Let Them Eat Chips

February 24, 2011

by Jerry O’Driscoll

In today’s Wall Street Journal, David Wessel (“Capital” column, A5) revisits the question of whether current Fed policy is inflationary. He correctly states the Fed’s position is that inflation is caused by expectations. Inflation will stay low if people expect it to stay low.  He quotes Fed Chairman Bernanke: “The state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”  

The Fed chairman of course has the causation precisely backwards. Fed policy systematically shapes inflation expectations. His statement is the product of the focus on the short-run and ephemeral over the long-run and permanent. In that, Ben Bernanke follows a long line of central bankers.

In A History of the Federal Reserve, Volume 1: 1913-51, Allan Meltzer summarizes the central bank mindset from the banking school writers like Thomas Tooke down to the Fed. Tooke “denied that money, credit, or base money bore any consistent relation to prices. Most Federal Reserve officials remained in this tradition in the 1920s. They denied that their actions affected prices” (57-58).  

Unfortunately for defenders of Fed policy, today’s paper is filled with stories of rising inflation. In Singapore, consumer price inflation is running at 5.5%. In Vietnam, consumer price inflation is running at over 12%. There are food riots in India. In yesterday’s Wall Street Journal, George Melloan detailed the linkage between economics and turmoil in the Middle East. Consumer price inflation in Egypt rose to 18% annually in 2009 from 5% in 2006. In Iran, inflation rose from 13% in 2006 to 25% in 2009. As Melloan wryly observes, “about the only one failing to acknowledge a problem seems to be the man most responsible, Federal Reserve Chairman Ben Bernanke.”  

Monetary policy is not the sole culprit in food price inflation. There have been supply shocks. Central bankers always point to supply shocks to explain rising prices. But it is not just food prices rising, but most commodity prices. Plus, as noted, broad measures of consumer prices around the world are signaling rising inflation.

The Bernanke’s response is two-fold. First, he questions the linkage between his policies and what is happening to global prices. Second, he argues other central banks are in a better position to mitigate the effects of Fed policy. Both arguments are disingenuous.

Commodities, plus most traded goods, are priced in dollars. The Fed creates base money. The more base money, the higher the dollar price of goods globally.

The Fed Chairman argues that foreign central banks can offset the Fed’s policy. As discussed here recently, this is true only to a limited extent if at all. Small, open economies have great difficulty in offsetting inflows of the global currency. If these central banks raise domestic interest rates and appreciate their currencies, they are likely to attract additional capital flows. If not, they risk sending their economies into recession.

Bernanke’s defense amounts to a restatement of Treasury Secretary John Connally’s quip to Europeans during the Nixon prequel to current dollar policy: “It’s our currency, but your problem.” The Fed inflates, and other central banks must mitigate.

Consumers purchase daily and weekly the goods whose prices are increasingly rapidly: food, energy and clothes. The goods whose real prices are falling, such as consumer electronics, are purchased infrequently.  But they keep measures of consumer prices subdued. Marie Antoinette famously remarked that the French peasants rioting over bread prices could eat cake. Policymakers apparently believe US consumers can do the equivalent of eating microchips: stop eating and driving, and just buy more electronics.  In reality, US consumers face the prospect of a falling standard of living.  They can’t eat chips.

17 Responses to “Let Them Eat Chips”

  1. Ned Baker Says:

    “Commodities, plus most traded goods, are priced in dollars. The Fed creates base money. The more base money, the higher the dollar price of goods globally.”

    This is the premise of your argument and I’m not sure it’s the certainty you claim. Doesn’t global credit have something to do with the money supply? How do you square your argument with the fact that the M2 multiplier is on the floor and broader measures of the money supply have not moved in line with M0 growth?

  2. Ned Baker Says:

    Correction: I was thinking of the M1 multiplier. But M2/M1 is down a lot as well.

  3. Lord Keynes Says:

    “Monetary policy is not the sole culprit in food price inflation. There have been supply shocks. Central bankers always point to supply shocks to explain rising prices. But it is not just food prices rising, but most commodity prices. Plus, as noted, broad measures of consumer prices around the world are signaling rising inflation.”

    What about surging demand from emerging economies like China?

    “Small, open economies have great difficulty in offsetting inflows of the global currency. If these central banks raise domestic interest rates and appreciate their currencies, they are likely to attract additional capital flows.”

    Countries around the world are turning to capital controls as well:

    http://blogs.wsj.com/economics/2011/01/31/economists-urge-us-to-rethink-capital-control-restrictions/

    Another serious problem here is that China is experiencing high inflation, but has comparatively rigid capital controls. You can’t blame the Fed as soew kind of major factor for inflation in China. That is being caused by a complex number of factors: poor harvests in China, a booming economy, rising labor costs, and surging international commodity prices.


