luv2read
07-11-2008, 08:51 AM
A primer on inflation
Gven the recent concern of investors about inflation, I thought this would be a good opportunity to lay out some basic economic principles that are helpful in understanding what actually drives price changes, beyond simple statements about “too much money chasing too few goods,” and misconceptions such as the idea that economic growth causes inflation.
To understand inflation, it helps to know a little bit about “marginal utility.” The typical way I used to teach my economics undergraduates was to get them thinking about ice cream. The first cone might give you a lot of happiness. But if you eat a second cone, you'll get a little less enjoyment. The third cone might be just slightly enjoyable. You might be indifferent toward the fourth, and are likely to be averse (negative marginal utility) to eating a fifth. So as you increase the availability of a good, the “marginal utility” – the value you place on an additional unit – declines.
The same basic principle holds for the economy as a whole. Suppose that given the economy-wide supply of ice cream, the marginal utility of ice cream is six smiley faces, and the marginal utility of a pencil is two smiley faces. Given that, the price of an ice cream cone, in terms of pencils, will be just the ratio of the marginal utilities, so an ice cream cone will cost you 3 pencils.
Exactly the same holds true for money itself. If you hold a dollar in your wallet, you might be giving up some potential interest earnings, but you're willing to hold it anyway because that dollar of currency provides certain usefulness in terms of making day-to-day transactions and so forth. If that dollar is held as reserves against checking accounts at a bank, that dollar is implicitly providing a certain amount of banking services. So a dollar bill has a certain amount of marginal utility, by virtue of legal factors like reserve requirements on checking accounts, and convenience factors like the ability to buy a nutty sundae with cash at the ice cream truck.
As a result, the prices of various goods and services in the economy, in terms of dollars, will reflect the ratios of marginal utilities between “stuff” and money. The dollar price of good X is just the marginal utility of X divided by the marginal utility of a dollar.
So how do you get inflation? Simple.
• increase the marginal utility of “stuff”: This happens either if the supply of goods and services becomes more scarce, or if the demand for goods and services becomes more eager
• reduce the marginal utility of dollars: This happens either if the supply of dollars becomes more abundant, or if the demand to hold dollars becomes weaker.
But wait. I've noted frequently over the years that longer-term inflation is not primarily driven by the growth of money, but rather by the growth of government spending. Isn't that view at odds with what I just described? Isn't it at odds with the whole of economic theory?
Not at all, the importance of fiscal policy in determining inflation is immediately apparent if we stop thinking in terms of “partial equilibrium” (the supply and demand of one item at a time) and think instead in terms of the full or “general” equilibrium imposed by a government budget constraint.
See, if you're a banana republic and want to run a huge government spending program, you're not likely to go through the etiquette of issuing government bonds or setting a proper marginal tax policy. You'll just print up pieces of paper. Friedman's first dictum that “inflation is always an everywhere a monetary phenomenon” is largely a reflection of a long history across many countries that a heavy government spending financed by printing money predictably leads to inflation. In particularly unproductive economies, it leads to hyperinflation.
But what if the government spending is financed by issuing bonds? It's tempting to think that somehow printing money means an increase in spending power, while issuing bonds means that the government is taking something in return for what it spends, but it's important to focus on the general equilibrium. In both cases, regardless of whether government finances its spending by printing money or issuing bonds, the end result is that the government has appropriated some amount of goods and services, and has issued a piece of paper – a government liability – in return, which has to be held by somebody. Moreover, both of those pieces of paper – currency and Treasury securities – compete in the portfolios of individuals as stores of value and means of payment. The values of currency and government securities are not set independently of each other, but in tight competition. That is particularly true today, when bank balances are regularly swept into interest earning vehicles as often as every night.
To the extent that real goods and services are being appropriated by government in return for an increasing supply of paper receipts, whatever the form, aggressive government spending results in a relative scarcity of goods and services outside of government control, and a relative abundance of government liabilities. The marginal utility of goods and services tends to rise, the marginal utility of government liabilities of all types tends to fall, and you get inflation.
Contrast this with the Great Depression. Output declined enormously, but goods and services weren't scarce because of production constraints. Rather, output fell because of a major reduction in demand. So the marginal utility of goods and services most likely declined during that period even though production itself was down. In contrast, despite a rapid increase in the monetary base during the Depression, people were frantic to convert their bank deposits into currency, so even the monetary growth that occurred wasn't nearly enough. The frantic demand for currency, resulting from credit fears, translated into a major increase in the marginal utility of money.
