Yes, Inflation/Deflation is Hard to Measure

One of the hardest concepts for Principles students, politicians and pundits, oh heck, just about everyone to fully grasp is inflation.  A big part of the reason is because inflation is an abstract concept that is not directly measurable.  We can conceive of it, but we can’t measure it.  I’m no physicist (and open to correction) but it strikes me that it’s a bit on par with “momentum” or “latent energy” in physics.   We don’t have direct-measuring energy-o-meters.  We measure the effects and infer the energy.  Inflation is similar.  We can conceive of a generalized, across-the-economy, sustained trend pushing all/most prices upward such that the unit of money is losing real value in general terms.  Inflation is the sustained push behind all prices. We can’t measure that directly. But we can measure the effect it has: rising prices. The problem comes in that not all prices will be rising at the same time or by the same amount.  Further, during any time period, at least part of the change in price for any good is it’s change in real price relative to all other goods (supply and demand as taught in micro).

We try to deal with this measurement issue by creating a price index – an index that tracks the changes in shopping list of goods over time.  But any price index is a just a subset of all the prices.  Even the Billion Price Project index at MIT admittedly misses most services and lots of consumer goods that aren’t available online.  Price indices are very imperfect beasts.  They have many faults, not the least of them being that they often tend to be volatile in nature.  Since we’re looking for an estimate of inflation which means sustained increases, we need to massage the data further by creating some kind of “core inflation” measure or “trimmed means” type price index.  I’ll explain those some other time.

What prompted today’s post is an article in Bloomberg and a post by Krugman about it.  Together they illustrate one of the reasons so many people want to believe we have greater inflation than we really do.  Companies like to disguise price changes.  They don’t want to be known that prices could be cut in response to demand. Example: auto company offers $2000 rebate on $20,000 car but won’t cut price by 10%, or a firm offers a “value meal”, or they offer a freebie bundled product.  Similarly they often disguise price increases by reducing sizes or portions or by changing the financing.  From Krugman:

Good article in Bloomberg:

Procter & Gamble Co.’s failure to raise the price of Cascade dishwashing soap shows why investors are buying Treasuries at the lowest yields in history, giving the Federal Reserve more scope to boost the economy.

The world’s largest consumer-products company rolled back prices after an 8 percent increase lost the firm 7 percentage points of market share. Kimberly-Clark Corp. (KMB) started offering coupons on Huggies after resistance to the diapers’ cost. Darden Restaurants Inc. (DRI) raised prices at less than the inflation rate as patrons order more of Olive Garden’s discounted stuffed rigatoni than it anticipated.

This is basic economics; prices tend to fall, or at least slow their rise, when there is vast excess capacity and weak demand.

As both the article and Krugman’s excerpt show, we’re closer to deflation than most people realize.  They don’t see the failed attempts to raise prices.  They don’t see the shifts in portions or increase in coupons that reduce effective prices.  What they do see and remember is the $.50 increase in a loaf of bread or the $.70 increase in a gallon of gas.  But even with the gas, they selectively remember the $.70 price increase in summer, but forget the $.75 price drop in autumn.  Inflation and deflation are tricky things to measure.

 

Does Anybody Understand Debt?

Does anybody understand debt?  Some – but not many.  Today’s post is less of my normal extended prose and more of an outline.  I’ve been invited to speak at some writing classes here at the college and this is intended to serve as my speaking notes.


Background: What have you heard?

Krugman in New York Times

Harvey in Forbes

Background Info on U.S. National Debt

Brazelton:  The US CANNOT Go Broke


Numbers, Metaphors, and Stories


Get the terms right

Debt, Deficit, and tr/b/m-illions

$1,000,000,000,000

$1,000,000,000

$1,000,000

$1 trillion =  1 million times $1 million

Debt


Deficit

1984-present U.S. Federal Budget


Measuring the Debt

Counting Absolute Dollars of Debt Deceives. It's All Relative.


Three Bad Metaphors


Government is NOT a Household

Government is NOT like a Household!

