Russ Roberts

Boudreaux on Monetary Misunderstandings

EconTalk Episode with Don Boudreaux
Hosted by Russ Roberts
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Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts on some of the common misunderstandings people have about prices, money, inflation and deflation. They discuss what is harmful about inflation and deflation, the importance of expectations and the implications for interest rates and financial institutions.

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0:36Intro. [Recording date: January 10, 2011.] Inflation and deflation. Let's talk about inflation, what is usually meant and what we mean as economists. You asked the right question to begin. The definitions of inflation and deflation have changed over time, and in ways that are significant. The original meaning of inflation was an increase iin the money supply. There are still a few people today who hold out for that definition. I'm much more of a spontaneous order guy when it comes to language--words mean what people take them to mean. In fact, inflation today means, to the average person here, even the typical well-informed professional economist who uses it, not an increase in the money supply, but a sustained increase in the general price level--a sustained increase in average prices. But it's important to remember what inflation originally meant, because there's a connection of course between changes in the money supply and changes in the price level. Similarly with deflation. Deflation originally meant a decrease in the supply of circulating medium, and now it means a general decrease in the price level. Let's start with one of the common confusions. Much of the confusion about these two topics of inflation and deflation--really one topic, the average level of prices and their movements--one of the sources of confusion is how the media writes about it. Want to talk about two issues. One is they'll often talk about inflation in one price or deflation in one price. Generally, economists are very careful to distinguish between inflation--which is the average level of prices going up--as opposed to one particular price going up. That's one important confusion; think comes from misuse of the word "inflation" in the media. The other, which is related, is the media often reports, and the government sometimes collects--or always collects, I don't know--the core level of inflation, where they'll exclude certain goods. I think the core level is the level of inflation not including energy prices and food, say. Yeah, I've never understood that. It's a meaningless concept. And yet, it's commonly used. Why is it a meaningless concept? First, let's talk about the first issue--the difference between changes in the average level of prices, general level of prices, and changes in individual prices. It is important to distinguish between changes in individual prices--changes in one price relative to the price of something else--and changes in the price level. The concept to keep our eye on is--we have to ask why does the price change? Inflation becomes salient, becomes a meaningful and interesting concept to study when we recognize that prices are changing not because of any changes in real resource constraints, real consumer demands in the economy, real shifts in consumers' preferences for savings as opposed to consumption--but changes simply caused by exogenous increases in the supply of money. That is inflation. You are correct--a lot of the time people use the term "inflation" quite mistakenly to talk about individual price increases: "The price of gasoline is inflating." Or: "There's been a lot of inflation in the energy sector this year." That's quite confusing and nonsensical talk. If what is meant by "There's been a lot of inflation in the energy sector this year" simply means that the price of energy has risen relative to other goods, all that means is that the supply of energy resources has fallen and/or the demand for those resources to increase, which of course causes their relative price to increase--and their relative price should increase to reflect those underlying real changes in the economy. There's nothing about changes in the money supply that we would expect to show up exclusively in the energy sector, or any other individual sector for that matter. Similarly, the idea that they could somehow on their own ripple through the economy and cause inflation in the absence of a monetary change is unlikely and not really economics, the way you and I were taught it. Underlying what we are going to talk about today is the Milton Friedman sentence that "Inflation is everywhere and always a monetary phenomenon." It used to be people had many theories as to why the average level of prices would increase or decrease. It may be one of the few if not the only area of economics where decisive empirical evidence established a theory that virtually all economists--mainstream and out-of-the-mainstream--accept. In the 1960s there was an idea of wage-push or cost-push, even into the 1970s--this idea that unions could push up the price of labor and since labor is in every commodity. What the monetarists responded was--well, some prices will go up more than others because of their labor component, but sectors that are not unionized would then have decreases in prices in the absence of a monetary change. Just to take another example from the news, I think you often hear people say: What's all this talk of inflation? TVs are getting cheaper! TVs and other electronic goods--there's so much technological improvement in the production of those goods that their relative price has fallen dramatically. Had there not been inflation, it would have fallen even more. The nominal price would have fallen even more. If the average price level had been unchanging--if there had been no inflation over the last 25 years--then the goods that had the most technological increases would have even bigger nominal--meaning the dollar amount that we actually see that is not corrected for any kind of inflation, the actual number written on the price tag in America, say--would be even lower. But if there's inflation--if the money supply had increased enough over the last 25 years--you could have TVs and other goods getting more expensive in nominal terms--that is, the price written--but relative to other things getting dramatically cheaper, which they have, because of the technological changes. That concept is very tricky. Hard for people not used to thinking that way to see it. The real changes you are talking about get tangled up with these overall changes in prices as a whole because of changes in the money supply.
8:39Let's launch our discussion from Milton Friedman's famous statement that inflation is always and everywhere a monetary phenomenon. It does not mean inflation is always and everywhere necessarily caused by an increase in the money supply. It can be caused by that; in fact, it's probably usually caused by that. But, conceptually it can also be caused by changes in money demand. Bank behavior, regulations. Anything that causes the supply of circulating money to rise will cause inflation. Obviously the most common way to do that is for the monetary authority to increase the supply of base money, which will cause the banks to increase their supply of loans, which will increase the supply of money. But it can also happen if consumers decide to spend their money faster--something economists have called the Equation of Exchange: MV=PQ. Money supply times velocity equals price times quantity, and that price means the average level of prices. So any time the money supply increases or the rate at which the typical dollar is spent, or alternatively the amount of money people seek to hold in their cash balances on average falls, you'll have inflation--assuming the quantity of output produced in the economy remains relatively stable. It's an equation with four variables; I learned it as MV=PT, where T is the number of transactions; same idea. If you move one, something has to change. It's not even an equation--it's an identity. It should be MV three-lined--identically equal to--PQ. If something goes up, there are three other things that could change--V, P, and Q. We often say: Assuming V and Q don't change, then P has to move one-to-one in correspondence with M; and usually, barring any real effects, which we'll get back to later, that would be true. There's no reason people are going to change their desire to hold cash balances; if productivity hasn't changed in the time we're talking about then all monetary changes will be reflected in price changes. This goes back to Irving Fisher--Friedman certainly attributes it to Irving Fisher. I think Fisher is properly credited with having first formulated the Equation of Exchange. Milton Friedman is not the person who formulated it, but he is the person who conducted the most extensive empirical studies that convinced people. As much as empirical evidence in the social sciences can convince people. Friedman's statement that inflation is always and everywhere a monetary phenomenon, I think, was meant to discredit the notion of cost-push inflation. This is one of those many notions that non-economists have that are pretty widespread. On a par with tariffs can increase employment at home, that inflation is caused by higher prices. Well, inflation is higher prices; and a thing can't cause itself. Not just a political thing--I'll hear a lot of people of conservative or free-market bent say: Well, one of the problems of minimum wage laws is that they cause inflation. There are a lot of problems with minimum wage statutes, but that they cause inflation is not one of them. They can raise the price potentially of goods produced predominantly by low-skilled labor; but that's not inflation. It's possible to posit a very small effect that minimum-wage legislation or some other regulations reduce the operating efficiency of the economy, reducing output, and therefore the price level increases. But small effect. The idea that you raising the price that you charge me for whatever it is that you sell to me can spark inflation because I will therefore have to raise the price at which I resell the product to my customers--that that will cause a general, sustained increase in all prices is ludicrous. If you don't have any more money--if you spend more on one thing, then you have less to spend on another. That's just the way it is. I don't remember exactly when Friedman wrote that line. It's in a lecture I think he gave in India in the late 1950s. Friedman spent a good deal of time fighting--and I don't think yet we have to fight this battle again, although we may--the notion of what were then called incomes policies: inflation is a rise in prices, it's a problem, so let's just outlaw it. So we had price controls. We had them in the United States. If inflation truly is caused by someone raising his or her prices too much--if it really is a cost-push phenomenon--then you could potentially really stop it by price controls. If inflation is not a cost-push phenomenon--if it is a demand-pull phenomenon, caused by injecting too much money into the economy and therefore the nominal demands for goods and services rise because people have more money, outlawing nominal price rises does nothing to solve the underlying problem. Here's an interesting issue: If you define inflation as a general increase in the price level--then price controls solve the problem in a very literal way--but they obviously don't solve the underlying issue. The underlying issue is that the value of money relative to the goods and services that people want to buy is falling. Price controls do nothing to solve that problem; in fact, it makes it worse because the supply of goods and services less. Loved Friedman's example, back in the era when people used a lot of mercury thermometers, he said: Well, to talk about inflation as if it's a cost push phenomenon we can solve with price controls is the equivalent of thinking that the heat in a room is caused by the thing we use to measure the heat--the thermometer. So, the room is getting kind of hot. Let's solve the problem. So, rather than turning down the hot air that's causing the room to heat up, what you do is you walk over to that thermometer and take a sharp metal plate and you stick it in the thermometer at 72 degrees Fahrenheit, and that prevents the mercury from rising higher, and say: Hah, we've solved the problem! Great analogy. To the extent that there a thermostat, you have made the problem worse, because now there's no feedback at all. People get hotter and hotter; and those people who rather naively focus on the measured temperature by looking at the thermometer think everything's fine and dandy. Everyone of course is sweating like pigs and suffering.
