There’s an interesting cross-blog conversation about supply, demand, inflation, and Fed policy going on. First, John Cochrane wrote a highly technical post with a rather simple message—inflation is hard:
Why is it so hard? The standard story goes, as there is less “slack” in product or labor markets, there is pressure for prices and wages to go up. So it stands to perfect reason that with unemployment low and after years of tepid but steady growth, with quantitative measures of “slack” low, that inflation should rise, as Ms. Yellen’s first quote opines.
That paragraph contains a classic economic fallacy, that of composition; the confusion of relative prices and the level of prices and wages overall. If labor markets get “tight,” companies finding it hard to find workers, then yes, one expects wages to rise. But one expects wages to rise relative to prices. You only tempt workers to move to your company by offering them wages that allow them to buy more. Similarly, if there is strong demand for a company’s products, its prices will rise. But those prices rise relative to other prices and to wages. Offering a company higher prices when its wages, costs, and competitor’s prices are all rising does nothing to get it to produce more.
which highlighted a number of misconceptions about inflation, including misconceptions shared by the board of governors of the Federal Reserve. Then Tyler Cowen linked to it. Then Scott Sumner responded to it:
This is one of those cases of two things that look superficially similar but are actually radically different, like eels and snakes. When money became very tight in 1921, 1930, 1938 and 2009, the equilibrium price level fell sharply. Nominal wages also needed to adjust downwards. Unfortunately, nominal wages are sticky, so wage growth slowed much too gradually to prevent high unemployment. Thus even though nominal wage growth slowed in all four cases, real wages actually increased sharply. Cochrane’s right that the wage changes we see in this sort of labor market have nothing to do with microeconomic models where a high level of demand means rising prices and a low level of demand means falling prices. Those micro models refer to real or relative prices, not nominal prices.
Hidden in the posts are a number of interesting points:
- The Fed has maintained a tight money policy for some time. Some (like me) have suspect that the problem the Fed has actually been addressing rather than, say, persistently low inflation or slow growth, has been big bank insolvency which, unfortunately, they’ve abetted.
- The Taylor Rule actually would be doing a better job.
all of which, naturally to my mind, raise the point are Fed screw ups inevitable? I believe they are. The Great Depression, the Capital Strike of 1938, and the Great Recession are all, arguably, the consequences of mistakes by the Fed rather than the myriad of explanations that have been presented for them. The reality is that there are just too many moving parts for any small group of individuals however well intentioned, educated, and informed to execute all of the tasks the Federal Reserve is presently undertaking.
What to do? I think that the Fed’s mandate should be limited to bank governance and the popular press and the public need to discard the image of the Fed governors as all-mighty and all-knowing wizards.
When people talk about the Fed, I start thinking about how little we know about who they answer to. Conspiracies? I use Bank of the West, Follow their website back, part of Parabas group…? There is actually a Rothchild on their Board of Directors.
The problem is that money, currency, and financial products are not very well understood. The classical concepts do not match the reality of the existing monetary/financial system, and a financial backed monetary system cannot be understood using Adam Smith or Lord Keynes.
It would be like trying to understand quantum physics or string theory using Newtonian mechanics.
The 21st century economists trying to understand the existing monetary/financial system are like the 19th century physicists trying to understand light. Light acts as both a wave and a particle, but light waves do not require a medium. They can propagate within a vacuum or empty space which is impossible with Newton.
When the monetary system is backed by the financial system, money, currency, and financial products are different manifestations of the same thing, or the old story of the three Hasidic merchants who were shipwrecked on a desert island.
In Professor Summer’s comment section, there is a comment about […] why they are called “banks” and not something like “money factories”. […]. I believe the “banks” are central banks, but amusingly, it is correctly applied to financial institutions. When money is created through lending, a bank is a money factory.
Money created through lending is destroyed through repayment or default. As such, repayments and defaults must be replaced with new lending, but simply replacing one destroyed dollar with a newly lent one will not work. There are additional costs required for the lending process to function.
For a system in equilibrium (old lending replaced with new lending one-to-one), these overhead costs will not allow the system to remain in equilibrium. Because the system is in equilibrium, there is no way for these costs to be included on the balance sheet, and they will continually be compounding. This monetary/financial system is always on the verge of collapsing.
When the lending produces assets (houses, factories, offices, etc.), these assets need to inflate to cover the cost of creating the money being lent. Assets that produce goods or services, add to the economy, and as the asset value increases, they can be used as collateral for additional lending.
Lending used to purchase goods and services for consumption can only be productive as long as the asset value and asset production increases, but after a slow-down, it must be done even faster. “Free-trade” where imported goods and services are traded for financial products will eventually cause a collapse.
In the 2008 Financial Crisis, the question that should have been asked is, “What happens to the monetary/financial system when the assets used as collateral for the money created suddenly collapse?”
Instead the question was, “How do we get the government to cover this giant fucking Ponzi scheme, and how do we keep the game going?” Easy, find two dumbshit politicians, get a Wall Street lackey, and a bought-off president – Dodd-Frank, Geithner, and Obama.
I asked my two dogs if it was a good idea to let Dodd-Frank, Geithner, and Obama. They are not that smart, but they tilted their heads and looked at me like I was stupid.