Econproph: Once Again, Government is Not Like  a Household


 Govt Debt is NOT a Burden on future generations


Private Debt is NOT like Government Debt

Federal Reserve Breakdown of Household Debt

Foreigners Don’t Control


So…

A Sovereign Government Cannot “Go Broke”


Eurozone Countries Can “Go Broke”


Government Debt is Like Money that Pays Interest


But What About Inflation?  Printing money?

Inflation involves real demand vs. real supply, not just $


Test on Debt:  Interest Rates

Rates are historically low and staying low.


Are Gov. Deficits Necessary?

Yes, if you want to save money.

Forever?   Yes.

Econproph: But What About National Debt-to-GDP Ratio? Not a Problem, Really


Are There Limits to Deficits?

Yes, but related to full employment and capacity.


In Practice, Nobody Understands Money.

Well they understand yesterday’s money, not modern money.

That’s why they don’t understand debt.

The Quantity Theory of Money and Fears of Inflation Are Nonsense

We rarely get to conduct scientific experiments in economics, but for the last 3+ years The Federal Reserve has unintentionally conducted a test of an economic theory called the “Quantity Theory of Money” (QTM). QTM makes some very specific predictions – predictions that Ron Paul, conservatives on Wall Street, and others have been repeating a lot.  Unfortunately for them, QTM has failed the test.

First, some background on the theory. The QTM is and has been one of the foundations of both monetarist thought and Austrian economic thought.  In it’s base form, it’s based on an accounting identity that must, by definition, be true.  The notation sometimes varies, but the quantity theory of money is based on a definition called the equation of exchange.  This equation goes like this:

M times V = P times Q
where:
M: Money supply
V:  velocity of money, or the number of times the average dollar changes hands and is spent during the same time period as Q is measured.
P:    price level
Q:   real GDP (sometimes real National Income, Y, is used – same thing essentially)

So what does the equation say?  If you look at the left hand, M x V, you get a representation of the total spending in the economy.  It’s how much money was in circulation times the number of times that money was spent.  The right side, P x Q, gives us the value of nominal GDP.  It’s the value of all the real stuff we bought (Q, real GDP) times the Price level P which translates it into today’s prices.  Put the two sides together and you’ve got total nominal spending in money terms must be the same as the total value of the things we bought.  Duh.  Of course it is.  It’s an identity.   It’s the macro equivalent of saying that if I spend $5 each time (M) on 7 trips to the grocery (V) to buy 70 apples (Q) at $0.50 each (P), then I will spend $35 on $35 worth of stuff.

As an identity definition it’s not really very interesting.  It’s when economists begin to use it as a model of future outcomes that problems arise.

The typical way QTM is used, and the simple way folks like Ron Paul and a lot of folks who are upset at Federal Reserve efforts to stimulate the economy, is by thinking of what happens when M, the money supply, is suddenly increased.  The thinking is that an increase in M must result in an increase in P in order to keep the equation balanced.  This is the foundation of modern inflationary fears in the last  few years.  Typically folks using the QTM this way don’t say things like “an increase in M must lead to an increase in P”.  They say things like “The Fed is printing money like mad and that’s going to lead to inflation”  since an increase in the price level, P, is how we measure inflation.

But there’s actually four terms in this equation.  Any of them can change.  That’s where assumptions come in.  The advocates of QTM, whom I’ll call “inflation-phobes” for the moment since they’re always fearful of inflation, make some strong assumptions.  They assume three big things.  First, they assume that the velocity, V, is constant.  In other words, according to them, you and I always spend our money at exactly the same rate. Suppose I spend my whole paycheck every two weeks now.  They assume that I’ll always spend my whole paycheck every two weeks no matter how big or small that check is or whether I’m suddenly fearful of losing my job next month.  The evidence for the constant velocity assumption is weak.  You be the judge using the St.Louis Fed data:

To me, that doesn’t look constant.  If V is constant, then any increase in M also increases spending, MxV.  But if V isn’t constant, then an increase in M can be offset by simultaneous slowdown in velocity.

The next assumption is that real GDP is always at capacity.  In other words, there is no unused capacity in the economy such as unemployed workers or empty office buildings or factories running only 1 shift when they can run 2.  This is assumption is essential to the inflation-phobes because it means that Q can’t be increased.  This is necessary to their desired outcome because it would imply that the only way for PxQ to rise to meet an increase in MxV is by having P increase.  I won’t go to the trouble of showing data and graph to prove that Q isn’t at capacity.  If you have doubts, see last week’s update on employment and GDP.