17:23So, before we go on, I want to ask you about the aggregation question that comes up here. We're talking about the average level of prices. Two issues here: one definitional and somewhat conceptual, the other more conceptual. The definitional idea is that inflation isn't just a one-time increase in the price level. It's an ongoing--I think you used the word "sustained"--meaning a continuing rise, a continuing increase in the average level of prices. If prices just went up once and stopped, there's technically some kind of inflation over that little period it happened, but when we are talking about inflation usually in a modern economy, be it Germany in the 1920s, the United States in the 1970s, or recently in modern economic history, or extremes like Zimbabwe, what we are talking about ongoing, perpetual increase. And that means there's an ongoing, continuing expansion of the money supply--not always but usually the money supply. The question I want to ask is: the way that usually gets measured, the way we assess how serious the inflation problem is out there, is we go out and measure prices. We take a bunch of goods--inherently a statistical problem; you can't measure every good. You can't even measure the price of apples--you have to talk about the price of a certain kind of apples. I don't mean just Delicious apples--you have to have Delicious apples of a certain crispness. In principle you have to do it by location, and time of year. How convenient it was to buy them, what other amenities were with it. So, it's an approximation. The Austrian in me--and you and I both have a little or a lot--they don't like aggregates. Austrian economics was against the idea of aggregates. Aren't we playing the same error that Austrians often complain about, when we talk about the price level, as if there is a single good. In practice, what has to happen in order to measure the price level at a point in time, compared to the price level at a previous point in time, and then continue to do that and see that the price level is growing at some relatively constant or perhaps erratic rate. And to do that you've got to sample a whole bunch of products and six months later come back and do it again and continue to do that. And you talk about the price level--typically in the United States the Consumer Price Index, the CPI--as if there was an average. It is a weighted average of all the measured goods that the Bureau of Labor Statistics (BLS) samples. Is that a meaningful idea? What a big question! This issue points out why it is regrettable that the older definition of inflation is no longer used. With the older definition, inflation is an increase in the money supply. Then, what happens to the price level after that is separate, kept theoretically distinct. But that's not the definition we have any more. It's not correct to say that Austrians--or let's not even aggregate that--Hayek or you or me are opposed to aggregates. I quite joyfully draw demand curves on chalk boards; I actually use the apple market. Useful theoretical concept. The issue is using concepts, judgments required, that enlighten us as opposed to concepts that hide important forces that, were they visible to us, we'd get a better understanding of the economy. Austrians are famous--I think rightly so--for objecting to the Keynesian aggregates: aggregate demand, aggregate supply, capital in the economy as this K, labor is L. We are not talking about the letter you use; we are talking about that you can talk about labor with a capital L meaning that it's all the same, so if there's excess supply of labor there's unemployment, some markets that are highly tight where there's not excess supply. I believe by focusing on those aggregates, the economist blinds himself to important microeconomic adjustments that either are or would take place in the absence of government intervention. Talking about the average level of prices--on one level, perfectly fine. We understand that there are prices for apples, automobiles, cups of coffee, sugar, and we can make a distinction between those prices rising more or less in unison and price increases are caused not by changes in underlying, real economic factors--resource constraints--but instead simply by changes in the supply of the medium of exchange used to purchase them. The more specific we get with attempts to actually measure the average level of prices--that's where problems arise. I have no problem with the concept of the average level of prices. I think it illuminates when used in the Equation of Exchange. It enables us to understand what happens when the supply of money increases. The supply of money itself is in some ways an aggregate concept. Different kinds, M1 versus M2. When I was in graduate school back in the early 1980s, there were big debates: M1, M2, M3. What is money at all? You can't do any kind of analysis without abstracting away from any kind of individual differences. A lot of people take cheap shots at Austrians by saying: Well, you people are opposed to aggregates and therefore--but look, you talk about supply here and the money supply over there so you are hypocrites. But that's not it at all. The issue is to do your analysis and use your concepts at a level that enlighten rather than hide. I truly believe the Keynesian aggregates hide more than they enlightened. Now, having said that, I believe that the Chicago money-macro theory is also a little too dependent on aggregates that hide rather than aggregates that enlighten. Milton Friedman's even guilty of this. Typical University of Chicago discussion about the problems of inflation, they talk about the problems of wealth redistribution that inflation has from creditors to debtors. But I think the effects of inflation, particularly the process of increasing the money supply does have effects on relative prices that are ignored, unfortunately, by otherwise insightful monetary theorists at Chicago. We'll come back to that, maybe. As a Chicago economist with some Austrian in him I'm sort of conflicted by this part of the conversation.
27:14The thing I want to mention--I like what you said that obviously you have to abstract at some level. You can't model or analyze the world in minute detail. Any theorizing has to have some kind of simplification. Having said that, my caveat would be that our attempts to measure the level of inflation with any precision is fraught with problems because of the quality changes. That's a subject for another podcast. Michael Boskin. Let's turn to the harm and potential benefit of inflation and deflation. One of the most remarkable, commonly-held views is that inflation is good, a little inflation is good; and a little deflation is bad; and here's the reason. Before I talk about the fallacy, let's talk about the truth. Why is inflation and deflation bad, if they are? We were talking before the podcast--there is a distinction between anticipated and unanticipated inflation. Unanticipated inflation is even worse than anticipated inflation. If I want to borrow money from you, if we both correctly anticipate that the rate of inflation will be 10%, then I'm willing to pay a 13% rate of interest--with 10% to account for the fact that I'll be repaying you in money that will be worth 10%, and 3% real rate of return. You will demand at least a 13% nominal rate of interest from me. Meaning, if there were no inflation, let's suppose that I would charge you 3% to borrow my money and I wouldn't have it for that year or have the opportunity to do anything with it. If we both agree that the dollars you are going to pay me back are going to buy 10% less because the average level of prices is 10% higher, then I'm going to ask for 13% instead of 3%--and you'd be willing to pay it. One more caveat about aggregation--of course the bundle of goods that I buy is not the average; the bundle you buy is not the average; that's another sense in which the aggregation is sloppy. But again, we are talking about the general effects. But if it weren't anticipated, if I naively lent you the money at 3%, I'm going to get punished. You get a windfall; I get hurt. You don't even receive your full principle back in real purchasing power, much less a return for having undergone the risk of lending to me and foregoing consuming. So if I gave you $100, you later give me back your $103, that's going to buy me less than $100 worth of goods because of the ensuing inflation. We call that a distributional effect in economics; it's unfair. I think by far the most dangerous consequences of inflation go well beyond that, even fully-anticipated inflation and accurately anticipated changes in however we define the general price level are dangerous. For reasons that Chicago economists overlook. Inflation is not created by helicopters hovering above and distributing money evenly. Money is injected into the economy at certain points. And wherever it's injected it causes those prices to rise first; and as the money works its way through the system, it causes prices to rise. So it causes distortions in relative prices. When people make economic decisions, there is no price level to look at. When you are deciding whether to buy an extra gallon of gasoline or milk, build a house or not, borrow money for consumer or commercial, you look at relative prices. If relative prices are being distorted by changes in the money supply. If relative prices are being distorted, that leads people in the economy to make decisions that they would otherwise not make and that they shouldn't make were the relative prices more accurately reflective of the true resource scarcities in consumer demands. So people misdirect resources. Resources get misallocated. This is part of the Austrian business cycle theory; we've talked about it in a couple of past podcasts. So, it's not so much the rise in general price level that's harmful. It's the process by which the rise in the general price level gets sparked. That's one harm. That's a subtle harm. That's a major harm! I don't disagree with it. I think there are two things that are important to add. One is that Friedman talks a lot about--you see more people coming into your store. You don't know if that's because your product is more popular or because the Fed's been misbehaving. Certainly he was aware of these kinds of issues at the micro level. My real complaint about your observation about the harm is that--certainly that distortionary effect is real; it's difficult to measure; we would say it's smaller at low levels of inflation at low levels of inflation than high levels of inflation and it may cause some listeners to miss another harm that I think both Austrians and Chicagoans would agree on, which is if inflation is large enough and erratic enough--a little bit of hand-waving to say it's anticipated; it's never fully anticipated. I might be confident there's going to be higher prices a year from now than today, but if it's going to be 40% higher versus 4% higher we're going to make all kinds of mistakes in our allocation of resources. But in particular, when there is so-called hyperinflation--which is high levels of inflation which we haven't seen in the United States in our lifetime; talking about Germany in the Weimar Republic, Hungary in WWII, Zimbabwe recently--these are cases where the level of inflation is rising fast enough that people are unable to use money as a medium of exchange any more, and we go to a barter economy. Somewhere in between 3% inflation a year and 100% a week--which everyone agrees is hyperinflation--along that continuum from a lowish level to a high level, all along there there's going to be some distortion of the decision of how much cash and liquidity to hold in your portfolio of assets versus how much to keep in the form of goods. When it gets up to 100% a week, prices doubling a week, and not even regularly doubling, not quite sure what's going on, just you know money is losing its value extremely rapidly, you get out of money and you get into pigs and chicken and corn and stuff you can carry around and put in your truck. Most of us have heard the stories; recall seeing pictures of workers in Germany at the height of the hyperinflation of getting paid two or three times a day, in cash, and they would literally roll wheelbarrows full of cash to the factory gates so their wives could get this cash and then rush to the stores in order to buy sooner rather than later. That is an unnecessary waste of resources, workers taking time off from work to deliver their bundles of cash to their wives, not able to plan, buying the wrong things because you'd buy anything just to have it in the form of physical goods. Obviously as inflation increases in severity, the harm it causes increases. It's not linear. It gets disproportionately worse until the entire economy breaks down into barter. Catastrophic, of course. I want to mention some research done along these lines. Not an Austrian at all, but the Israeli economist, Alex Zukerman, did a fair amount of research in the 1980s and 1990s, empirical research, on the relationship between inflation and what he called the dispersion of prices. And he found clear evidence. Some of this was published in the Brookings Review and other journals. Clear evidence that the higher the rate of inflation, the higher the dispersion of relative prices. I've always taken that to be empirical evidence of at least one part of the Austrian theory of the trade cycle. Inflation does not cause all prices to rise at the same time. If it did, then the dispersion of relative prices wouldn't be affected by inflation and the only thing we'd have to worry about is to what extent is inflation anticipated or not, so we get redistribution from creditors to debtors and it affects the willingness of people to lend credit or to borrow productively. I'm sure it does. The question is how important is it for the business cycle. This doesn't answer that. And our choices being inaccurate is clearly a cost.
38:37Deflation. I said I was going to give an example of a fallacious argument; and I want to use your German wheelbarrow story to do it. I hear all the time--meaning more than once, close enough, my empirical study--I've heard smart people say, more than once: Well, inflation's good; it's deflation that's bad. I've heard that often, too. Let me give you what I hear as the standard argument for why inflation is good and deflation is bad. Bizarre argument in the sense that it assumes a Keynesian argument underlying it that is clearly wrong as a general rule. The argument is this: Here's why inflation is good. See, with inflation, prices are going up so you buy now rather than later; and that's good because people are encouraged to spend. Underlying this fallacy is that spending is good and not spending is bad. Strange and silly, as if the entire mechanism of the economy and our exchanges with each other, our cooperation, has to be driven by our nominal spending. Not real; economic forces are ignored. So, inflation's good, so the story continues: but with deflation, because it's always going to be cheaper because prices are falling, you don't buy anything. You just wait. Now it's wrong on many, many faces. People obviously buy plenty of stuff when the prices are going down. It's like saying no one will ever buy a cell phone because they just keep getting cheaper, so you just keep waiting. Ridiculous argument. That's obviously false. People buy TVs because they'd rather have it now than later. It's true it will be cheaper eventually, but you don't get to enjoy the TV. If you go to Best Buy now you'll see a lot of people buying computers. They're not ignorant. You know with 100% certainty the price will be cheaper 6 months from now. So that argument I find strange, just the logic of it. But let's get at the underlying economics below that argument, which is even stranger. It's like saying Zimbabwe, or Germany in 1923 or Hungary after WWII or Germany after WWII which I think had the same problem--those are the greatest economies of all time. Because there was so much inflation, people were spending with such frenzy and so hurried to spend their money that that multiplier kept going. Of course, that's nonsense. That doesn't create real wealth. It creates nominal spending but not prosperity. It creates measured nominal increases which have nothing to do with your standard of living. In fact, it's the opposite. The faster you are out spending, the less time you have to be productive and creative, and the economy is getting poorer because of that inflation, not richer. Exactly. I hear this all the time, as well. Particularly egregious among economists. It reflects, I'll say first, an appalling lack of understanding or lack of familiarity with even basic economic history. Deflation, defined as we define it now, a sustained decline in the general price level--marked the U.S. economy for the last 30 years of the 19th century. In each of those years the general price level either remained the same or more often fell. As best as we can measure it. But what happened then, was, the United States was, for better or worse, on a gold standard, not a perfect gold standard. The money supply was not very elastic as a consequence. Productivity in the economy rose dramatically, so output increased. So we had pretty much the same amount of money chasing far more goods. So the value of money relative to the larger number of goods continued to increase--it's prices were falling--from the late 1860s until the first year or two of the 20th century. So prices fell. So here we have an economy that was one of the great success stories of all of human history, the last three decades of the 19th century--yes, they had some recessions but nothing like we had in the 20th century. Well, 1894 was pretty bad; but relatively short. Not like the 1930s. So, the post-Civil-War American economy up till the turn of the 20th century was by and large a hugely successful economy, one in which deflation was the norm. Now, how can you say an economy cannot prosper when there's deflation, unless you argue that we've measured it completely wrong and we really had inflation--but I've never heard anyone make that argument. I have one really big empirical fact. Late 19th century America--deflation. Counter that with the examples you gave about inflation in post-WWI Germany, modern-day Zimbabwe--a lot of inflation, not much success. Those arguments are even more illogical than you suggest. All the arguments you gave are correct. They only look at one side of the argument. They say that with inflation, people will want to buy now because the prices will be higher tomorrow. Sellers have the opposite effect--they'll say: I don't want to sell now, because prices are going to be higher tomorrow. And the opposite is true with deflation. Sloppy, sloppy thinking.