  4. Both comments concern the monetary transmission mechanism.

    The M1 multiplier is at recent historic lows. I have two comments on that. First, base money is still money, whether “multiplied” or not. (This issue was always a substantive point in dispute in the 19th century banking controversies. Again, I recommend Meltzer.)

    Second, QE1 and QE2 did not result in a monetary and credit “pyramid” in the US (at least not thus far). But it did so in emerging markets in Asia and Latin America. The why of that is an intersting question on which more work needs to be done. But the fact of it is evident.

    Which gets me to Lord Keynes’ observations (which I think are at odds with the views of the authentic Lord Keynes). I will respond in a second comment.


  5. To Lord Keynes:

    Along with many others, including the Chinese, I do identify the Fed as a major factor in China’s inflation. But I don’t understand why you raise China in the context of my statement about “small, open economies.” China is neither.

    There is a view, which I find plausible but not proven, that Bernanke’s true goal with QE2 was to force a revaluation of the Yuan. In that he has certainly succeeded. The inflation in China has already forced the real Yuan x-rate to appreciate. Now we see liberalization proceeding with an expected appreciation in the nominal x-rate. Call it gunboat diplomacy, central-bank style.

    I repeat that in the history of central-bank controverises, central banks typically blame supply shocks. And there are always supply shocks. (Global food supply is up not down, by the way.) If there were just supply shocks, then they would result only in relative-price changes and once-and-for-all movements in price indices. If observed supply shocks are accompanied by inflation, then monetary stimulus is at work.

    Today’s monetary policy replicates that of the 1970s. It was a cheap dollar policy, as is QE2. The energy supply shocks were superimposed on easy money. The decade ended in disaster, the dismissal of a Fed Chairman and appointment of Paul Volcker. Those who know their monetary history find it unlikely that this episode will end well.

  6. Richard Ebeling Says:

    To make a comment on expectations and the “transmission mechanism,” to which Jerry has referred to.

    If people believe that higher price inflation is coming, they may very well attempt to build that into their buying and pricing decisions “today.”

    But if, in fact, the central bank has not increased (or accelerated the growth in) the money supply, sellers will find that they have raised prices to a level unsustainable given the actual money supply (or monetary trend) in the economy.

    And any decrease in average cash balances (increase in “velocity”) resulting from higher consumer and buying inflation expectations would be short-lived as, after they have accelerated some purchases to get ahead of that expected higher rate of price inflation, the actual rate of monetary expansion and expected general rate of rise in prices turns out not to be true.

    Likewise, if people expect a lower rate of price inflation than is actually consistent in the longer-run with the actual rate of monetary expansion, they will, over time, find themselves (due to that rate of monetary expansion) with larger average cash balances than they were desiring to hold, and the excess cash balances will be spent.

    And, in turn, sellers will find, over time, that goods-demand for their products and services is rising more than they had anticipated, they they will start adjusting prices upwards to reflect actual money demands on the market.

    So, in other words, monetary policy will bring about a change in buyer and seller expectations, rather than monetary policy somehow being the “passive” element in the expectations and pricing process.

    Richard Ebeling

  7. Ned Baker Says:

    Dr. O’Driscoll,

    You wrote the following above:

    “Second, QE1 and QE2 did not result in a monetary and credit “pyramid” in the US (at least not thus far). But it did so in emerging markets in Asia and Latin America. The why of that is an intersting question on which more work needs to be done. But the fact of it is evident.”

    I’m not an economist, so maybe you can help me understand what is evident here. Are you saying the Fed’s expansion of our monetary base increased the broader money supply in Asia and Latin America? How is this measured? Can you point me to some indicators or research on this for my own edification?

    Thanks,
    Ned


  8. Ned Baker, Please reread the 4th para of my post. Check out the link to the WSJ article. Emerging markets have been booming for some time. Particularly in Asia, real-estate markets are booming. Now they have consumer price inflation.

    That has been financed with domestic credit. Many emerging-market currencies are dollar-linked. There are almost clean floats in any case. That links their domestic money supplies to the supply of dollars.

    You might google Global Money Supply or something similar for literature.

  9. Lord Keynes Says:

    “Today’s monetary policy replicates that of the 1970s. etc etc”

    The inflation of the 1970s was caused by

    (1) the uncertainity in financial markets and rush to speculate in commodities caused by the end of Bretton Woods in 1971

    (2) the dismantling of the US commodity buffer stocks in the 1960s, which had previously stabilized commodity prices. Price shocks due to poor harvests and other supply factors in 1970-1973 exacerabted (1)

    (3) wage price spirals due to much stronger union power back then

    (4) the first and second oil shocks.

