rates and money supply (see the FEDERAL RESERVE POLICY post below) a government must often print lots of money to keep interest rates low. This resulted in the remark, quoted in the paper a few years ago, from the Russian economist who said (with a straight face) that the problem with the Russian economy is that they didn't have the capacity to print 1000 ruble bills fast enough to keep up with inflation! Federal Reserve Policy Recent postings have questioned the Federal Reserve policy of raising interest rates just when it looks like the economy is recovering and ready to take off, thus keeping it hobbled and causing unemployment, etc. I have seen articles in USA TODAY and local papers with the same theme and the implication that low interest rates are a GOOD THING because they promote borrowing and economic growth. I haven't seen much in the popular press about why interest rates can be too low as well as too high and a balance must be made. Interest rates are like prices in that if "too high" they discourage purchases but if "too low" they don't cover costs. Either too high or to low can cause problems, and the Federal Reserve Board tries to find the correct balance at any given time. Look at it this way: if interest rates are "too low" as they sometimes are, not enough people are depositing enough money INTO the banks to provide the money that other people want to borrow. So where does the bank get the money to load OUT? Well it borrows from the Federal Reserve. And where does the Federal Reserve get the money? They just print it. Remember when there were two different KINDS of bills in circulation? Some said Silver Certificate (there is on deposit $1 worth of silver and this bill can be exchanged for it), and some said Federal Reserve Note (this piece of paper looks like a dollar and the Federal Reserve says it is as good as one). The government creates money routinely through changes in the discount rate and in a more direct manner through the purchasing of US Treasury Bonds by the Federal Reserve. See "Understanding Money" for details. If the supply of money increases at the same rate that the amount of goods and services (GNP) increase, on the average prices are constant (of course some go up and some down but there is no overall pressure either way). Historically this averages out to somewhere between 3% to 5 % per year. Not everyone agrees as to how the Federal Reserve Board ought to set the rate that it charges banks to borrow (discount rate), but one school of thought (monetary theory) says they should monitor the money supply and keep its growth within the above range using the discount rate. The argument that low interest rates are good even when they lead to a rapid expansion of the money supply by printing bills to loan to banks, is just a variation on the idea that the government can make us all rich just by printing lots of money. If I had a million dollars tomorrow, I could live like a millionaire. If everyone had a million dollars tomorrow, prices would rise quickly and the million dollars wouldn't buy much. The expansion of the money supply IS inflation, the general rise in prices which follows is the consequence. This is all complicated these days by credit cards and electronic money transfers which reduce the role of paper bills as the only form of money, but I think the same general principles apply: printing money so the amount expands faster than the goods and services it buys is inflation and will result in a general price rise if done for very long. Printing money is not creating wealth. Date: Mon, 5 Dec 94 14:28:43 CST From: "jim blair" To: alt-politics-economics@cs.utexas.edu,rooster@netcom.com Cc: BCc: Subject: RE: INFLATION, INTEREST RATES, & DUMB QUESTIONS RE: INFLATION, INTEREST RATES & DUMB QUESTIONS In my attempt to be brief, it seems that I was not clear. rooster@netcom.com says that during a period of inflation capital goods can still be purchased from printed money. (I had claimed that while an economy can function in the short run with high inflation, without capital goods things will falter when the machines wear out) What I was trying to say was that with stable currency it makes sense for people to save some of their current income. To put it into a bank where it can be loaned out for others to invest in new capital goods. Or to buy bonds from companies who can use the money to expand or improve or replace old tools. During a period of inflation, the wise move is to spend every paper bill you have as soon as you get it, and to borrow all you can and spend that too. Prices will be higher tomorrow, and paying back a loan will be with cheaper money. Thinking in terms of delayed gratification is not encouraged. The US was approaching that stage in the late 1970's, and many countries have been there. A government can finance projects like the Aswan Dam or the construction of Brasilia from printed money (and they DID!) and that can be called a capital investment and I guess it is. But the multitude of small investments that make a market economy work dry up with inflation. One additional thought: Michael Coburn suggested that inflation hurts only those with money, and implies that the more you have the more it takes from you. He sees inflation as an equalizing factor. I claim that the rich are usually better able to cope with inflation that the population at large, because they are more "finance literate". Consider also: the less money you have the greater percent of it is in cash. A rich person probably doesn't have much more CASH around than a typical middle income one. Their assets are in other forms which are less harmed by inflation. PS no one actually used the phrase "dumb question" but I know what they meant. IN CONCLUSION To summarize, according to monetary theory, an increase in money supply faster than the growth of goods and services IS inflation. It is usually MEASURED by the change in the consumer price index (CPI), determined by the price of a "basket" of commonly bought goods. But CPI is somewhat misleading since different people buy different things and there is often a dispute as to what goods and services should be included. Young people, for example, are more likely to be effected by the price of housing than the elderly, who may own their own house, but who spend more on medicine. And here is a follow up post about a recent "correction" to the CPI There has been much discussion on the net and in the press about whether workers in the US are doing better or worse than in the past. There have been many claims that wages are down since their high point in the 1960's (or 1970's, depending on who is writing). In fact there has been a whole industry created to explain the dire consequence of this. We read of the "pauperization" of America, and the loss of the "middle class", etc. (see "America Doesn't Have Any Class" and "Baseball Players Syndrome" both on my web page for my views on all this) There was also much made of the surge in productivity in the early 1990's. Many economists provided various explanations for it, and