Tyler Cowen Disagrees with me about Inflation

So do the markets

Tyler Cowen and I had an email exchange about my forecast for continued high inflation, and how his outlook differs from mine. He posted his side of the exchange on his blog.

What prompted the exchange was a challenge he made along the lines of

are you short the long bond?  Are you buying those puts?  I’m not so convinced if all you’ve got is “I’m not buying so many equities any more!”

As a matter of fact, my investments are much more inflation-hedged than they were eighteen months ago. TIPs mostly, and some commodity funds. But I am not a brave speculator. If you want to see someone willing to rise to Tyler’s challenge, consider Michael Burry.

That aside, Tyler and I are economists, and an economist should be able to say more than “I believe the financial market indicators.” An economist should have a model, or be able to tell a story. Hence our exchange.

The key sentence from Tyler’s post may be this one:

The stock of saved wealth is now quite high relative to debt and deficits, especially if you count human capital.

I look at the pile of wealth in the hands of the public and think: pent-up demand, like at the end of World War II. The personal savings rate shot up during the pandemic. Much of the income that was saved over the past 18 months was created at the stroke of a pen by government “stimulus.” In my story, as people spend this paper wealth, we will see inflation.

To get at why Tyler thinks that a lot of accumulated wealth implies low inflation, I have to tell a different story. I am not confident that this is the story he has in mind, but here goes:

Inflation can be useful to government as a tax. If the government can pay for goods today with money (or bonds) that will depreciate tomorrow, then it does not have to collect as much in other taxes.

But for a variety of reasons, nowadays the inflation tax is not very useful (“Seigniorage returns from inflation are especially low in the contemporary environment”) as a source of revenue. And inflation is very, very unpopular (“The median voter hates inflation”). So the government’s incentive is to avoid using the inflation tax.

In short, we won’t have a lot of inflation, because the government does not want it.

Tyler says that “I think the Fed knows the true model in gross terms.” In other words, if the stroke-of-pen wealth threatens to cause inflation, the Fed will find a way to choke off demand. But I think that this means that the Fed will have to engineer an increase in interest rates. And because government debt is now more than 100 percent of GDP, each one percentage point increase in interest rates raises the cost of government debt by about one percent of GDP.

Higher interest costs may be too much for the government to bear. I would hazard a guess that the amount by which interest rates need to rise to stem inflation is more than what the government can afford.

Perhaps that is where the “stock of saved wealth” comes in. The only way that I can see a “stock of saved wealth” helping to hold down inflation is if some of it is taxed in order to avert a fiscal crisis that would otherwise be brought about by higher interest rates. By taxing away a portion of the saved wealth, the government can hold down its interest expenses and tamp down inflationary pressures.

Tyler begins by saying that “Price level dynamics and money supply processes are murky, at least in recent times.” If nothing else, on that we can agree.