So what happened to prices during the Great Depression? Think in terms of the marginal utilities: the marginal utility of “stuff” dropped, while the marginal utility of money soared. The result was rapid price deflation.
In short, inflation results from an increase in the marginal utility of goods and services, relative to the marginal utility of money. It can reflect supply constraints, unsatisfied demand, excessive growth of government liabilities, or a reduction in the willingness of people to hold those liabilities. Apart from commodity prices, which may take a bit longer to reverse, the pressures on marginal utilities are presently on the disinflationary side.
As a side note, it's interesting to observe that inflation typically picks up in late-stage economic booms, not because the economy is growing too fast, but rather because the economy begins to hit capacity constraints and is therefore not able to grow fast enough. The resulting increase in the marginal utility of goods and services is what the Fed often attempts to cool down by trying to make sure that demand growth doesn't outstrip the increasingly constrained level of supply. To the extent that you often get a recession a year or two later, and that Congress tends to respond to recessions by increasing government spending, it may appear that inflation actually "causes" government spending with a lag of about two years (an observation made by Ned Davis, discussing a chart from my June 9 comment (http://www.hussmanfunds.com/wmc/wmc080609.htm)). That's a result of the general pattern of the business cycle, but shouldn't be confused with the actual line of causality from sustained (say 4-year) growth in government spending to sustained inflation trends of similar duration.
Milton Friedman is widely known for two phrases, one which is half right, and one which is exact. The half-right dictum is that “inflation is always and everywhere a monetary phenomenon.” It's half right because a government spending expansion, regardless of the form, will tend to raise the marginal utility of goods and services while lowering the marginal utility of government liabilities. It's very true that the major hyperinflations in history have been triggered by currency expansion, but as long as a government appropriates goods and services to itself in return for pieces of paper that compete as stores of value and means of exchange in the portfolios of investors, you'll get inflation.
The completely correct dictum from Milton Friedman is this: “the burden of government is not measured by how much it taxes, but by how much it spends.”
http://www.hussmanfunds.com/wmc/wmc080707.htm
Gven the recent concern of investors about inflation, I thought this would be a good opportunity to lay out some basic economic principles that are helpful in understanding what actually drives price changes, beyond simple statements about “too much money chasing too few goods,” and misconceptions such as the idea that economic growth causes inflation.
To understand inflation, it helps to know a little bit about “marginal utility.” The typical way I used to teach my economics undergraduates was to get them thinking about ice cream. The first cone might give you a lot of happiness. But if you eat a second cone, you'll get a little less enjoyment. The third cone might be just slightly enjoyable. You might be indifferent toward the fourth, and are likely to be averse (negative marginal utility) to eating a fifth. So as you increase the availability of a good, the “marginal utility” – the value you place on an additional unit – declines.
The same basic principle holds for the economy as a whole. Suppose that given the economy-wide supply of ice cream, the marginal utility of ice cream is six smiley faces, and the marginal utility of a pencil is two smiley faces. Given that, the price of an ice cream cone, in terms of pencils, will be just the ratio of the marginal utilities, so an ice cream cone will cost you 3 pencils.
Exactly the same holds true for money itself. If you hold a dollar in your wallet, you might be giving up some potential interest earnings, but you're willing to hold it anyway because that dollar of currency provides certain usefulness in terms of making day-to-day transactions and so forth. If that dollar is held as reserves against checking accounts at a bank, that dollar is implicitly providing a certain amount of banking services. So a dollar bill has a certain amount of marginal utility, by virtue of legal factors like reserve requirements on checking accounts, and convenience factors like the ability to buy a nutty sundae with cash at the ice cream truck.
As a result, the prices of various goods and services in the economy, in terms of dollars, will reflect the ratios of marginal utilities between “stuff” and money. The dollar price of good X is just the marginal utility of X divided by the marginal utility of a dollar.
So how do you get inflation? Simple.
• increase the marginal utility of “stuff”: This happens either if the supply of goods and services becomes more scarce, or if the demand for goods and services becomes more eager
• reduce the marginal utility of dollars: This happens either if the supply of dollars becomes more abundant, or if the demand to hold dollars becomes weaker.