44:57I'm going to add one more fallacy to the pile, which is this idea that you can't have inflation and unemployment going together--hear it all the time--because if you have inflation, there's all this money circulating; people are going to try to spend it, and that will increase the demand for goods and workers will get put back to work because they are going to be expanding production. I have one word for it: 1970s. The 1970s in the United States, we had high rates of inflation and high rates of unemployment. Zimbabwe another example. Hyperinflation is not associated with the highest levels of employment. It's actually the opposite. It's a breakdown in the economic system. You can salvage it by saying it has to be at certain rates, but as a general principle it's clearly not true. Let me go back to deflation. In the 2008 financial crisis, which we are still in the middle of in many senses, the worry was that we could have deflation. This was a justification by the Federal Reserve and Chairman Bernanke to expand the Fed's balance sheet--which it did dramatically. It is the current justification, partly--these are the public justifications; I don't know what the real justifications are. We have to do these things, the Fed said, because if we don't we're at a risk of deflation. You hear a lot of people screaming--inflation hawks worry that the Fed's policies, the money they've been injecting into the banks is actually injected into the economy; but it's being held right now by the banks and the money is not being injected into the economy. For those of you out there wondering if inflation is always and everywhere a monetary phenomenon, why hasn't the Fed's expansion of the money supply led to inflation? The standard answer is: because the banks have not done anything with it. Once they do, the presumption is that the money supply increases will then translate into price increases. But those of us who are worried about that are told: You are fools. Inflation is the last thing we have to worry about. We have to worry about deflation. And the worry, as I understand it, is that unlike the deflation of the late 19th century in the United States, which was driven by productivity increases and a relatively fixed money supply--and that was a world, by the way, that people alive today have never experienced. Most of us in America who are alive today have experienced mild, steady inflation, steady increases in the price level from 0-5% in recent history, what we call modest inflation. Most of us have never lived through steady deflation. The claim is: because we have not experienced that, we have no anticipation of that. We've made a lot of contracts in nominal terms. Most contracts are in nominal terms: I'll give you $1000 today and you'll pay me back the $1000 and $30 in a year. As a result, if wages started to fall, alongside prices--which often happens, they move in tandem--then you would find yourself having made promises in nominal terms without an inflation adjustment that you'd be unable to keep. So, you'd be unable to make the mortgage payment on your house. This would make our foreclosure problem even worse. Banks who had been expecting certain inflows of cash would find themselves unable to receive those funds and banks would become more likely to become insolvent. That would further exacerbate the problem of deflation as banks start to retract, bring their assets in and try to salvage their balance sheets. So the claim is that a little bit of deflation can be extremely destructive if it's unanticipated. Unlike the period of the late 1879. That was a world people got used to living in and made their contracts presumably in nominal terms being aware that prices were likely to fall over the next year. You think there's anything to this argument about deflationary fears? There are always adjustment costs or adjustment issues. I wouldn't deny that when the Fed, our monetary authority, shifts the way it operates, to change the likely course of the value of money over the course of the future compared to what people expected, that some people will make decisions that turn out in retrospect to be wrong. But that argument cuts way too broadly. The same argument could have been used against Paul Volker's famous 1979 decision to change the Fed's target policy, a decision that is credited with reducing inflation from the double digits that it had reached in the late 1970s, early 1980s, to the much more moderate 3-4% that it reached a few years later. Following that monetary policy, the economy did go into a fairly deep recession in the early 1980s. Part of the problem may have been that people were making decisions based on their previous expectations of inflation--that proved to be wrong. But what do we do? Just because the Fed is pursuing a mistaken, unwise policy today, we don't say: We can't stop this unwise policy because people are expecting us to continue this unwise policy. The problem is you, the Fed, started with this unwise policy. That's part of the problem of an unwise policy. It creates bad expectations. But what if it's not the Fed's policy? Let's take the 1930s, recently had Doug Irwin on the program talking about the role of falling prices and monetary policy, that France may have played an important role in precipitating the worldwide Depression. And why? Because they were hoarding gold, imposing price decreases on other nations, and that helped precipitate the Great Depression. Certainly Friedman and others have argued that the U.S. Fed, for whatever reason, should have responded by being more aggressively expansionary. It seems to me that deflation driven by monetary changes can be very destructive. Or do you disagree? Deflation driven by monetary changes? Absolutely. No reason I can think of to either actively pursue or even to allow the money supply to contract. That's uncalled for. That will create problems. But that could happen because of decisions elsewhere--under a gold standard it could happen; an increase in the demand for gold; the shutting of a gold mine that wasn't anticipated. Doesn't have to be a Fed blunder. That kind of deflation, caused by monetary policy by commission or by omission, is fundamentally different from deflation caused by increases in the economy's productivity. Why? Because the money supply is, in the latter case--when the economy becomes more productive and more goods and services get produced, say, per hour of human labor, more goods, the money supply is not being mucked around with, and the ability to calculate and contract in prices is much stronger than when the money supply itself is decrease.
54:15Not sure that's true. When the economy is improving and we are becoming more productive, it doesn't get equally better at an equal rate in all goods. Some goods, innovations are a very fast pace--say, electronics in our modern world--and some the pace is very slow--such as our field, education, where because it's very labor-intensive, it's very hard to get the kind of Moore's Law type of improvements that are driving the lowering of costs and prices in the electronics industry. I still use chalk--that's what the ancient Greeks used in Athens. Whiteboards are a huge technological improvement but not all of you join us. So, the innovations are still improving our standard of living. Let's start with the simplest case where the monetary aggregate however we define it is relatively constant. No changes in the money supply. All the changes in prices are being driven by innovation. This is the example from the 1870s onwards, relatively fixed money supply, productivity increases at varying rates in different parts of the economy, leading to lower prices; but changes in relative prices all the time because some goods are getting cheaper at a faster rate than others because they are innovating at a faster rate. We'd observe the average price level falling, relative prices would be changing, signaling people to buy more of the things that got more cheap due to the innovation and economizing on the things that hadn't got cheap as quickly. That's all good. Our purchasing power would increase; the standard of living would increase. That's case 1. Case 2 is: there's a change in the supply of gold for whatever reason that suddenly causes prices to fall--at non-uniform rates across the economy because the gold changes are going to ripple through, which the Austrians are correct about. Now in that second case, our real standard of living would not be rising. We would not have any larger command over goods and services. But in both cases would we not have the same borrower-creditor lending issues talked about earlier that alarm people about deflation if they were not anticipated? If they were anticipated certainly both cases would be relatively unimportant. Right. The real issue it seems to me is whether financial institutions are going to have extra stress because of these falling prices, because of past promises that have been made in nominal dollars, nominal contracts. If people want to hold a certain portion of their assets in money, and the monetary authority starts contracting the supply of money, people are going to reduce their spending in order to increase the size of their money balances. That would be an unnecessary shock to the economy; and I don't see the same kind of shock occurring when the money supply stays relatively constant but the supply of goods and services in the economy increases because of productivity increases in the economy. George Selgin and Larry White would have been better, particularly Selgin on this issue. He could explain the difference between, what should we call it--demand pull and supply push deflation. I'll ask George to contribute a comment on it. Link to 1997 monograph. But the point I'm asking here--I accept Selgin's point and yours. There's no doubt in my mind that a contraction in the money supply that leads to deflation is either neutral if anticipated--relatively neutral to allow for the kind of issues you raised earlier about the transmission of this through the economy--or slightly harmful relative to a deflation that is caused by an increase in productivity where the money supply is held constant. There's no doubt that the latter effect is an increase in our standard of living and the other one is not. The other one is just a punishment, making it harder to figure out what's going on in the world around us. Maybe a subtle point: It seems to me that if it's not anticipated, the effects on borrowers and lenders could have real impacts on financial institutions, which could lead to other real impacts. But those very same issues you highlight would exist if there's an unanticipated decline in the rate of inflation. If people had been living with a more or less steady 10% rate of inflation and the Fed unexpectedly decreases the rate of inflation to 5% then you get those same problems. Nominal contracts. I agree with that. It's not an inflation-deflation issue. I'm trying to understand why fairly sensible people are worried about deflation. Those fairly sensible people, when inflation was 15% or 12% didn't worry about it falling to 5%. Maybe they figured that the monetary policy that lead to that would be seen and maybe anticipated. Interesting question.
101:24Want to end with a quote you gave me before we started taping, which was: Economists like to say that money is a veil. It's not a very helpful expression for non-economists. What we mean when we say that is that the dollar figures we attach to our activities are not what we really care about. What we really care about is real things--our command over goods and services. So, take a wonderful example that Mark Twain has in A Connecticut Yankee in King Arthur's Court: if you double my wages and you double the prices, I'm not richer. Neither richer nor poorer. The fool in Twain's story says: But my income is twice as high! But it doesn't buy any more than it did before. It's hard to grasp that sometimes. If you are an economist and think about it relatively large amount, think of it that money is a veil--the dollar figures we attach to things are not so important and it's the real underlying things that matter, both in the sense of what we care about and in the sense of what drives our activities and what causes things to happen. Changes in consumer preferences or innovation that causes falls in the cost of production--those are real and they have real impacts and should. But as we also know, changes in monetary factors, although often a veil, can have real effects. I quoted my former teacher, Leland Yeager, great money, banking, and international trade theorist, who said that: Yes, money is a veil, but it's a fluttering veil. The idea is that we should look through this veil to the real underlying factors that matter. And that's true. But money, because it does have real effects, it flutters. So it distorts our vision of the real economy. So the best policy is to have that veil be as steady as possible, fluttering as little as possible, so that our perception of the real economy--real consumer demand, real resource constraints--is as accurate as possible and as distorted as little as possible.

