Nonsense from the WSJ

This article needs a response. The gist of it is that high inflation is the right medicine for the U.S. economy right now. Unfortunately the writer does not appear to understand inflation and so the article doesn't make a lot of sense. Furthermore, the writer fails to account for the "unseen" as any good economist must. As Bastiat tells us, that is the difference between good and bad economists.

The writer begins with the premise that the real problem with the U.S. economy right now is debt. The federal debt is high right now; it hasn't been higher, as a percent of GDP, since the mid-1950s. The feds ran up a huge debt paying for WWII, and then spent a decade paying it down. The current debt is high for other reasons, although defense spending is certainly a big part of it. Households also have a lot of debt, but the personal savings rate has gone back up recently and is now around 5%.

After going on about how indebted Americans are, at all levels, the writer calls for a round of inflation so that people will have more nominal dollars to make it easier to pay off their nominal debt. This is essentially a wealth transfer from debtors to creditors. This effect is true; I have no quibble about it. But here's where the article makes claims that I find unacceptable.

First, the writer repeats the fallacy that WWII ended the Great Depression. I get that Keynesians still buy into this fallacy, but much recent research has pointed out that WWII did not end the Great Depression in the sense of a recovery in business investment and improvement in labor conditions. Sure, unemployment went down, but that's because boatloads (literally) of young men were shipped off to fight in Europe and the Pacific. Yes, GDP went up, but it was because the federal government was buying a whole bunch of war materiel that was destined for destruction. It should be clear why measuring well-being through GDP is dangerous and we must take great care when doing so. People can't eat tanks, after all.

Next, the writer insists that the inflation must be a general effect: not just commodity prices but also wages must rise. This ignores the non-neutrality of money. Price inflation comes about through money printing (in the U.S. case, monetizing the federal debt). But money doesn't appear in all places at the same time. It works its way through the economy starting with new bank loans. So one might see commodity prices and asset prices go up first, and then maybe only for certain industries where the loans are concentrated. It can take a lot of time for the inflation to get through to wages. In that time period, people will not have higher wages to pay off their debt, and their groceries are going to be getting more expensive. That's just grand for peoples' well being, isn't it?

This brings me to my next point - the writer confuses monetary inflation and price inflation, and he goes on to make the familiar point that a general deflation would be a disaster because there was a price deflation from 1929 - 1933, and that was a horrible time for the U.S. But, as Friedman and Schwarz (1966) point out, that was caused by a massive monetary deflation. That is certainly bad news for anyone, because what happens is you can't get the means of payment for goods and services. You may have productive capacity, but if you haven't the means to pay for raw materials and labor, you can't produce. This is a great danger of having a money monopolist, but I digress. The point is, price deflation isn't a problem, but monetary deflation is. We certainly do not have monetary deflation now. And, I think the writer is going to get his wish, because price inflation appears to be heating up.

The writer's thoughts on why the Great Depression lasted so long appear to be misinformed. He has certainly not kept track of the recent work in this area. Furthermore, the GD wasn't one ten year long depression. It was two depressions and a minor recovery in the middle of the decade.

In the last few paragraphs, the writer seems to be calling for a greater number of transactions to increase the velocity of money. In the quantity theory of money, MV = PQ, where M is the money supply, V is velocity, P is the price level, and Q is the quantity of goods. He seems to be saying that a higher P will cause a higher V, and that itself will be good. This is because he wants prices to be maintained. The problem here is that keeping people in homes they can't afford keeps their money tied up. The better solution might be to let home prices crash and have foreclosures. Declare bankruptcy and start moving forward - stop throwing good money after bad.

In the third to last paragraph, the writer confirms my suspicion that he does not understand the non-neutrality of money when he calls for helicopter drops of money. This is nonsense.

All in all, this article is unfortunately based on a misunderstanding of price inflation, and a conflation of price and monetary inflation. Further, because the writer doesn't appear to understand the non-neutrality of money he calls for high inflation that would likely hurt the very people he wants to help, before it would start to help them.

Expansion of the Exchange Media in a Closed Economy with no Production

What follows is a piece of correspondence I sent to a friend regarding money expansion and price changes. It is meant to suggest that money inflation may not show up in price inflation for all goods.

"The purpose here is to consider the effects on nominal prices of goods and services when exchange media expand in a closed economy with free exchange. I choose prison as an adequate metaphor here, with cigarettes as the media of exchange.

Suppose that there is a prison where the inmates provide goods and services to each other, and some goods are delivered from outside the prison. These latter can be considered to be ‘endowments’ from a neoclassical point of view. In fact, in prison, the endowments are likely to be the dominant goods available. The endowment includes cigarettes. Every day, the prisoners will be endowed with goods, (e.g. food, cigarettes, books) and then they may consume, store, or trade with each other.

Services are traded within prisons too. One of the most important services may be protection. This is not endowed, although the guards may provide some protection among inmates. Thus the inmate-provided protection is on the order of extra protection that may be purchased.

