In some tribes studied by anthropologists it was found that members believed that animals and objects, rather than human beings, were responsible for pregnancies. Pregnant women were asked by other members of the tribe what object or animal they had seen immediately before discovering that they were pregnant. That object or animal — say, a large rock or a monkey — would then be considered to be the father of the unborn child.
Such is a rather humorous example of what is called “animistic” or “magical” thinking. At root, it is based on spurious correlation — the belief that just because two things coincide, in this case the discovery of the pregnancy and the sighting of an object or animal, that one must have caused the other. We see such spurious correlations together with magical thinking in certain economic tribes today too.
In my last post pointing out how an Austrian blogger had grossly misused data the debate in the comments section eventually turned to the idea that inflation was a monetary phenomenon. I anticipated this was going to happen (Austrians are remarkably predictable because their theories are so simplistic that a computer program could very nearly follow and anticipate their reasoning) and so I crunched some of the numbers on inflation in advance.
First I should establish that it is true that inflation is generally accompanied by a rise in the money supply. But this is as true as the fact that the pregnant tribeswoman sees a large rock just before she discovers her pregnancy. The fact is that money does not “do” anything — just as large rocks do not impregnate women. Money is a passive medium and saying that it “causes” inflation is simply animistic or magical thinking.
The money supply expands and contracts as inflation rises and falls. This was well-known by the economist that the Austrians claim to follow: Knut Wicksell. Wicksell realised that bank credit was flexible and that money was passively “pulled” from the banking system as prices rose. He understood this because he had read and comprehended the views put forward by the great pioneer of modern monetary theory, Thomas Tooke.
The Austrians, however, together with their monetarist cousins came to forget this and today they will make animistic claims about money as some sort of active agent driving economic activity. To others this appears bizarre and amusing. Practical economists working day-to-day know that in order to understand why inflation occurs — and what drives the expansion of the passive medium known as “money” — we must study what the causes price rises. These are usually events or institutions that have all-too-human aims and goals.
It might be illuminating then to turn to the inflation of the 1970s in the US to illustrate this point. All the data used in what follows is from FRED.
Here is a graph showing the CPI and its major components between 1970 and 1982:
The two major components of inflation in this era were rising unit labour costs — that is, rising wages relative to productivity — and rising oil prices. The former was due in large part to the strength of union-bargaining power which we shall break down in more detail below. The latter was due to the oil price spike initiated by OPEC in response to geopolitical events in the Middle-East.
Let us, however, zoom in to the first outbreak of inflation and see what the data tells us:
This is a very interesting graph because it tells us a pretty solid story about the beginning of the inflation in the US in the 1970s. As we can see, it is actually the inflation that takes off before the rise in unit labour costs. The inflation begins to pick up in the 3rd quarter of 1972 while unit labour costs only begin to rise in the 1st or 2nd quarter of 1973. Unit labour costs responded quickly to the inflation because many contracts were indexed to inflation measures similar to the CPI, but it is clear from the data that the inflation came first.
The reason for this was that spending on the Vietnam War had gotten out of control in the late-60s. In his last year as president Lyndon Johnson was running a budget deficit of somewhere between 3-4% of GDP (the numbers are very unreliable for this period) while unemployment was substantially below 4%. The reason for this was that because the Vietnam War was very unpopular the Johnson administration did not want to fund it out of tax receipts and instead opted for a “guns and butter” economy.
The result of this was that inflationary pressures began to build. These pressures were initially contained by a strong, fixed dollar. This lasted until the Bretton Woods system began to falter. As the fixed exchange-rate system fell apart between 1971 and 1973 the dollar lost over 20% of its value; meanwhile the US continued to run trade deficits. By 1972 the inflation could no longer be contained and prices began to rise. Nixon put in place wage and price controls in the 3rd quarter of 1971 but these began to gradually break down, unleashing the beginning of a wage-price spiral from the then heavily unionised workers. Finally, in the 4th quarter of 1973 OPEC initiated the first oil price shock and inflation reached a high of 12% in the 4th quarter of 1974 — pushed on, no doubt, by a continuing wage-price spiral. After this the situation got completely out-of-control and was exacerbated by another oil price shock in 1979.
That is basically the story of the 1970s inflation. As we can see all the actions undertaken were by people, not by animistic monetary forces. The politics of the Vietnam War played a large part; so too did OPEC and geopolitics in the Middle-East; and so too did the unions, although there is a case to make that they were reacting rather than acting. The money supply did increase in this period but this was due to increases in bank credit together with new money spent into the system by the government.
Saying that this inflation was a “monetary phenomenon” is a bit like saying that a bruise is the result of internal bleeding; while this may be somewhat accurate, it leaves the cause of said internal bleeding completely unanswered. And maybe that’s the point. Maybe the point is not to discover true causes but to blame imaginary ones that fit with preconceived notions. It is, after all, a lot easier to say that a large rock is the father rather than admit that your brother impregnated your wife.
Nice post, but some minor quibbles:
(1) I think you need to look at wage rises from 1968–1969 in Japan, France, Belgium and the Netherlands and then from 1969–1970 in Germany, Italy, Switzerland and the UK. As Kaldor (1976: 224) argued, this was most likely the cause of the initial inflation from 1969-1971.
(2) “The reason for this was that spending on the Vietnam War had gotten out of control in the late-60s. In his last year as president Lyndon Johnson was running a budget deficit of somewhere between 3-4% of GDP (the numbers are very unreliable for this period) while unemployment was substantially below 4%.”
I think that cause is exaggerated. It is more likely the mechanism was
(1) above, then
(2) The end of Bretton Woods induced inflationary expectations and instability on financial and commodity markets, as well as a rise in commodity speculation as a hedge against inflation.
(3) more primary commodity inflation in 1972 occurred since the US had ended its commodity buffer stock price stabilisation policies, and then the failure of the harvest in the old Soviet Union in 1972–1973 occurred, and Soviets made nexpectedly large purchases on world markets.
Kaldor, N. 1976. “Inflation and Recession in the World Economy,” Economic Journal 86 (December): 703–714.
(1) I don’t see what this has to do with US inflation…
(2b) The breakdown of the Bretton Woods system was due to overspending. The US spent to fund the war. A trade deficit opened. Gold reserves fled the US. Eventually the Bretton Woods system broke and all of what you say happened.
(2c) Yes, I think this was important too.
Regarding (1), I was thinking of these as important for the general causes of stagflation world wide, but I see now your post is concerned with the US, so, yes, you are right that it is not really relevant to US inflation.
Another thing that you miss out as a cause of inflation is the Occurrence of “Peak Oil in the Lower 48” in 1970 – this caused an increasing reliance of imported oil starting much earlier.
My skepticism of Peak Oil theory notwithstanding, this is indeed true:
Of course the inflation was a “monetary phenomenon”. Without the increase in funny money, the higher price paid for oil and gas would have left much less to spend on others things. Demand for and the prices of those others things would have gone down.
Lol… because unemployment didn’t increase during stagflation…
From someone who was there …
By the mid-to-later 60s, factory utilization in the US was screaming. 60-hour workweeks were often mandatory, and I even saw some 70-hour workweeks around. These extra hours of course were “rich” hours, with pay at time-and-a-half, double-time, and even double-time-and-a-half (the latter occurring on Sundays & holidays when working overtime). These were hard-working men (and they were pretty much all men then) who were “rich” for the first time in their lives, and they wanted to spend it. Second cars and second TV sets became common, and it seemed like everyone was building an extension on their homes. It was too much and too fast. Towards the end of the sixties, serious (for those days) inflation jumped up.
By this time however, the ramp up for Vietnam was pretty much done, and the inflation subsided. Still, these factory workers felt they had been ripped off. All their extra work, they reasoned, had been for nothing, inflation having eaten away at their wallets. They asked for Cost-of-Living adjustments in their new contracts, and a quite flush manufacturing community readily agreed. This of course is why you see wages FOLLOWING prices upward in the two oil panics; these COLAs were (and always are) respective, and not prospective. (By offsetting the cycle 180 degrees, monetarists always falsely claim the opposite.)
But here is the thing. If the COLAs aren’t there, the American middle class would have gotten gutted by the twin oil panics of the 70s. Instead, there’s an insecure period followed by a normalization, and the Middle Class remains intact.
[What happens then of course is that the bankers decide to blame it all on wages, and decide to butcher the wage earners.]