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COMMENTS (59 to date)
Peter Boot writes:

Ross

You debunked the usefulness of low and consistent inflation as motivating consumption. But is it useful as a motivation for individuals to productively invest funds rather than sit on cash thereby driving growth in the economy ?

thanks

Peter

George Selgin writes:

A couple things to bear in mind concerning the difference between (unanticipated) productivity-driven deflation and unanticipated demand-driven deflation:

(1) Increased productivity means falling unit production costs. So, productivity-driven deflation doesn't imply any decline in either firm revenues or firm profits.

(2) Nor are nominal incomes declining. So, peoples' ability to pay outstanding debts isn't impaired, in the sense that they just don't have the income they once had to cover (nominally unchanged) debts.

(3) True, whatever the cause of a fall in P, the real debt burden increases relative to that for a constant P, holding the nominal obligation unchanged. However, in the productivity-driven deflation case, you can't presume that the increased burden is regrettable. On the contrary: suppose everyone had anticipated both rising productivity and corresponding deflation. In that case, they might well have contracted for the same money rates of interest. (The anticipated decline in P reduces the equilibrium nominal rate. But the increase in anticipated real income increases the equilibrium real rate. In other words, it's a wash.)

I hope these remarks help.

Nathan writes:

I would have been interested in a discussion of the government's/central bank's underlying motivations for tinkering with the supply of money. For instance, being a large debtor, doesn't the government have a natural tendency to expand the money supply? To what extent does politics keep this tendency in check? To what extend does the bond market keep it in check? When hyperinflation has historically occured, what has gone wrong in that balance?

Ole writes:

A highly interesting topic. As an average guy who tries to understand the current economic crisis, i have been thinking a lot lately about the Feds Qe2. Qe2 is increasing the monetary base with 600 billion. The problem I have with Qe2 is once the money come into circulation, the Fed immidiately need to pull the money back again if they want to avoid inflation. And i guess this means the Fed at that point needs to increase interest rates, which could cause a recession or at least slower growth.

Of course as long as businesses and banks are just holding the money from Qe2, they wont circulate and cause an inflationary multiplying effect through the Fractional Reserve Banking system. But once the money is used, The Fed immidiately need to pull them back in order to avoid the Qe2-cash multiplying into thrillions of "bank money".

And this what makes me nervous. I just dont think the Fed can finetune the reduction of the monetary base. Inflation will happen within a few years due to Qe2, and only high interest rates that could cause a recession will bring the inflation back.
I d

Pingry writes:

Please correct me if I'm wrong, but you claim that core inflation is a meaningless concept?

Is this right? Don doesn't understand it?

--Pingry

Sebastian Hagen writes:

I'd like to second Peter Boot's question.

More specifically, doesn't even completely predictable and expected deflation put a lower bound on the real interest of loans anyone would be willing to make? Making a loan with a less than 0% nominal interest rate is strictly inferior to just waiting for your money to appreciate, so in an environment with a predictable 10% annual deflation rate, no loans with a real interest below 10% would be made available. That seems like it would be likely to hurt economic efficiency regardless of the source of the deflation in question.

Am I missing something fundamental?

George Selgin writes:

Like myself, Don doesn't argue for deflation except when it's reflecting real (productivity) growth. If that's the case, since the real equilibrium rate of interest is generally at least equal to the anticipated rate of productivity rule, Don's argument doesn't call in practice for allowing equilibrium nominal rates to go into negative territory. Here again, it's crucial to distinguish between demand- and supply-driven deflation. The zero bound problem arises in the vase of the former only.