There’s one more unstated assumption by the inflation-phobes.  They assume that any increase in base money, which is primarily the bank reserves The Fed makes available to commercial banks, will necessarily translate into M1, money in circulation among the public.  This too is a bad assumption.  There times, like the last 3 years, when commercial banks don’t want to or can’t lend.  In times like this bank reserves just sit there on the books safely tucked away from any kind of productive economic activity or spending.  The Fed can push reserves onto the banks’ books, but it can’t turn those reserves into loans or spending by customers. Another weakness in this assumption is the idea that even if the money ends up in private hands it will be used for spending on goods and services. Instead, what we’ve seen is that much of what little lending the big banks have been doing has been to finance financial market trading and speculation – things like oil futures.  Speculating in oil futures isn’t the same thing as actually refining and selling oil.  The speculation doesn’t create jobs and isn’t part of the circular flow. Production is.

So we’re back to the question of testing the QTM theory.  The QTM theory of money as inflation-phobes express it, says that increases in base money (M) necessarily must result in inflation (increases in P) at some time in the near future.

In 2008 and 2009 The Federal Reserve expanded bank reserves greatly.  It expanded the monetary base dramatically.  The Fed invented a variety of new names and methods for doing it, although almost all of them involved The Fed buying some kind of bond, security or financial asset.  If the QTM theory and the hard-money inflation-phobes are right, there should have been a dramatic increase in inflation.  They predicted it.  Again and again.  It simply hasn’t happened.  Paul Krugman put together an nice little graph showing the failure of the QTM theory:

The thing is, of course, that the past three years — the post-Lehman era during which the Fed presided over a tripling of the monetary base — have been an excellent test of that model, which has failed with flying colors. Here are the data — I’ve included commodity prices (IMF index) as well as consumer prices for the people who believe that the BLS is hiding true inflation (which it isn’t):

A couple of notes: for the commodity prices it matters which month you start, because they dropped sharply between August and September 2008. I use the IMF index for convenience– easy to download. (Thomson Reuters I use when I just want to snatch a picture from Bloomberg). But none of this should matter: when you triple the monetary base, the resulting inflation shouldn’t be something that depends on the fine details — unless the model is completely wrong.

So, we’ve had a test, a pretty substantial test of the Quantity Theory of Money and the assumption that any increase in monetary base must lead inevitably to an increase in prices and inflation.  The theory has failed.  It should be put to rest.  Milton Friedman, a man as responsible as any other for pusing QTM, once famously claimed that “inflation is anywhere and everywhere always a monetary phenomenon”.  He was clearly wrong, there’s more involved than just base money growth.

John Stossel Fails an Education Test and Demonstrates That He’s Economically Illiterate

John Stossel is a Fox Business News reporter.  Stossel is an unabashed “libertarian” with a strong Austrian orientation on economics who focuses on economic issues.  He’s made a living out of being indignant and disgusted by “liberals” and “big government” which he sees as the root of all economic problems.  He’s been quite successful over the years, first at ABC News and now at Fox.   He also writes a blog to go with his Fox News show.

In other research I was doing recently I stumbled upon a post of his from Sept 15 called “Stupid in America” in which he asserts that schools have gotten too expensive and don’t deliver the goods.  In Stossel’s own words and graph:

School spending has gone through the roof and test scores are flat.

While most every other service in life has gotten faster, better, and cheaper, one of the most important things we buy — education — has remained completely stagnant, unchanged since we started measuring it in 1970.

It looks appalling right?  Scores have increased by 1% but the cost of an education appears to have increased by approximately 246% ($43,000 up to $149,000).  Except it’s very deceptive and the obvious product of an economic illiterate.  There’s two clear, elementary economic errors here.

First, he’s comparing test scores, a measure that’s in absolute terms on fixed scale to dollars spent in nominal terms over a 40 year period.  Dollars are not fixed units of measure.  They change value over time because of inflation.  If you want to compare test scores to dollars spent “buying” those test scores, then you need to use real dollars with the inflation taken out.