But wait. I've noted frequently over the years that longer-term inflation is not primarily driven by the growth of money, but rather by the growth of government spending. Isn't that view at odds with what I just described? Isn't it at odds with the whole of economic theory?
Not at all, the importance of fiscal policy in determining inflation is immediately apparent if we stop thinking in terms of “partial equilibrium” (the supply and demand of one item at a time) and think instead in terms of the full or “general” equilibrium imposed by a government budget constraint.
See, if you're a banana republic and want to run a huge government spending program, you're not likely to go through the etiquette of issuing government bonds or setting a proper marginal tax policy. You'll just print up pieces of paper. Friedman's first dictum that “inflation is always an everywhere a monetary phenomenon” is largely a reflection of a long history across many countries that a heavy government spending financed by printing money predictably leads to inflation. In particularly unproductive economies, it leads to hyperinflation.
But what if the government spending is financed by issuing bonds? It's tempting to think that somehow printing money means an increase in spending power, while issuing bonds means that the government is taking something in return for what it spends, but it's important to focus on the general equilibrium. In both cases, regardless of whether government finances its spending by printing money or issuing bonds, the end result is that the government has appropriated some amount of goods and services, and has issued a piece of paper – a government liability – in return, which has to be held by somebody. Moreover, both of those pieces of paper – currency and Treasury securities – compete in the portfolios of individuals as stores of value and means of payment. The values of currency and government securities are not set independently of each other, but in tight competition. That is particularly true today, when bank balances are regularly swept into interest earning vehicles as often as every night.
To the extent that real goods and services are being appropriated by government in return for an increasing supply of paper receipts, whatever the form, aggressive government spending results in a relative scarcity of goods and services outside of government control, and a relative abundance of government liabilities. The marginal utility of goods and services tends to rise, the marginal utility of government liabilities of all types tends to fall, and you get inflation.
Contrast this with the Great Depression. Output declined enormously, but goods and services weren't scarce because of production constraints. Rather, output fell because of a major reduction in demand. So the marginal utility of goods and services most likely declined during that period even though production itself was down. In contrast, despite a rapid increase in the monetary base during the Depression, people were frantic to convert their bank deposits into currency, so even the monetary growth that occurred wasn't nearly enough. The frantic demand for currency, resulting from credit fears, translated into a major increase in the marginal utility of money.
So what happened to prices during the Great Depression? Think in terms of the marginal utilities: the marginal utility of “stuff” dropped, while the marginal utility of money soared. The result was rapid price deflation.
In short, inflation results from an increase in the marginal utility of goods and services, relative to the marginal utility of money. It can reflect supply constraints, unsatisfied demand, excessive growth of government liabilities, or a reduction in the willingness of people to hold those liabilities. Apart from commodity prices, which may take a bit longer to reverse, the pressures on marginal utilities are presently on the disinflationary side.
As a side note, it's interesting to observe that inflation typically picks up in late-stage economic booms, not because the economy is growing too fast, but rather because the economy begins to hit capacity constraints and is therefore not able to grow fast enough. The resulting increase in the marginal utility of goods and services is what the Fed often attempts to cool down by trying to make sure that demand growth doesn't outstrip the increasingly constrained level of supply. To the extent that you often get a recession a year or two later, and that Congress tends to respond to recessions by increasing government spending, it may appear that inflation actually "causes" government spending with a lag of about two years (an observation made by Ned Davis, discussing a chart from my June 9 comment (http://www.hussmanfunds.com/wmc/wmc080609.htm)). That's a result of the general pattern of the business cycle, but shouldn't be confused with the actual line of causality from sustained (say 4-year) growth in government spending to sustained inflation trends of similar duration.
Milton Friedman is widely known for two phrases, one which is half right, and one which is exact. The half-right dictum is that “inflation is always and everywhere a monetary phenomenon.” It's half right because a government spending expansion, regardless of the form, will tend to raise the marginal utility of goods and services while lowering the marginal utility of government liabilities. It's very true that the major hyperinflations in history have been triggered by currency expansion, but as long as a government appropriates goods and services to itself in return for pieces of paper that compete as stores of value and means of exchange in the portfolios of investors, you'll get inflation.
The completely correct dictum from Milton Friedman is this: “the burden of government is not measured by how much it taxes, but by how much it spends.”
http://www.hussmanfunds.com/wmc/wmc080707.htm