Ole writes:

To Sebastian Hagen:

Expectations of hyperdeflation will be an incentive to keep your money as an investment, while hyperinflation will be an incentive to get writh of them as soon as possible. Thats basic logic. If there is deflation, you might save your coins. Like im sure happend a lot in the late 1800s.

Maybe an issue with deflation is that it is less tempting to save the money in the banks, since the interest u get in a bank then would be close to zero.

And as we know, money gets multiplied through the Fractional Reserve System, so maybe deflation will cause a viscious circle. After all, under The Great Depression the public distrust of the banks became so large that people kept their money in the mattress. And these money effectively went out of circulation so that the multiplier effect of letting the banks send your money back into the economy went away.

Btw, Im not claiming that I have a clear idea about this issue, so dont thake this as a critique. Im just trying to figure it out these things for myself.


Schepp writes:

Thank you Gentlemen, excellent work on a great topic.

I was wondering why you did not point to the fact that inflation is not just the printing of money, but it also includes the spending of the printed money without market demands of return on investment. This in my view has a huge impact diverting resources from productive uses. May be that is simply implied, but I thought it could use a little emphasis.

Andrew Fischer Lees writes:

Hi Russ, Hi Don,

You're dismissal of deflation fears and inflation comfort was subpar, insofar as it relied on carefully chosen anecdotes. Listen: every theory has exceptions. The key is whether there are so many exceptions that it erodes confidence in the theory. If you really want to dismiss a theory, you must BOMBARD it with exceptions. A single exception does not disprove a theory; it merely points out that it is a theory, not a law of nature.

For example, Japan - why didn't you talk about the lost decade? A skeptical audience member might think you were cherry-picking your examples (FYI, I agree with your positions, but I was disappointed by your reliance on point observations)

Thanks for everything you do. I've learned immensely from this show, and continue to look forward to the Monday jog+podcast perfect complementarity every week.

Cordially,
andrew fischer lees

Peter Laan writes:

Thanks for a great podcast! I loved the nice debunk of the "deflation causes people to not spend" argument. It's annoying how many people still cling to that myth.

I'm beginning to prefer the old definition of inflation. Not because it's more correct (I agree with Don here), but because it's more useful. One problem with the old definition is that it doesn't account for expectations of future money supply nor long term changes in velocity. Wouldn't such a definition of inflation be more useful? Something like 'changes in the general price level due to changes, or expectations of future changes, in M or V.' Also, wouldn't changes in NGDP be a pretty good estimate of this type of inflation?

One advantage with inflation might be that relative changes in wages for different groups is easier, due to the wage stickiness problem. People hate nominal wage decreases a lot more than getting a raise that's lower than the inflation rate.

Peter Laan writes:

One more thing. Thinking about money will often make my head spin. So, when possible, I try to remove money from the situation and try to consider the problem in a barter economy. This rarely works for monetary problems, but in the case of deflation due to increases in productivity and think it almost works.

Consider two cleaners (the normal ones, not the Leon type!), A and B. Let's say A lends B a house cleaning service. He cleans B's house in exchange for B cleaning his house a year later (let's ignore the normal interest he would likely want).

A year later the technique for cleaning houses has improved. People realized that you could clean a house in half the time if you twist the broom while you sweep the floor. A is happy that he only has to spend half an hour to clean B's house. B is happy, but maybe a little bit annoyed that he had to spend a full hour when he did it a year earlier.

Now, let's say they contracted in nominal terms instead (this is where the 'almost' part comes in). A would have to clean B's house two times. But it still only takes an hour, so he's OK with that. B is happy to get his house cleaned twice. But he knows it only takes A the same amount of time he spent, so it doesn't matter much.

Peter Laan writes:

Sorry for all the spam. I wish it was possible to edit old comments.

There will be a problem for B in the first case. If he had exchanged his house cleaning service for food he would have gotten twice as much as he could get if he one year later sold A's service. A company would have been bankrupt if they had used this business model.

So the second, nominal, case is the most 'fair'.

Nicholas Conrad writes:

The piece I don't understand is why inflation/deflation has to be known ex-ante to mitigate the damage. As long as it is discoverable ex-post contracts can be written as:

principle + interest +/- inflation

I realize CPI is a particularly poor metric as it tends to over-emphasize goods which take advantage of productivity gains, and explicitly excludes food, fuel, and housing; painting an almost laughably rosy picture of inflation. Naturally, being a government index, CPI's purpose is not to provide actionable data to firms, but rather political cover for the regime. However, industry groups, consumer groups, or government watchdogs could provide more accurate data, and particularly useful standards would emerge for reference. Hence, you might see contracts something like:

principal + interest +/- The Heritage Foundation's core inflation index

"You debunked the usefulness of low and consistent inflation as motivating consumption. But is it useful as a motivation for individuals to productively invest funds rather than sit on cash thereby driving growth in the economy ?"

Peter Boots, this sounds like a restatement of the deflationary spiral fallacy. The inflation creates pressure not to sit on your cash, true, but that is not synonymous with 'investment'.
For share-holders, this translates to the 'next quarter profits' mentality so ironically decried by many interventionists, while for the rest of us, artificially high demand for investment opportunities leads to- ...that's right bubbles. Inflation actually feeds the business cycle.
Deflation would cause the economy to retool for long term investment in real growth and higher standards of living rather than scrambling for quick payouts.

Besides which, what's wrong with sitting on your cash? Individuals increase their command of goods and services without having to gamble it on risky schemes, meanwhile firms still have access to the funds through the banks. It's a win/win.

David B. Collum writes:

That was great. I thought it was the economists pushing a purely monetary definition of inflation.

Although not necessarily directly on topic, I would have liked to have heard a little about the flaws in the CPI. Part of our failure to anticipate inflation is certainly traceable to the system's willingness to tamper with the measure of inflation. I got into it a little with one of my favorite economists (Kotlikoff) over his use of the CPI to correct for inflation; I don't think it begins to capture the real consequences of inflation and can't fathom how economists build mathematical models that include the CPI as a mathematical term. I wrote a lot this year about my thoughts on inflation in my annual blog (possibly familiar to the KPC readers). I offer a link...

http://forums.wallstreetexaminer.com/topic/921049-2010-year-in-review/

and simply note that taxation on inflation is unfair, economists should include accelerating depreciation cycles in their analyses, play Monopoly if you wish to understand the ravages of inflation, look at college tuitions if you wish to measure the real rate of inflation.

It seems to me that an interest-generating system is inherently inflationary unless you are willing to let defaults reset the mistakes. Our aversion to defaults seems to be new era thinking stemming from Keynes.

The notion that higher inflation leads to higher dispersion is fascinating: Dispersion becomes an independent measure of inflation. So when you find that oil is skying (tenfold in twelve years for those keeping score) and tuition is soaring yet salaries are not keeping up (or, better yet, dispersing), this is symptomatic of higher inflation.

Is it not true that nasty, virulent deflations always follow nasty (although possibly undetected) inflations? Is there not a causal relationship here? I think so. To blame deflation on deflating prices is no different than blaming inflation on inflating prices. Of course, there is the cause of the inflation to wrestle with...

andy writes:

I have a question regrading the debated interest rate problem - you claim that if the inflation is anticipated (10%), I will demand 13% interest and you will happily pay it.

What is my other alternative? Store the money in the mattress; in that case I get 0% (real -10%). The question is: why should the resulting 'market interest rate' be anything higher than 10%? Are there perfect substitutes for mattress that yield 10% in such case?

David B. Collum writes:

There are alternatives that Russ mentioned somewhat facetiously: fill your truck with stuff. The market will offer you appreciating assets in some form once it figures out that inflation is here. Alas, it might be pork bellies and soybeans.

Ole writes:

Deflation might not be so bad if there has not been a monetary expansion(low interest rates) beforehand.

If I understand George Selgin correctly, deflation should only happen when there is economic growth that causes it.

I think the the current mess is so great that letting the big firms collapse would have been too dangerous. The risks of social instability would have been too great. And the deflationary effects would have come during a recession.

So the idea of the Feds Qe2 is to avoid a liguidity trap ala Japans last 20 years.
But the downside of this policy is that one risks runaway inflation within a few years.

Dave writes:

The best explanation of inflation and deflation that I've seen is from Mish.

Economist on the Bayou writes:

So if inflation is a general rise in all prices, can inflation happen in one area/state and not another? In other words if all prices are generally rising in one state but prices are not rising in all other states then is this not inflation in the state with rising prices?

Also, does anyone know if the CPI calculation adjust for price increases caused by demand increases and/or supply decreases for individual items in the CPI's basket of goods? Also, both Russ and Don seemed to be baffled by the exclusion of energy and food prices for core CPI, and I as well, but if I had to guess I would say the core CPI excludes those prices due to the large shifts in demand and supply for energy and food products.

This is also already a long post but I have to say thank you very much to everyone who contributes to this podcast. I look forward to this podcast every Monday! Thanks again!

