Inflation and history 11/15

Inflation does not end well

Noah Smith writes,

The Carter and Reagan eras, and Japan’s experience, show that monetary policy is far more effective at controlling inflation than fiscal policy — if the Fed is committed to restraining inflation, big deficits probably don’t do much.

I disagree. In Japan, low inflation came from the collapse of wealth when a huge bubble popped, particularly in real estate. That could happen here, by the way, where the most overvalued assets are share prices of companies don’t have much in the way of earnings (e.g., Tesla). That would not be a happy outcome, especially if it turns out the way it did for Japan.

In the U.S., I think it was the bond market vigilantes (Ed Yardeni’s phrase) who brought down inflation. I still remember our first mortgage in 1983, at 12.5 percent (which was a below-market rate subsidized by the builder). Housing markets were pretty weak back then.

The Fed does not control mortgage rates. But if you want to stipulate that the Fed is the driver, go ahead.

I recently clicked on something, I forgot what, where Larry Summers was pontificating, and he said that soft landings almost never happen. That is, we don’t see inflation follow a gentle glide path down. In 1980-1982, we had a steep recession, and subsequently it took many years to bring down unemployment.

The way I would put it is that the bond market can be very unforgiving when investors have been burned by inflation. It does not deliver the mythical r* that keeps the economy poised near full employment. Instead, it raises rates far higher.

In the early 1980s, the government was still able to borrow, albeit at very high interest rates, in large part because foreign investors stepped up. But now we have much more outstanding debt to roll over, and foreign savings may already be maxed out. Today, high interest rates have the potential to cause a fiscal crisis, because the government can’t afford high interest payments.

I spelled out my view on the outlook for inflation and interest rates here.

Basic Economics

It continues to frustrate me to see articles that “explain” inflation by looking at problems in the supply chain. I think you are better off thinking of inflation as spending rising faster than production. And spending is rising faster than production primarily because the government has injected a lot of paper wealth into the economy through unprecedented levels of deficit spending.

Unlike Noah Smith, Tyler Cowen, and many other economists, I think it is unlikely that the Fed will offset this huge increase in paper wealth. The actions that the Fed would have to take are too radical and would threaten the ability of the government to fund its operations.

I also think that the press is flunking basic supply and demand analysis. In particular, journalists cannot seem to get the difference between an adverse shift in supply and a “shortage.”

An adverse shift in supply cause the price to rise and a reduction in the quantity sold. But supply and demand are in balance at the higher price. To an economist, a “shortage” is when prices fail to rise, so that the quantity demanded exceeds the quantity supplied at the too-low price.

If the “supply chain” is not delivering as many computer chips as auto makers want, what does that mean? Suppose that there are problems in the manufacturing and distribution system for computer chips. Then this is an adverse supply shift and prices should have risen. If there is a “shortage,” then supply and demand for computer chips are out of balance at current prices, and prices need to increase further.

Suppose that there has been an adverse shift in driver supply in the trucking industry. The market would have responded by raising the pay for truck drivers, possibly leading to more truckers but more reliably curtailing demand. Supply and demand should be in balance at these higher trucker salaries. If there is a “shortage” of truck drivers, that means that truck drivers are not being paid enough. Truck driver wages have further to rise.

Please share this article with journalists who write stories that display an ignorance of freshman economics.