So let’s do that.  Using the Bureau of Labor Statistics CPI Inflation Calculator, we find that what $43,000 purchased in 1970 would require $241,660. in 2010.  Yes, inflation has changed purchasing power that much.  Inflation compounds so even a 2% annual inflation rate would more than double nominal costs in 40 years.  In the late 1970’s we had some years of inflation in the double-digits.  So really, the graph is telling us the opposite of what Stossel wants us to believe.

The second big problem is that Stossel is assuming that the all money spent on education goes to buying improved test scores in math, science, and reading.  He also is assuming that the inputs, the students being educated are the same in 1970 as in 2010.  They aren’t.  He ignores that we might be paying for something else in addition to math, reading, and science test scores.

Stossel then goes on the attribute all of the problems to education being a government monopoly.  Again, he ignores facts. Facts are inconvenient for Stossel.  Competition has been brought to K-12 education in many areas. Maybe not as much as he would like, but it’s a significant change since 1970.  As his test scores indicate, it hasn’t helped much.

Finally, I want to note that it’s poor practice to not cite your sources and more precisely define your data series.  The graph is labeled “Source: NCES”.  NCES is a huge website and archive of a lot of data.  Stossel doesn’t give a source. Is it because he wants us to take him at his word and not verify or check it out for ourselves? He doesn’t even label what the spending series is to which he refers.  I am assuming it is a “spending per pupil over 12 years” type of series.  A search of NCES for a series labeled as he has it turned up nothing.

I find it enormously ironic that Stossel would make such elementary errors as to not deflate a data series or to not label his measures precisely.  That’s what we demand in principles of economics courses.  What makes it ironic is that on August 23 Stossel takes Congress to task for being “economic illiterates” and not having degrees in economics or business.  Pretty rich stuff from a guy with only a psychology degree who makes elementary economic errors.

US Government Bond Market & Interest Rate Watch – No Signs of Worry Over Deficits, Inflation, or Default

Just a quickie to bring your attention to this, yesterday’s close on the U.S. Government bond market as reported by Google Finance. Note the 10 year bond – less than 2%.

Bond Maturity Yield (effective interest rate) change in points(percent)
3 Month 0.01% 0.00 (0.00%)
6 Month 0.04% +0.01 (33.33%)
2 Year 0.19% +0.01 (5.56%)
5 Year 0.86% 0.00 (0.00%)
10 Year 1.99% -0.07 (-3.40%)
30 Year 3.30% -0.11 (-3.23%)

Why does this matter?

There’s two reasons.  First, the politicians and economists who have been opposed to stimulus efforts, either deficit spending increases or monetary stimulus, have been screaming for well over three years now that  these policies were “reckless” and going to lead to inflation.  Some of the more shrill have been seeing “hyperinflation just around the corner”.  They’ve been saying this for a long time but the inflation and hyperinflation simply aren’t happening.  Why?  Well they’ve argued this because they subscribe to economic theories such as quantity theory of money, crowding out, efficient markets, and a whole host of other neo-classical/neo-liberal theories.  These are the same people that claim Keynesian or post-Keynesian or Modern Monetary Theory is totally wrong.  But the data disagree.  These same critics were the ones pushing Washington to cut the budget and not raise the debt-ceiling limit.  They put concerns about the deficit ahead of concerns about jobs or growth rates despite having over 9% unemployment and over 16% slack in the system. They’re wrong. The data and investors in markets are showing them wrong.  Bond buyers aren’t worried about the U.S. becoming another Greece because they know it’s not possible.  Instead the big money is worried about the lack of economic growth and the potential for banking failures in Europe, and that leads them to want to park their money in the safest thing around: U.S. bonds.

The second reason is because these rates are so low, it’s foolish for the government to not borrow more money and invest it in the country’s future. Readers of this blog and my students should know that the U.S. government is not like a household and doesn’t  face the same budget constraints.  But even if you do believe that, why wouldn’t you borrow money at less than 2% and invest it in projects like infrastructure, innovation, and education that bring a rate of return well above that?  There’s no evidence that the private sector is doing any of this investing and the nation has plenty of idle capacity and idle workers that the private sector has shown it won’t hire.  Why shouldn’t a rational government borrow and invest in growing future GDP?  There’s no reason not to as long as you are sincerely committed to economic growth.