Artturi Björk writes:
Let's hold supply of money constant and the only change in prices comes from technological change...

No. It comes from technological change and change in demand for money! Please just be a supply and demand side economist rather than a supply side economist.

If you hold supply of money constant with respect to demand for money you have to make that explicit. (Constant NGDP growth, constant final sales growth, productivity norm...)

The problem of unanticipated inflation/deflation is not that people don't adjust quickly enough. You make it seem that even after the unanticipated event people still behave as if the event hadn't happened.

Really the problem is that there are stickiness because of all sorts of nominal contracts, not just wages.

That's why level targeting or productivity norm or what ever is a good idea and inflation/deflation is not always bad. Inflation/deflation to catch up to expectations is good.

Also it seems bad science that you just dismiss deflation fears. Like Scott Sumner says economists should infer market forecasts. If the market is saying that inflation is going to be lower than Fed's target then there is a reason to loosen policy more than the market expects.

It's irrelevant that banks are hoarding money. The market has already taken that into account. (And also Fed's reaction to that hoarding.) If the market thinks that the Fed has the ability to vacuum the money from the market should it start moving, then this should be your stance as well.

Ole writes:

A few replies to Artturi Björk:

"If the market thinks that the Fed has the ability to vacuum the money from the market should it start moving, then this should be your stance as well."

You are presuming that the market participants hae perfect information and perfect understanding of the Federal Reserves ability to withdraw base money from the economy. Yet the Fed hasnt disclosed how they are going to do it in a timely fashion. In fact i dont think this approach has been tried before in history. The key point is to not to let the base money multiply into bank money. If the Federal Resere acts accurately, it might be possible to accomplish, but i wouldnt bet my house on it.

"That's why level targeting or productivity norm or what ever is a good idea and inflation/deflation is not always bad. Inflation/deflation to catch up to expectations is good."

Well, I dont think this is true. During the stagflation in the 1970ies, inflation did catch up to expections all the time and it still did hurt the economy.

Ward writes:

With regard to the question of why policy makers fear deflation and not inflation; don't you think what they really fear is debt restructuring since that involves making difficult political choices and forcing people to acknowledge their over indebtedness whereas inflation is more like morbid obesity. You can get fat until you die or be slim but you have to amputate a few fingers.

David B. Collum writes:

Artturi:

I think your post is telling in that it describes a complex relationship between the market and the Fed. There are many (including myself) who think that the Fed's incessant interest in trying to trick the market--displace it from its attempts to find its way--are completely unnecessary (counterproductive). Why should a business owner have to figure out what the Fed will do next so as to construct a rational business plan? It seems unassailable that the Fed amplifies the boom-bust cycle. The Fed should, at most, be a referee on the playing field. As Russ would likely say, the best referees aren't even noticed by the fans because they do not become part of the game.

Craig writes:

Dear Russ,

Very much enjoyed the podcast. One issue that you didn't discuss is the claim (made by Doug Irwin in your recent podcast on the gold standard) that the money supply must grow in proportion to the growth of the economy.

My understanding is that this is a widely held view among modern economists, and that it explains a lot of the hostility to the gold standard (indeed, it was Irwin's main criticism, if I recall correctly).

You seemed to accept this position in the Irwin podcast (or at least I don't recall you challenging it). Yet if it's true, then Don and George's arguments about the deflationary benefits of economic growth with a fixed money supply must be false, no?

Russ Roberts writes:

Craig,

I don't think that is what Doug Irwin said. He said that France's behavior forced a sudden, large decrease in the money supply on other nations. When I asked George Selgin about that in his recent podcast, he said that the interwar gold standard was not like the classical gold standard before WWI and didn't face these kinds of problems.

George Selgin writes:

Just to be clear: the "productivity norm" I've defended doesn't call for a fixed M. Nor does is argue against any monetary accommodation of output growth. It allows for M-expansion to offset both declines in velocity and growth in factor (labor and capital) input. It differs from a zero inflation rule merely in holding that it isn't necessary to expand M to offset the deflationary effects of falling unit costs and associated productivity improvements.

James Oswald writes:

The first formulation of the equation of exchange was J.S. Mill in 1848. Both Fisher and Friedman did important research on the equation and related issues though.

Just to keep you economists honest, I'd like to note that you all stammered, stuttered, and left a broken trail of self-interrupted sentences all the way through the podcast. Did NOT provide a tone of certainty.

May I deduce that the banks, and perhaps others, are holding on to their money until this EQ batch is completed and it is safe to release it from an inflation proof storage?

John Berg

Charlie writes:

This was probably the worst podcast ever. Legitimate mainstream economic arguments were badly caricatured. And when it came to the somewhat heterodox views of George Selgin, Boudreaux wasn't able to reproduce the salient points.

I actually went back and listened to this podcast with Tyler Cowen. In it Tyler, takes a crack at explaining some of the arguments caricatured in this podcast. The first 15 minutes are especially good.

Jesse Haifley writes:

John Berg: There are plenty of economists and others earning a lot of money to constantly project a tone of certainty in public. A recent well-documented and hopefully extreme example would be Mishkin, but the airwaves are clogged with self-assured punditry. The lack of slickness on EconTalk is part of the appeal, especially when that lack stems from a refusal to pretend that the issues are simple or certain. That's the honesty you're looking for.

http://movieclips.com/KCct-inside-job-movie-financial-stability-in-iceland/

andy: That's a fair point, but there are at least two others to consider:

1) Although savers seek yield, borrowers also seek funds. "Deposit wars" such as that currently in Spain illustrate that savers are not in all cases passive price-takers.

2) Saving equals consuming, later. An important alternative to saving, if the rates offered are too low, is to consume, now. Not necessarily an ideal substitute for all savers in all situations, but points up that there are more choices than deposits vs. mattress.

Jesse: your point is well taken. The "certain numbers" assigned by economists to the Obamacare debate illustrate your point.

Is it possible to assert with responsibility that those "promised" insurance/pension payments can not be paid? What prevented Congress from spending the lockbox savings before it became obvious that general revenues would not meet the annual costs of Social Security and the added programs Congress added to Social Security?

Can we say with any certainty the government has to stop spending here and here in order to stay under the current debt limit?

John Berg

Rondy K. Smith writes:

It's way past time to remove Ben Bernanke as Chairman of the Fed. If we don't, he is going to destroy the economy with his reckless and ineffective monetary policy.

QE isn't working, won't ever work, and the sooner that is realized and the Fed, as it exists, is reorganized, the better off the economy will be.

Rondy K. Smith writes:

To Ole:

Quoting you:

"Well, I dont think this is true. During the stagflation in the 1970ies, inflation did catch up to expections all the time and it still did hurt the economy."
---
Absolutely correct. There was a time during and just after the late 1970s through the early 1980s when one would quickly examine the WSJ for the latest results of the Money Supply measures for an anticipation of yet higher interest rates on MMMFs and deposit accounts. Disintermediation was ramping, both with banks and insurance companies.

Business planners thus lacked the opportunity to calculate the true marginal cost of capital.

Some labor unions levered the momentum into stellar multi-year contract renewal gains, being fed the incentives by an accommodative FED that failed to realize, as this one does that expansive monetary policy cannot itself stimulate economic growth.

AHBritton writes:

Russ & Boudreaux,

I hate to be always posting largely critical comments because I really do love this podcast, but oh well.

It seems to me Don that you often caricature the opposition and make statements such as "you don't know why" they claim this or that, as if those in opposition have literally NO argument. If you really "do not know" the oppositions argument I would think you would want to run out and find out what it is otherwise your own position loses credibility since you haven't considered the alternatives. For instance you could argue that Core CPI is a poor measurement, deceptive, etc. but to saw "you don't know why" is surprising because it is easy to find the argument that energy and food are excluded because they are very volatile markets with rapid fluctuations and those are less representative of "the consistent and steady growth in price level."

In addition the first 40 min or so of this podcast was based on a huge straw-man. Tell me who at there argues that hyperinflation is stimulative? or that it is better than moderate deflation? This seemed to be the position you were arguing against yet I'm not aware of anyone ever making such a claim.

Another thing is that comparing deflation resulting from increases in productivity and efficiency to deflation as resulting from the hoarding of money are very different situations. Another instance of the U.S. experiencing deflation was during the Great Depression (probably a closer analogy than the late 1800's), how did that one turn out?

In addition this argues against the thesis of Milton Friedman's "A Monetary History of the United States," hardly a fluff piece with little thought involved, yet no refutation of his systematic data collection or arguments was presented (strange considering it is one of the most famous books on the topic).

Rondy K. Smith writes:

Quoting from the piece:

"For those of you out there wondering if inflation is always and everywhere a monetary phenomenon, why hasn't the Fed's expansion of the money supply led to inflation?" (end quoting)
--

I suppose the better question would be: "Why hasn't it led to employment, capital spending and improved economic output?"

The answer is that it won't ever lead to anything more than naked inflation of input costs, just like junk food only contributes empty calories without the corresponding nutrition.

What we're seeing on the inflation front is merely an anticipated readjustment of the unit value of fiat USD, versus commodity prices. QE or whatever you want to call all forms of monetary expansion will not initially act to recover depressed economies. Why?