extrapolated various consequences that would result from it. For both of these, the wage loss and the productivity gain, I questioned their very existence. See my review of Peddling Prosperity and the Are THINGS getting :-) or :-( sections of my home page, for example. The Vanishing Problem Well, now it looks like economists are "correcting" their data for a Consumer Price Index error and suddenly both of these things have disappeared! See for example USA TODAY Feb 15, Money Section. The same report was also in a recent Wall Street Journal. As an example of the correction, wages for US workers adjusted for changes in the CPI have dropped 13% since 1979 and 2% since 1989. But most economists agree that the CPI overstates inflation since it doesn't change the mix of products and services in the "basket" surveyed, to keep up with changes in consumer purchase patterns. NOTE: when I posted this a few weeks ago, I was corrected: Not "most" but rather *ALL* economists agree that the CPI overstates inflation. It is not just that the mix of goods and services in the "basket" monitored by the Bureau of Labor Statistics has not been updated frequently enough; but that it cannot be. The very fact that some prices change more than others will change buying patterns. Say you have no preference between butter and margarine. When they are the same price per pound, your selection is random. But now butter increases by 20% but margarine stays the same, so you switch to margarine. The CPI registers an increase, but YOUR cost of living is not effected. People "compensate" for price changes to offset their effect. And no one knows how to correct for this. Using an alternate price gauge called the personal consumption deflator, compensation is UP 7.8% since 1979 and UP 4.1% since 1989. Using another gauge which adjusts for inflation in the entire economy (not just consumer goods), compensation is up 12.7% since 1979 and up 5.7% since 1989. The bottom line is that by selecting the numbers, you can have about any result you want: this is in keeping with my essay on the USE of Statistics (also on my web page). I think the result of all this is a vindication of my claim that you should pay more attention to how people actually live than to numbers that are supposed to represent "the economy". A post by Jay Hansen over a year ago pointed out that there is a difference between how "the economy" is doing and how "the people" are doing. He claimed that the "economy" is doing better than the "people" and I claim the reverse; but either way, there is a distinction between them. Here is Another Reply to this Thread news:4il9ji$r58@axil.megalinx.netbumpy@megalinx.net (Capt Jack Internaut) wrote: >COMMON SENSE: RETHINKING the CPI > >One of the simplest and appropriate ways to decrease the govt deficit >would be to recalculate the CPI (consumers price index) to better >reflect the actual inflation rate and account for price induced >consumer behavior. The current CPI is generally accepted to over state >the inflation rate, leading to higher interest rates, higher social >security payments, higher debt payments by the govt, a higher deficit, >and a slower economic growth rate. It does this in a number of ways, >but the most important is that it ignores the product substitution >that occurs with an increase in the price of a product. If the price >of hamburger goes up, people often buy less hamburger and may buy more >hot dogs. The current CPI ignores this behavior and continues to >include the higher amount of hamburger in the representative basket. >Almost every consumer behaves in this way, and yet the CPI ignores it. >It would also be very easy to correct. Price elasticities, the % >change in the quantity sold resulting from a % change in the price >(%change Q/%change P), exist for most products and could be included >in the CPI calculation. Cross elasticities, the %change in the sale of >A resulting from a %change in the price of B. An example of a cross >elasticity would be the sales of hot dogs increased with the increase >of the price of hamburger. Now to calculate a more representative CPI >these elasticities could be included in the CPI formula. > >Price of hamburger(Ph), Quantity of hamburger(Qh) >Hamburger elasticity = %Qh/%Ph >Price of Hot Dog (Phd), Quantity of Hot Dog(Qhd) >Hot Dog elasticity= %Qhd/%Phd >Cross elasticity of hamburger and hot dog= %Qhd/%Ph >Cross elasticity of hot dog and hamburger= %Qh/%Phd > >Now to calculate the new CPI: >If the price of hamburger had increased since the last CPI >calculation, the %Ph would be multiplied by both the elasticity of >hamburger, and the cross elasticity of hamburger and hot dog. The >resulting quantities would then be used for the new calculation, with >more hot dogs and less hamburger being purchased. The new CPI would be >based on a weighted average of the two substitute products, with the >consumer behavior lowering the average cost, and thus the CPI, through >substitution. > >Now for one other adjustment that would greatly effect the Social >Security payments, and thus the government deficit. The CPI is >intended to be a representative basket of goods for the average >person. Different age groups however, have different spending habits. >One basket of goods does not fit all. Young children do not buy cars >and houses, Young singles do not buy the same goods that young married >couples do, Young married couples do not buy the same goods that >married with children do, and the elderly do not buy the same basket >as the younger population. The elderly often own their own homes, >furniture, have low debt, have Medicare, and do not buy on a routine >basis the items that are included in the CPI basket. They are >sheltered from the effect of the price rise because they simply do >not buy certain items included in the CPI. A more appropriate approach >would be to create an age relative CPI. A CPI could be created for the >different age groups in the society. The CPI that represents a basket >of goods purchased by an average person over the age of 65, would >then be used to calculate the increases in Social Security. If the >CPI(65 and over) was lower than the current one size fits all CPI, the >government's Social Security payments would then be lowered. This >could lead to tremendous savings, a lower deficit, lower interest >rates, higher growth, and be done by simply using the CPI in its >originally intended manner. >That intention was to accurately measure the inflation rate and its >effect on the standard of living, not as a means to justify >overpayment of COLAs. > >> >> And finally, the CPI does not include stocking up on items when they are on sale, and does not use the various discount/rebate/two-for-one coupons that most shoppers clip from newspapers. ,,,,,,, ____________________ooo__(_O O_)__ooo_________________________ (_) Jim Blair (jeblair@facstaff.wisc.edu) University of Wisconsin, Madison (USA). For a good time, call http://www.execpc.com/~jeblair/index.html "This message is brought to you using biodegradable binary bits and 100 % recycled bandwidth."