The inflation monster

Kids are afraid of monsters, and so are Republican candidates apparently. The inflation monster that is. It really makes it hard to teach macro, since lots of students still think, because of the unrelenting 24 hour media coverage of GOP debates that since money supply increased (from about 7.5 to close to 9.3 trillions from Dec. 2007 until last July, using M2) we are in for a huge increase in prices. Hyperinflation should be around the corner.

It's not. As anybody with common sense knows the velocity of circulation does change (fell from slightly more than 2 to around 1.7 for M2), and the increase in money supply has no effect on spending. Banks are not lending, since demand is not growing sufficiently (if in doubt search endogenous money, now known as MMT, Modern Monetary Theory). And inflation has been subdued as the graph below shows (2011 is an IMF forecast for CPI inflation), even more after the 2007-8 crisis.

Inflation has increased a little bit in 2011, fundamentally associated to higher energy and food prices, but the pass-through to general prices in the US is relatively small (black line is a three year moving average). As noted by Adam Posen, central banks should continue to maintain low rates of interest. Unless they believe in monsters!

PS: Funny coincidence, after I posted this I saw that Krugman uploaded a graph of M2 velocity after the 1960s here.

Global Monetarism Strikes Back



Olivier Blanchard, the chief economist at the International Monetary Fund (IMF) announced in a triumphalist tone that “earlier fears of a double-dip recession—which we did not share—have not materialized” and defended the need for “fiscal consolidation that is neither too fast, which could kill growth, nor too slow, which would kill credibility.” For Blanchard fiscal expansion has done its job, since “private demand has, for the most part, taken the baton.” The risks are associated to the higher prices of commodities and inflation. The Bank of International Settlements (BIS) has added to the IMF’s view that inflation is the main risk on an otherwise recovering world economy. In their recent Annual Report they argue that: “spread of inflation dangers from major emerging market economies to the advanced economies bolsters the conclusion that policy rates should rise globally.” That is, add monetary contraction to the policy mix.

Read the rest of the entry here.

The strange persistence of Monetarist history

The Monetarist view of history, as I noted in a recent post, is quite popular. The conventional wisdom on the Great Depression is that the Gold Standard forced contractionary monetary policies and the Great Contraction caused the recession. An open economy version of Milton Friedman’s story. The dominant view on the recovery from Great Depression, due to Christina Romer, is that the non-sterilized inflows of gold led to an increase of money supply. And the money supply brings the recovery. Forget the New Deal, that made things worse in the Monetarist alternative reality.

Krugman, that has otherwise done a great job of showing the anti-Keynesian bias in current discussions of the budget, also seems to have an inner Monetarist. He tells us in a recent post on taxes that: “the feds have the Fed, which can print money. But there are constraints on that, too — they’re not as sharp as the constraints on governments that can’t print money, but too much reliance on the printing press leads to unacceptable inflation. (Cue the MMT people — but after repeated discussions, I still don’t get how they sidestep the issue of limits on seignorage.)”

I guess we call endogenous money MMT (Modern Monetary Theory) now. If you print money and people spend, and there is capacity, there should be no inflation, but lower unemployment. Also, as people spend, firms tend to adjust capacity to demand. So the capacity limit is endogenous. The limit that most economies encounter is the balance of payments. As the economy grows and it imports more, eventually the current account deficit becomes too large, and depreciation fuels inflation.

But my concern is why even Krugman buys the notion that money causes prices. A graduate student told me that monetarism is a simple story that is ideologically convenient. That is true, but not ideologically convenient for progressives like Krugman. In his case and other progressives like him (there are even Marxists with Monetarist proclivities!), it seems, that the reasons have to do with the ability to convince people that certain events can only be explained by Monetarist ideas. That suggests to me that the power of institutions (universities, journals, press) that reproduce acceptable knowledge is incredible strong. Institution building should be at the top of the agenda for progressives.

It must be hard to be a Monetarist!

Stephen Colbert is right; reality does have a liberal bias.  Or at least that is what the new study by D’Agostino & Surico posted at voxeu.org seems to suggest.  They forecast inflation using a Vector Auto-Regression (VAR) model.  They test for the relation between inflation and money, inflation and output, and inflation and past inflation in the United States from 1904 to 2004.  Their results show that:

“Under the gold standard, the Bretton Woods system and most of the great moderation sample [in other words, almost the whole sample] money growth and output growth had no marginal predictive power for inflation;”

And “output growth had marginal predictive power for inflation in only two periods: (i) the years that extend from the great inflation of the 1970s to the early 1980s … and (ii) the years between 1997 and 2000.”

In other words, money supply is never significant, output very seldom, and the only thing that really matters is past inflation.  So much for monetarist views according to which money supply explains economic history!  In the face of this paper, the only puzzling question is why the Monetarist view of history, as expressed in Friedman & Schwartz, and more recently in Meltzer, is still so popular.

There explicit conclusion is that: “the results reported in this column are consistent with the idea that a policy regime which successfully stabilizes inflation makes it harder to improve upon the forecasts based on “naive” models.”  English translation: the conventional idea that too much demand triggered by monetary expansion causes inflation does not work when compared to the simple idea of inflationary inertia.  Inflation is high if it was high in the past.

The first period in which output growth has predictive power is, incidentally, a period in which commodity prices boomed, and that means that inflation might be orthogonal to output growth, even if both are correlated.  The second period was associated to both a stock market and a housing bubble, and asset price inflation may also not result from full employment (output increasing beyond its potential).

They should have explicitly noted that periods (monetary regimes) with low inflation could not be explained simply by lack of excess demand or monetary expansionism, since those are ruled out by their own econometric work.  I wonder what explains monetary regimes that produce price stability?  Interestingly enough the authors do not seem to have an interest in what causes past inflation or price stability!

PS: Thanks to Steve Bannister for directing me to their post.  He may have something to say later on the advantages and the limitations of the econometric techniques used by the authors.  Also, he is giving a talk on heterodox approaches to econometrics this coming Friday.  Will post a link to his talk later.