Because monetary expansion at those times is sterile.

I've explained why in my theoretical work in which I introduce The Perceived Liquidity Substitution Hypothesis found here:

http://www.businessinsider.com/percieved-liquidity-substitution-hypothesis-2010-10

You must be patient and read it entirely. You'll have to turn yourself upside-down. Escape Plato's Cave and then you can tell others what you found.

Andy writes:

If you're talking about money and inflation, I hope you'll get beyond the Econ 101 and get some people to comment on Sumner's case (to use him as a representative) for nominal GDP targeting. I know you've had him on before, maybe bring on the other self-described "quasi-monetarists" such as Bill Woolsey, David Beckworth and others, then the hard-core Austrians could give their response.

Russ Roberts writes:

AH Britton,

Yes, there is an argument for looking at so-called "core inflation" but it's a bad argument that makes no sense to an economist. Yes, food and energy are volatile, but if they both go up dramatically and there is little growth in money supply, then non-food and non-energy prices would go down. What that mean there is deflation? No.

You misunderstood the point about hyperinflation. It was a reductio ad absurdum to show that "spending" in and of itself--an argument some people in the media advance on behalf of inflation--is not a good thing. It's not a good thing in and of itself.

Nothing we said contradicts Friedman's analysis. Neither of us said deflation was a good thing. Don's point was that deflation can be caused by productivity increases and that cause is a good thing. I wondered whether the effect--deflation--could lead to problems if it is not anticipated.

Josh Sher writes:

There is a huge difference between inflation and deflation.

First,
Lets consider two situations:
a. Positive 3% Annual Inflation
b. Negative 3% Annual Deflation

In situation a, if I have cash that I dont want to spend, it is losing value. In this situation I might be willing to lend it out at say a 1% interest rate (-2% in real terms) since its better than leaving it under my matress (-3% in real terms).

In situation b, I would never lend it out for less than 0%, since I can get 0% by keeping it under my matress. Thus I require at least +3% in real terms.

Hence, individuals would require a higher return in real terms under deflation than under inflation, and thus a lot of investment does not occur, and capital sits around idle.

Second, for whatever psychological reasons people do not like having their wages cut. Rather than lowering wages, employment suffers. Further this is an inefficiency since under the assumption that under the current wage level the final worker has positive marginal product, the final worker would continue to have positive marginal product if only all wages scaled with the general price level.

Anyway, being ignorant about 19'th century economic history, I am curious about exactly what happened. perhaps the fact that the capital markets were not that advanced, and the fact that most indiviudals did not make there savings available for other people's investment, meant that the "matress effect" did not have a significant impact on investment....

Thrid, again because of the "Matress effect", the Fed has less ability to influence the inflation rate once it goes negative, since they can't lower rates to less than 0... The fed has much more ability to correct the money supply under positive inflation. Now you may think that the fed's steering is bad thing, but certainly under convential monitary policy they have more ability to steer when inflation is positive than when its negative (or even when its near 0).


Charlie writes:

"Yes, there is an argument for looking at so-called "core inflation" but it's a bad argument that makes no sense to an economist. Yes, food and energy are volatile, but if they both go up dramatically and there is little growth in money supply, then non-food and non-energy prices would go down."

Russ, sometimes your statements about macro are just terrible. Do you even realize that this statement relies on markets always being in equilibrium, which in today's podcast you didn't even agree with? The fact is there is a debate among economists about when and in what ways core inflation is important. Mankiw covers the dispute. Here is one short explanation on the merits of core inflation. Yet, you say it makes "no sense to an economist." Are you unaware these debates exist?

Diana Weatherby writes:

To hear two economic professors discussing inflation and deflation for free on a podcast that I listened to entirely at my convenience while accomplishing other tasks say that the education industry is not really much more efficient than it used to be struck me as somewhat odd. Perhaps it is not of the same quality as being face to face with the professor but then again clothing from Walmart doesn't come close to tailor made items either. The means of getting an education for the masses is changing in both quality and quantity. Information is getting cheaper. Access to people who understand and can explain that information is easier. I can even get someone from China to tutor my child in Mandarin in person for a reasonable price. Low skilled jobs that help students practice grammar or math facts can be delegated to computers freeing up valuable teaching time. There is so much going on that it's hard to keep up with all the possibilities.

Obtaining a degree may be getting more expensive but getting an education seems to be getting cheaper.

Thanks for the doing these podcast. I have been learning a lot.

Stan du Plessis writes:

Russ and Don,

Thank you for another great discussion.

I would like to add my voice to those who think you've been overly skeptical of "core"inflation measures. Here is how I see the matter:

Inflation is a process that erodes the value of money over time. That means the price of everything else rises, in step, in terms of money. Unlike other prices in the economy though, inflation itself is unobservable. In practice we use various price indices such as the consumer price index (CPI), producer price index (PPI) and the GDP deflator, to measure inflation approximately. These approximation are subject to all the limitations you mentioned, so there is no disagreement up to this point. You also emphasized the distinction between absolute (you prefer "average") price changes and relative price changes.

Given our broad agreement on these points I was surprised by your strong rejection of core measures of inflation, strengthened by Russ' later comment on a posting by AHBritton. There Russ wrote:

"Yes, there is an argument for looking at so-called "core inflation" but it's a bad argument that makes no sense to an economist. Yes, food and energy are volatile, but if they both go up dramatically and there is little growth in money supply, then non-food and non-energy prices would go down. What that mean there is deflation? No."

I think the quantity equation is working to hard here. If you keep "T" (in your terms) and V constant, then yes other Pi's would decline even in money terms if the price of milk rises. But over the horizon that we are talking about when measuring inflation (i.e. somewhere from 1 to 12 months) it is much more likely that V and especially T would adjust, as Friedman also argued. The compensatory price changes which you expect would emerge over a longer horizon if M stays constant.

As a practical matter when we try to measure inflation as accurately as possible it may be a great help to exclude items that have experienced very large relative price movements as those movements do not represent any inflation, are not counterbalanced by other price declines and will end up dominating the measured inflation rate. This is why inflation targeting central banks, either de facto or de jure, use core measures of inflation to guide their policy decisions.


Russ Roberts writes:

Charlie,

Nothing I said requires markets to be in equilibrium, whatever that means.

My dislike of core inflation is that it is a bit bizarre to leave out categories of expenditure because they're volatile. Use a moving average but don't OMIT categories--their expansion or contraction has an unavoidable impact on the rest of the categories.

It's like trying to measure your calorie consumption and leaving out lunch because sometimes it's a salad and other times it's an all you can eat buffet. If I go to the buffet for a bunch of days in a row, my reduced dinner consumption will give a very bad prediction on what's going to happen to my weight. It will look like I'm dieting when in fact I'm putting on pounds.

Charlie writes:

"Nothing I said requires markets to be in equilibrium, whatever that means."

Imagine a hurricane hits and knocks out several refineries. The price of gasoline goes up immediately. What other prices must go down immediately? None, a shock just hit the economy, and it will take time for prices to adjust. If you measured CPI right as the hurricane hit, you'd conclude that the money supply had increased, but it has not.

The very notion that a rise in one price must coincide with a decrease in another price when the stock of money is held constant is an equilibrium conclusion. If markets don't clear, there is no reason that it need to be true. Why would you think differently? [Is this perhaps an example of why math and rigor is useful in economics to combat sloppy thinking?]

EPZEN writes:

One of the reasons I listen to this podcast is to get a better understanding of the Chicago School. The economic courses I took in university were from a salt water perspective and thus I often do not agree with many of the comments made on this podcast. The importance of core inflation seems obvious to me. Likewise, I don't agree that deflation is not a significant threat.

Between reading Krugman, Simon Johnson, Mark Toma and then listening to this podcast I find it very disturbing to see the divisions within the field of economics. In any case, thanks very much for the podcast. Even if I often disagree, it is interesting.

James Roane writes:

During the podcast both of you complained about the "sloppy" discussion of inflation, I agree by the way, but I also found your discussion sloppy. You were wondering why people think inflation is o.k. but deflation is not. To disprove them, you use the examples of Germany, and Zimbabwe for inflation and the U.S. in the last half of the 19th century for deflation. I'm neither an economist or economic historian but I can't believe those two examples are on the same scale. Most people who state that inflation is o.k. are referring to "modest" inflation, in the 0-5% per annum range, not hyperinflation. My guess is the U.S. experience in the 19th century was "modest" deflation in the 0-5%, not hyperdeflation, say of 20-25 per year. I don't think that America would not have prospered in that scenario.

Madugiallo writes:

If Hayek and Mises had heard these two supposed experts on the Austrian School talk about inflation/deflation, they would probably have had a heart attack.

You can't understand inflation and deflation, if you have the wrong definition of the two. Inflation is an increase in money and credit and NOT AN INCREASE IN PRICES. An increase in prices is the result of inflation. This distinction is very important because NOT ALL PRICES RISE AT THE SAME PACE. If they did, there wouldn't be any misallocation of capital due to inflation. Then we wouldn't need the Austrian Business Cycle Theory.