    It seems to me that the flawed quantity theory of money underlies the analysis in the blog post.

    The adoption by Paul Volcker of the quasi-monetarist attempt to target money supply growth rates was a spectacular failure, causing a massive double dip recession, as the Federal funds rate soared to 20%:

    http://socialdemocracy21stcentury.blogspot.com/2011/02/reaganomics-analysis.html

    The Fed badly missing its M1 targets (Wray 2003: 92), and simply could not control M1: but this should come as no surprise to advocates of the endogenous money theory:

    http://en.wikipedia.org/wiki/Endogenous_money

    Years after this disaster, Milton Friedman was interviewed by the Financial Times (7 June 2003). He stated: “The use of quantity of money as a target has not been a success, … “I’m not sure I would as of today push it as hard as I once did.” Pity it took him 21 years to realise what was obvious to many other people.

  10. Lord Keynes Says:

    One can see the monthly, seasonally adjusted M1 money supply growth rates here at the bottom of the page on Shadowstats:

    http://www.shadowstats.com/charts/monetary-base-money-supply

    The growth rate was between 5% and 9% in the 1970s. In the 1980s it was between 5% and 17% and was clearly higher, yet there was no double digit inflation o stagflation in the 1980s and mainly disinflation.

    You might get some support for your view by looking at monthly, seasonally adjusted M2 and M3 money supply growth rates on the same page.

    But there is a serious problem: since 2007 both M3 and M2 growth rates have plunged in a way that almost unprecedented historically.

    M3 has actually contracted from 2009 to 2010.

    Should this not signal deflation, on a monetarist view?


  11. Lodr Keynes systematically misinterprets history and misconstrues what others say. Instead of addressing what I actually wrote, he criticizes a caracture of the QT.

    Briefly on the 1980s. Volcker’s policy was a success in that it broke inflation. It was very costly because of the cheap dollar policies of the 1970s. The pain of the early 1980s was sown in the 1970s.

    Just when monetary targetting was adopted in 1979, the relationship between the monetary targets and prices or nominal GDP broke down. Whether that was cause-and-effect or adventitious has been the subject of a debate that will likely continue.

    Most monetarists recognized the breakdown by 1990, if not earlier. Friedman was very late to accept the new reality. Many monetarists adopted a form of nominal GDP targetting.

  12. Richard Ebeling Says:

    It is only a rather mechanical quantity theory that expects close and relatively rigid connections between money and the price level or nominal GDP.

    The general quantity theory tradition that emerged out of the approach of Richard Cantillon Henry Thornton, John E. Cairnes, Ludwig von Mises, and Friedrich A. Hayek never expected simple and one-to-one relationships between “money” and “prices.”

    Precisely because these thinkers focused far more on the micro-economic sequential processes through time as money was injected in the economy and then worked it way from market-to-market, influencing demands and prices in non-uniform and non-proportional ways, they would not consider the quantity theory to be “refuted” or made “irrelevant” because money’s impact does not follow the Fisher-Friedman version of the theory.

    Also, someone holding a more “subjectivist” conception of money (and near monies, or widely used money substitutes) will also not be as surprised if the connection between money and prices (or nominal GDP) does not seem to “causally” show itself, if what people over time come to use as money (or money substitutes) is different from what the analyst defines as money for purposes of his policy expectations.

    Richard Ebeling

  13. Bogdan Enache Says:

    There’s a problem with Marie Antoinette’s remark : she never actually said that :)

  14. Joe Knight Says:

    We are now entering the third oil shock that will wake us up. $20 a gallon gas? My hope is that the United States will quit acting like a fuel junkie. We should utilize our shale oil technology to resource our needs.

    The hard part is that the shale needs to be heated for three years before oil comes out, while at the same time the well wall needs to be cooled down to keep water and chemical contamination down. Shell Oil is the leader in this technology. It is estimated that it would be profitable if oil stays above $120 for the forseeable future.

    When the technology is in use, the price of oil would drop considerably, maybe as low as $20 per barrel. The U.S. has enough oil shale to power the entire world for centuries.

    Consider the U.S. shipping ports exporting oil to Saudi Arabia, China, or even Europe. The U.S. would wipe out the huge accumulated debt that has been on the books in short order. Wouldn’t that be nice for a change?

  15. Tom Owen Says:

    I don’t get time to eat breakfast, so I go to school and have a small packet of chips, like baked lays. I don’t like my school lunch so at lunch time I eat another small packet of baked lays. And when I come back home, I eat dinner. Will eating chips in the day make me fat if I don’t eat anything else? I am 16years old.


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

Join 1,742 other followers

%d bloggers like this: