In my previous post I laid out why the Phillips Curve theory of inflation is wrong and why it was misguided to try to rebuild it. The key point I made in that regard was that inflation is a complex, multifaceted historical process and any attempt to reduce it to some abstract timeless law would always end in failure and confusion.
In this post I hope to address how the problem of inflation should be approached. In doing so I will draw on the excellent and under-read 1983 book by Wynne Godley and Francis Cripps Macroeconomics. This book led to the stock-flow consistent models that were put forward in Godley and Lavoie’s book Monetary Economics. I actually think that the 1983 book is a better guide for working economists (which is not to diminish the latter achievement). The models in it — if we can even call them models — are far more open-ended than those put forward in the Godley and Lavoie book.
In the book Godley and Cripps spend a lot of time on inflation and inflation accounting. The beginning of the chapter on inflation gives a good idea of the approach the authors take in the book which is an approach to macroeconomics that I would fully endorse. They write:
Our main concern is with logical accounting relationships which constrain what can happen without fully determining what will happen. (p169, Emphasis Original)
They do make some behavioral assumptions in the chapter but these are always highlighted as being rather arbitrary. The key is to understanding the mechanisms through which inflation is generated and what happens when these mechanisms are activated.
The authors focus mainly on wages, interest charges, profits and taxes and how these feed into inflation. It is important to note that these are rather different issues to those I dealt with in my last post. In my last post I tried to highlight some of the general types of inflation, of which I argued there were four. What Godley and Cripps are doing is highlighting the mechanism through which inflation feeds into the price system.
It is a fantastic approach and must be read in the original to be appreciated. It shows that the inflation process is one that is essentially distributional. When it occurs it manifests as various groups in society — governments, workers, capitalists and rentiers — vying to keep intact or even increase their purchasing power. Godley and Cripps summarise as such:
Each component of prices can be regarded as a claim on real income. We have portrayed inflation as a self-perpetuating process of adjustment which occurs when these real claims are mutually inconsistent. No single component — wages, interest, profits or taxes — can be regarded as causing the inconsistency by itself. (p215)
The authors use a framework that deploys the hypothesis of indexation. That is, the assumption various agents might bid up their share in line with rising prices. The extreme inflationary case then becomes one in which every component is fully indexed in which case inflation becomes infinite (hyperinflation), while the extreme non-inflationary case is the one in which there is no indexation and every component does not respond to a rise in prices at all. The authors write:
We have given no theory at all about what determines the various real claims. Instead we have concentrated on the process by which they are reconciled. If all components of prices were fully protected against this process (fully indexed) inflation would be totally unstable, accelerating rapidly and indefinitely whenever the real claims were inconsistent. The fact is that inflation is not so unstable from year to year despite substantial exogenous shocks from changes in tax rates, government incomes policies, interest rates and — in open economies — prices of imports and exports. The observed element of stability in inflation tells us that indexation is by no means complete and therefore that at least some real incomes are vulnerable to inflation. (p215).
This is a fascinating approach and one that I think should be promoted by every ‘real world’, reality-based economist. It sets up a framework through which we can actually study inflation in the real world. In doing so it sidesteps the need for some sort of silly General Theory of inflation that holds good across time and space. The authors note this explicitly when they write:
We very much doubt whether any purely economic theory can ‘explain’ the rate of inflation or indeed whether it is fruitful to seek any general explanation. (p215).
Heterodox economists arguing with orthodox economists like Tom Palley would do well listening to this pearl of wisdom. Because trying to build a ‘model’ that explains inflation is likely to lead up a dark alley and it will come back to haunt the builder when an inflation that it cannot explain takes place.
Now, if we can just get Godley and Cripps’ book reissued! I note that the paperback version is currently selling on Amazon used for over £68. In the future I might look into approaching some people to suggest a reissue. It would be very timely indeed.
Fixing the Economists 
A very good post again Phil. Thanks for putting it out there.
To me inflation has a simple cause – somebody puts their price up and gets away with it. i.e. they alter their own terms of trade.
That could be in nominal terms – because they want to save more. Or in real terms because they want more stuff/assets, or want to stop getting less stuff/assets.
The system then has to either allow more saving, make more stuff/assets, or work out a way of disappointing somebody.
So I’d alter the above slightly to add in desired financial savings as another component.
Phil, in Brazil everyone who could read in the 1980s knew as “inertial inflation” what Godley and Crisps described. Some Brazilian economists became known with their “inertial inflation” theories in late 1970s and very respected in the 1980s. That inflation generates distributional effects I guess no one can deny. But one thing is to say that indexation perpetuates inflation another is that it generates hyperinflation. If everyone writes up a contract that says that, say, the last year inflation will correct todays prices it seems to me quite clear that, unless somebody is able to increase their prices beyond contracted every turn, inflation would not turn hype. In such a case inflation would only be reproduced every year, whatever its rate. True, if the inflation rates of the economy are high and increasing, we should expect indexation keeping it at high and rising rates. In Brazil since the 1980s thoses economists a said before recognised such problems with the theory and termed “inertial” factors which kept inflation high but not that generates inflation.
Also, I find something misleading in this Godley and Cripps quote:
“The observed element of stability in inflation tells us that indexation is by no means complete and therefore that at least some real incomes are vulnerable to inflation”.
If we understand “complete” indexation as “all prices are indexed by the same price index”, should one not expect more stability as all prices will be corrected at the same time at the same rate?
If some prices are not indexed it is true that their receivers will loose to inflation. But why should one expect stability from the indexed part of the economy?
cheers
I know this is off-topic, but any thoughts on this:
http://www.bloomberg.com/news/2014-07-30/argentina-defaults-according-to-s-p-as-debt-meetings-continue.html
Like divorce, default is a messy process. I don’t have much sympathy for creditors who took a bet that they could cause enough trouble in the courts to extract money from a broken country either, which is what this fund apparently tried to do. All in all, this won’t have any economic effects. There is no doubt that Argentina can repay any bonds denominated in the domestic unit of account so they are still safe investments. Well, apart from the inflation there. That’s the real problem. I note that the Argentinean central bank massively hiked interest rates at the beginning of the year. That is probably a signal that real inflation (as opposed to the fake numbers the government puts out) is rising.
The question is “what are you trying to measure?”
Are you trying to measure the effect of money-printing on prices or are you trying to measure prices? It’s a bit like “climate change” – just as CO2 traps heat thus increased concentration of it in the atmosphere generally results in “global warming,” its effects across various locations are not uniform (e.g., cool vs wet, hot vs cold, much like asset bubble vs simple retail price hikes) and it can be temporarily offset by natural factors (e.g., any new invention, end of a war, opening up of trade barriers). We would never claim that, if such factors were trending toward general cooling, that it would be good for the ecosystem to head that off by deliberately emitting more CO2 to offset the natural cooling. That’s a bit what the Fed says (replace ecosystem with economy) when it seeks to “prevent deflation” and offset real price declines with money-printing. Over time, prices SHOULD come down as they are measures of the relative value of resources and our continuous improvement in efficiencies more than offsets the increasing scarcity of the resources – – we saw this in the 19th century. We saw in the 1920s that real price declines were offset by Fed policy in an effort to achieve “price stability.” Same for the 1990s – the internet, the fall of the USSR and the opening up of China were all major factors pushing toward naturally falling prices and the Fed printed in an effort to offset this, resulting in the NASDAQ bubble. These factors continued to put natural downward pressure on prices in the 2000s and the Fed and ECB responded with low rates, resulting in the housing bubble. Similarly, measuring different “baskets of goods” does not measure only the effects of monetary policy on prices – it nets that against the ability of the consumers to work around those effects.
As with many economic issues, the matter appears to be one of defining one’s terms. You can’t say “inflation is X” or “inflation is Y” – just figure out what you’re trying to discern, and go from there. Most of the differences in different people’s definitions stem from differences in what they’re trying to measure.