If we consider the real rate of interest (the nominal or face rate of interest minus the expected inflation rate) we get pretty much 0%.  The money is being offered to the government essentially for free, yet opponents of stimulus don’t want to borrow it. Proof of this is that TIPS bonds, which are a variety of U.S. government bond where the interest payments and principle is indexed for inflation, are trading with a negative interest rate these days.  The ironic part is that the very people opposed to government borrowing in this environment are often the same people who claim government should act more like a business.  Any rational business that had profitable investment opportunities and also had access to borrow at essentially 0% would rush to say “where do I sign to borrow?”

Just What Is Inflation? Is A Monster Just Around The Corner?

A casual reader/listener of many economics blogs, news stories, cable shows, and political speeches (in other words, the usual sources), would be forgiven for thinking that “inflation” is some awful comic-book super-villain that constantly threatens society.  It’s as if they think that any momentary lapse in vigilance that allows perhaps a declining unemployment rate will bring the villain back to life.  And worse, if we aren’t careful, they warn, the Inflation will morph dramatically into Hyperinflation, kind of like making the Incredible Hulk angry.  So even though the economy is struggling with millions of unemployed and underemployed people, we seem obsessed with the fight against Inflation.  Nevermind that inflation doesn’t harm us as much as unemployment, it’s what the powers-that-be fear now.  And recently as food prices rose during the winter and gas prices have recently risen back to the $4.00 per gallon range, we’re being told it’s coming!  Inflation.  Now before we hide the women, children and checkbook in fear, let’s stop and think about it.  Let’s start with Just what is inflation?

Inflation Is Not Just Price Increases

Many people assume that inflation is rising prices. It’s not. Rising prices are one of several signs that the economy might be experiencing inflation, but the fact that some prices go up is not inflation.  Inflation is a continuing, ongoing rise in all prices in the economy.  If you think of it this way, phrases that we read/hear like “food price inflation” or “gas price inflation” are just absurd, nonsense phrases that don’t mean anything.  It’s like saying “specific generality” or describing something as being “uniquely universal”.  If the price of only one group of specific commodities or goods are going up, then it’s not inflation. If the prices of all goods and commodities are going up, then it’s inflation.  So the fact that gas prices are going up or that food prices might have gone up means that buyers of those goods, which is most folks, are having to adjust their spending.  Those items are getting more expensive relative to other items.  In micro-economic terms, they are getting scarcer relative to the demand for them.  That’s an uncomfortable place to be if you need those products.  If you can’t cut back your consumption, if means you experience a real decline in your living standard. But it doesn’t mean the economy is experiencing inflation.  You cannot look at the price of one or two specific types of goods and conclude that inflation exists.  Period. You have to look at all prices across the economy. You have see that prices are rising for nearly everything that gets purchased.

This inflation-means-rising-prices-across-the-entire-economy aspect means we have to look at a very large number of goods prices, not just gas or food or gold.  But it also means more than goods prices going up.  All prices must be rising.  That means wages (price of labor), prices of financial assets, and prices of non-financial assets (things like real estate, collectibles, etc).  When we consider these other prices, we see that despite what we’re paying at the local Exxon station, inflation is conspicuously absent.  Wages are not increasing.  According to Data360, reporting government BLS data, the average hourly wage for good producing workers rose from $20.55 to $20.59 in first quarter 2011. That’s less than 0.2%.  On an annualized basis, it’s less than 0.8%.  No inflation in there.  Service-producing workers are worse off. The average wage is falling from $19.05 to $19.02.  Their wages actually declined!   Overall, no inflation in wages.

But what about non-financial asset prices?  Well the latest data on home prices also shows declining prices, not increases.  CalculatedRisk Blog reports on the March Case-Shiller house price index and reports a declines in recent months. No inflation in non-financial assets.

What about other goods, though? What about non-food, and non-gas price goods?  We can look at either the Consumer Price Index, the official government source, or we can look at MIT’s Billion Price Project index which tries to track a billion different prices and price changes in real-time.  It’s still a sub-set of “all goods”, but surely it’s a reasonable cross-section.  Paul Krugman reported on these indices on March 28, 2011 in his NYTimes blog.  This the graph he used:

Notice the scale.  Prices of a wide selection of goods are rising at a less than 1% rate.  That’s not really inflation folks. So despite the prices in the groceries (which may be easing in coming months – they’re driven by weather issues) and the price at the pump, inflation is not a problem.