Here is what the cargo cult of the Monetarists conceals. Their simple slogan is that inflation is the result of too much money chasing too few goods. Money is a social convention, a tool, a claim on quantities of produced for market/profit output and existing assets that is of unknowable value and unknown duration. Money cannot chase anything. People with money can. So this is some sort of weird reification of money qua agent – which is precisely what cargo cults do, right, associating agency and causality where there really is none? The kernel of truth in the monetarist slogan is that if prices of goods and services are going to be put up, the only way higher prices can get validated is if there is more money spent on these products. Otherwise, the higher prices just don’t stick. Inventory builds up and price cuts are one likely response. The money value of aggregate demand can go up if firms and households spend more out of their income flows, of if their income flows increase, or beyond that, if they borrow, and deficit spend. The first two tend to show up in higher “income velocity” of money, the second tends to show up as increase in the money stock, as bank credit expands and the associated bank liabilities (as loans create deposits) get picked up in the various money supply measures. The two together – increase in money stock outstanding, and increase in the income velocity of money – represent an increase in the “effective money stock”. In an accounting sense, by definition, it must be equal to the increase in aggregate nominal final sales (of produced for profit output), as well as aggregate nominal income flows. Much gets clarified if your realize total expenditure flows must at the end of any accounting period equal total income flows, and money has to be earned or borrowed before it can be spent on higher costing goods and services. Money, by itself, has no legs, and no will or instinct. It cannot chase anything. That is Alice in Wonderland absurd. But it does not, for a moment, stop years, decades, and yes, even centuries, of Monetarist Cargo Cult worshippers.
this article takes some unrelated absurdity and tries a non-sequitur. i guess this passes for the science of economics.
since inflation is a measured or deduced number, it being more fundamental than money growth is absurd.
this article takes a peculiar view on the chicken and egg problem.
there is not one inflation. inflation in collateral assets comes first. then it leads to inflation in other things further away from the financial sector. eventually yes, when it becomes widespread it will cause money growth in the collateral assets again.
True. Most bank credit (up to 70%) is created to finance borrowers’ asset purchases, especially real estate — which is the collateral asset whose sellable price inflates when debtors and their creditor-banks create the buy-money by making mortgage loans. As the offered price increases, more of the existing supply of real estate is made available for sale by real estate owners who want to cash in on the capital gains. Real estate sellers earn the new money, some of which they spend on consumer goods, which might add a bit to CPI inflation. But about 60% of all bank credit (deposit account money) quite quickly ends up in long term savings accounts; and another 20% is transferred into savers’ brokerage accounts in the capital markets financial system. Only about 20% stays in checking accounts where the money is spent-earned in the producer-consumer economy whose prices are recorded in the CPI. So bank credit expansion inflates asset prices, with some secondary CPI inflation; and savings inflation; and investible brokerage account balances inflation that inflates the sellable prices of financial assets like stocks and bonds. Credit card spending directly adds to CPI inflation, as do car loans, home improvement loans and other kinds of consumer credit that creates buy-money for consumer goods purchases. Monetary authorities myopically focus on CPI inflation. Asset prices can be inflating to the moon, but as long as the price of Corn Flakes is stable, they see no price inflation being enabled by credit expansion that adds buy-money into the demand side of asset markets.
ok, let me try to explain more clearly.
money growth leads to inflation in collateral assets (the ones considered safe collateral by the lenders, ie treasuries, MBS, real estate).
then that leads to inflation further away from the financial sector as the new money reaches there.
you seem to require a y =- mx + c kind of model, which being impossible because the world is not so simple (especially the human world, which economists try to comically model), you claim victory. you are creating some (not even wrong) mystical theory of inflation being the cause and money supply being the effect. this does not even address the problem of what causes inflation, which is the real question.
ref chicken and egg problem. if you are economist who is on exile from the math/physics world because of career prospects (most are), think of multiple level feedbacks.
i cannot make it simpler than this.
No, I understood exactly what you were trying to say. I just found it incomprehensible because it was clearly complete garbage that has nothing to do with what I wrote above and instead introduces some crankish theory of inflation that you appear to have invented yourself. It remains so.
leaving aside some of your adjectives about my “theory”, let me get to the point:
the inflation that you claim to be the “primary cause” of money growth is itself the result of (among other things), money growth in the past.
(nothing about my “theory” here, just about yours).
And what caused that money to grow? Did the money grow legs and walk out of the banks? Or did people take out loans and spend it? If so, why did they take out the loans? And so on, and so on.
“chicken and egg”.
the control variable (that which is set to control the system) is not inflation (a measured value), it is the (overnight) interest rate. and that _is_ under someone’s control.
The money supply is credit-driven and demand-determined, nbt, in a non-commodity (and non-convertible) money economy.