Now, consider a prison after all endowments have been made. Trade will occur, facilitated by cigarettes, and prices of various goods and services in terms of cigarettes will be set. These prices will reflect each prisoner’s value scale, including the consumption value of cigarettes, not just the exchange value. Note that cigarettes, then, are basically commodity money.

Imagine that cigarette endowments are now restricted to the ‘replacement’ level, such that when a cigarette is used up or wears out, it will be replaced. This assures the current arrangement of prices will not change unless the prisoners’ value scales change. So as new endowments (sans cigarettes) occur, trade occurs using a constant price matrix. We should expect no inflation or coordination problems in this case, assuming value scales are stable (constant).

Suppose now that one inmate is given an endowment of cigarettes that is reasonably large given then amount of cigarettes currently available. This could be from visiting family, for example. Now what will happen to the prices of available goods and services?

Suppose the inmate really enjoys small powdered cake doughnuts, the kind made by Hostess and other companies. The first thing, then, our inmate (call him A) might do is go and locate some doughnuts and procure them. He may already have some that he purchased previously. So he might go back to the same person (call him B) he traded with before to get the doughnuts. If that person (B) still has some doughnuts, then A will offer some cigarettes in exchange for the doughnuts. There are two possible outcomes here. The first is that B accepts A’s offer and an exchange is made. The second is B rejects A’s offer and no exchange occurs.

Remember now that all trading had ceased prior to the injection of new cigarettes. Thus, the last price offered to B was too low to trade any more doughnuts. So if A wants some of B’s doughnuts, A will have to offer a higher price than B accepted before in order to induce B to sell doughnuts to A. Alternatively, A can seek someone else from whom to buy doughnuts (person C). But since trade had ceased, the higher price required by B will also be required by C, although B’s price may be higher than C’s price, both prices will be higher than the previous market-clearing price.

Now, A might go on like this buying more things he likes. The prices of the things he likes will go up. But notice, too, that his trading partners will have more of the medium of exchange, so that they can buy more of the things they like. Thus one may  trace from A’s increase of exchange media a price increase in a variety of goods, according to the desirability of goods from the perspective of A and his initial trading partners.

A benefits the most from the increase in exchange media, and the benefit declines as the trading partners increase. A benefits more than others because he is using the new media before any of the other inmates are aware of the new media and so they have not yet adjusted their prices. In fact, it is A that causes the initial price adjustment and so he faces the minimal adjustment required to get his doughnuts, for example. Anyone coming after A to get doughnuts will have to pay a higher price than even A paid.

Note that if A hoards his new media of exchange and only uses a bit to get a small edge in trading whenever new endowments are delivered, the price effects will be minimal. But, if A exchanges all his new media quickly after receiving it for goods, price effects will be very rapid and may be large, depending on other inmates’ trading behavior.

After A’s new media have entered and circulated in the system, prices will have changed permanently. The price of doughnuts has gone up. Perhaps also the price of protection services, or books, has increased. We cannot know ahead of time. What is important to note is that i) prices didn’t increase immediately; ii) prices didn’t increase uniformly. In fact, a different pattern of trade may exist after prices change, assuming inmates’ value scales haven’t changed.

 If no new media are injected, the current price pattern will be constant. If new media are injected, two events are possible. If the media are injected by B (or C, D, whomever) then the price pattern will change to reflect first B’s most desired goods, and then his trading partners’ desires, and so on. However, consider what would happen if A were given the endowment of media again, and this became common knowledge. Then, as A were to go out and spend his new cigarettes, he would find B’s price of doughnuts already adjusted to (close to) the new market-clearing price. Since B wouldn’t know exactly what the new market-clearing price would be, he would estimate it but it would be, in any case, higher than the previous market-clearing price and likely higher than A’s initial offer would have been, since B anticipated A’s desire. This anticipation of higher market-clearing prices would move through the system in this case, and clearing prices would be reset much more quickly than when new media injections were unknown.

However, what would happen if A changed his pattern? Suppose A decided doughnuts were no longer on the menu. Then the anticipated price changes would be all wrong and have to go through a re-coordination process as A’s new media moved through the prison markets. This would likely through a lot of planned exchanges, perhaps ones that had already been agreed to (a forward exchange), out of whack and cause them to be less desirable than anticipated. Those plans that could be called off would be, and those that could not may result in value losses for those involved. At any rate, likely there would be less value gained than anticipated. A new price pattern would emerge, but now if A got another endowment and it was common knowledge, prices would not likely adjust since the other inmates cannot predict A’s behavior.

Finally, what would happen if the same size endowment of exchange media was given, but it was divided among 2 or more inmates? Unless the inmates had the exact same value scale, the exchange media would enter the prison economy more quickly than if just one inmate received the endowment, but the resulting price pattern would look different, since the inmates have different value scales. We cannot know, a priori, if the pattern would be a more or less general increase in prices than if just A got the endowment, although it is likely to be so. We do know, however, that as N becomes large, where N is the number of inmates receiving an endowment, the probability of a uniform increase in prices goes to 1."