But there’s another aspect to our definition of inflation that’s very important.  That’s the use of the word continuous or continuing rises in prices.  If prices go up once or go up for a couple months and then stop rising, it’s not really inflation.  Inflation is when all the price rises begin to feed off of each other.  Most goods go up in price, so workers demand and get a rise in wages.  The wages go up and firm owners want their profits to go up too, so they raise the goods prices, driving even more demands for wage increases.  A spiral develops.  It’s called a wage-price spiral.  Everybody begins to expect inflation, rising prices and wages and so they start basing plans on assumptions of future rising prices, further increasing their present demands.  That’s how inflation works.  That’s what happened in the U.S. and many developed countries in the period of the late 1960’s through the early 1980’s.  It is not happening now.

A major reason why it can’t happen now is that workers don’t have any bargaining power to make demands for wage increases.  Union membership is very, very low by historical standards.  When unemployment is at 9% and has been for nearly 3 years, there’s no bargaining power for workers.

Yes, we are experiencing higher gas prices today. Gas prices may well continue to rise for months yet.  We have also experienced some higher prices for food, although the future trend is not clear.  Yes, gas prices are a component of many other product prices since transportation is critical to any physical product.  But what we are not experiencing is inflation. We are experiencing, in econ-talk, rising relative prices for gas, oil, and food.  To the extent that these goods are essential and we must continue to buy the same quantities of them, it means something else must give. Our standard of living will decline. But it’s not inflation.  We could call it workers-get-screwed-againism, but it’s not inflation.

Why does it matter what we call it?  It matters because the usual sources want to call it inflation so they have a political cover to do things they otherwise couldn’t do.  They want to cut government budgets and spending.  Some of them (bankers and big investors) would actually benefit economically from mild deflation.  They can’t get a hearing that way, so they call it “inflation” and they raise up the threat of a monster.  But it’s only a comic-book fake monster. It’s not real. Not now.

The Fed Has NOT Been Printing Money

A common refrain among the “cut, cut, cut” chicken littles and the hard-money crowd is that “the Fed has turned the printing presses lose printing money”.  These folks should really join us in the 21st century.  That’s not how it works and that’s not what The Fed has been doing.  Quantitative Easing, as well as The Fed bailouts of the big banks 2-3 years ago, did not involve “printing money”.  It involved creating bank reserves that are NOT loaned out and therefore do not create new “money” or M1.  James Hamilton explains:

Money and reserves

I wanted to offer some clarification on stories about all the money that the Federal Reserve is supposedly printing. It depends, I guess, on your definition of “money.” And your definition of “printing.”

When people talk about “printing money,” your first thought might be that they’re referring to green pieces of paper with pictures of dead presidents on them. The graph below plots the growth rate for currency in circulation over the last decade. I’ve calculated the growth rate over 2-year rather than 1-year intervals to smooth a little the impact of the abrupt downturn in money growth in 2008. Another reason to use 2-year rates is that when we’re thinking about money growth rates as a potential inflation indicator, both economic theory and the empirical evidence suggest that it’s better to average growth rates over longer intervals.

Currency in circulation has increased by 5.2% per year over the last two years, a bit below the average for the last decade. If you took a very simple-minded monetarist view of inflation (inflation = money growth minus real output growth), and expected (as many observers do) better than 3% real GDP growth for the next two years, you’d conclude that recent money growth rates are consistent with extremely low rates of inflation.

Two year growth rate (quoted at annual percentage rate) of currency in circulation. Data source: FRED.
currency_feb_11.gif

But if the Fed didn’t print any money as part of QE2 and earlier asset purchases, how did it pay for the stuff it bought? The answer is that the Fed simply credited the accounts that banks that are members of the Federal Reserve System hold with the Fed. These electronic credits, or reserve balances, are what has exploded since 2008. The blue area in the graph below is the total currency in circulation, whose growth we have just seen has been pretty modest. The maroon area represents reserves.

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