There is no such a thing as the general price level and the idea of a CPI is a sham. College education has gone up tenfold in the last 30 years and healthcare has gone up sixfold, while the CPI has trippled.

The CPI in New Zealand went up 53,6% between 1990 Q3 and 2010 Q3, i.e. 2,7% compounded per year. However, if you look at the components of the CPI, you'll see that there is wild variation:

food +54,6%
clothing +10,4%
housing +206,9%
wages +81,1%
transport +35,3%
http://www.rbnz.govt.nz/statistics/0135595.html

So much for the idea of a general price level. This example shows you the nefarious effects of "mild" (2-3 %) inflation preached by monetarists. Owners of real estate have benefited a lot from the newly created money at the expense of others.

Look at all the personal debt created in America during the so-called great moderation. If you had the right definition of inflation, you would understand that this debt is inflation.

There is no such a thing as "bad" deflation. Either you believe in free markets, or you don't. If you do, then you must believe that "bad" deflation is a result of the natural restructuring of the economy. During the boom-years, capital was misallocated due to inflation, i.e. the structure of the economy has deteriorated. During the recession ("bad" deflation), capital is restructured (and destroyed) in a way to make the economy more productive. That's the Austrian Business Cycle Theory.

The use of aggregate data is wrong and it doesn't matter if it's done by keynesianists or monetarists. Monetarists try to beat Keynes at his own game; they think they can create just the right amount of (supposedly beneficial) inflation, but not too much (which would lead to stagflation). Friedman was still a keynesian because, as Hayek put it, "his theory is based on supposed regularities between statistical magnitudes." http://www.youtube.com/watch?v=fXqc-yyoVKg @0:49

AHBritton writes:

Madugiallo,

They discussed the original historical use of the term "inflation," and explained their reason for not using it. Namely NO ONE (except some austrians) uses this definition. In addition this podcast wasn't titled "On The Austrian Account of Inflation." They both (especially Don I believe) state themselves to be sympathetic to Austrian economics, but I never heard them declare that this is where the podcast is coming from. This leaves them as economists to decide whether to use the specific Austrian meaning of inflation, or what the whole rest of the world says and means by inflation.

In addition there are at least theoretical price increases that occur. For the population as a whole, no one would argue that the price to feed cloth and house your family hasn't increased substantially in dollar terms since the 70's, 80's, 20's, 1800's what have you. This fact, in theory at least, corresponds to what is generally meant by price level. Now it could be argued that this is impossible to measure (as you do) because it is not uniform across commodities, localities, and populations. Point taken. But it is possible to give general estimates (you might think they do more harm than good) that do relate in a very real way to the general price increase needed to maintain an "average" standard of living. This increase exists and is theoretically average-able, but like many things we don't have perfect information so all measurements and averages are just estimates vulnerable to many of the same problems most statistics suffer from.

Also I would venture to guess that Russ's knowledge of the Austrian school is not that thurough from listening to him, and he would probably agree that he is not and "expert" (where do they ever claim this?).

Madugiallo writes:

AHBritton,

Neither Don, nor Russ claim to be experts on the Austrian School in the podcast. However, Russ is the co-author of the Hayek vs Keynes rap video (http://www.youtube.com/watch?v=d0nERTFo-Sk), which explains very nicely the Austrian Business Cycle Theory. I suppose the fact that he can explain so well something he doesn't understand completely shows that he's a great educator. He is also the author of an op-ed in the WSJ "Why Friedrich Hayek Is Making a Comeback" http://online.wsj.com/article/SB10001424052748704911704575326500718166146.html
Don Boudreaux is the guest of "Don Boudreaux on Macroeconomics and Austrian Business Cycle Theory" http://www.econtalk.org/archives/2009/04/don_boudreaux_o_2.html

They can use whatever definition of inflation they want, but in my opinion, the original historical definition of inflation (it's not an Austrian definition) is the right one, if we want to understand what's going on in the economy. If people think that inflation is an increase in prices, they will think that a 2 % inflation rate means that prices increase by 2 %. However, when the central bank and banks (through fractional-reserve banking) create 2% more money, nobody can predict where this money will show up. You can understand this only if you use the historical definition of inflation. We can create inflation, but we can't predict where it will go. That's why Hayek said that the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

AHBritton writes:

Madugiallo,

I wasn't trying to claim Russ and Don are not intelligent, well read economists with strong sympathies for the Austrian School, but as Russ also states he is very sympathetic to Chicago Economics which differs from the Austrian approach in various ways. Also, although I have heard Russ often talk about Hayek, I have not heard him talk so much about the more "Misesian" form of Austrian economics typified by Mises, Rothbard, Hoppe, etc.

By describing that definition of inflation as "Austrian" and not "historical" was simply pointing out the fact that as far as I know they are the only ones to currently use this definition to any great extent. If you have examples otherwise I'd be glad to check them out.

To conclude I would suggest it would be more likely that a new term would be used to describe the inflation of the money supply than it would to attempt to reverse the meaning of inflation by economists today.

"If people think that inflation is an increase in prices, they will think that a 2 % inflation rate [monetary inflation?] means that prices increase by 2 %. However, when the central bank and banks (through fractional-reserve banking) create 2% more money, nobody can predict where this money will show up."

I agree, although I think the common individual largely cares more about getting some estimate of the increasing costs of their standard of living than they do about the money supply itself. Although I could be wrong.

Madugiallo writes:

AHBritton,

The main difference between the Chicago School and the Austrian School is that the Chicago School is just another branch of Keynesianism. When it comes to monetary theory, you can't be sympathetic to both the Austrian and the Chicago School because their theories are opposed. Hayek was well aware of this:

Q: "I think it's fair to say that you don't entirely agree with his [Friedman's] analysis of inflation."

Hayek: "No, no, very far from it. You see, in one respect, Milton Friedman is still a Keynesian. Not on monetary theory, but on methodology. Keynes - very much against his own intentions - decided for a mixture of what is called macroeconomics, and it still dominates economic theory, and Milton Friedman is one of the apostles of macroeconomics. Which has the effect that while we completely agree on general economic policy, we wholly disagree on monetary policy because his theory is based on supposed regularities between statistical magnitudes. He is convinced and he believes he has historically demonstrated that there's a SIMPLE RELATIONSHIP BETWEEN THE TOTAL QUANTITY OF MONEY AND THE PRICE LEVEL. Well, one of my main difficulties is that nobody knows what the total quantity of money is, money has so many different meanings. It's now fifty years that I once said in effect that one of the greatest misfortunes could happen in the field of economics if people ever ceased to believe in the quantity theory of money, EXCEPT THEY SHOULD EVER COME TO TAKE IT LITERALLY."

Q: "In fact, you are really arguing that monetarism is an example of a more general error of thinking that you can know too much, you can know all of the facts of some economic problem."

Hayek: "Oh yes, you can put it this way that the aggregates, sums, averages which statistics offer you are no substitute for the detailed knowledge of every single price and their relation to each other which really guide economic activity. That's a mistaken attempt to overcome our limited knowledge."

http://www.youtube.com/watch?v=fXqc-yyoVKg

I think we should try to reverse the meaning of inflation and return to the old definition because if the aim of science is to find out the truth, then we have to use definitions which are as close to the truth as possible.

Russ Roberts writes:

EPZEN,

I never said (and I don't think Don ever said) that deflation is nothing to worry about. I raised the point that deflation can cause banks serious problems because creditors may be unable to honor contracts written in nominal dollars.

Both Don and I agreed that the standard arguments in favor of inflation (encourages spending) and against deflation (discourages spending) don't make any sense. That's the argument we were attacking and we did so with a reductio ad absurdum.

Don's point (which he learned from George Selgin is that whether deflation is worrisome depends on the source of the deflation--productivity increases vs. reductions in the money supply.

In short, deflation is not always bad. That does not mean that it is good.

AHBritton writes:

First, people can have conflicting sympathies, so there is no reason one cannot be sympathetic to contradictory views.

Second, according to your own quotation using your definition of inflation would be similarly useless because "one of my main difficulties is that nobody knows what the total quantity of money is, money has so many different meanings."

This seems to undercut your own argument.

Third, I agree that we have VERY imperfect information. Not just in macroeconomics, but science in general, not to mention simple justifications such as whether other people even exist, whether reality corresponds to want our senses tell us, etc.

In the end though we have to make a decision and attempt to create a well justified and coherent reason for our many beliefs. I choose to believe the main postulates of quantum mechanics to be justified despite my inability to observe it directly and my incredibly inadequate knowledge of the field. My mind could be changed but it would likely be difficult. I believe you have a mind similar to mine even though I have no way to prove it.

Similarly I believe that econometrics, and economic statistics in general, when done according to certain standards are able to shed light on, and help us for beliefs about, economics as a field. This despite their flaws.

If you wish to deny that we can gain empirical knowledge in this way you must either demonstrate another empirical method for gaining such knowledge, claim that an opposing idea is irretrievably contradictory, or claim it is just "given to us" in some sense. The final choice does leave open the dilemma that it can be used to justify all beliefs.

Madugiallo writes:

AHBritton,

"First, people can have conflicting sympathies, so there is no reason one cannot be sympathetic to contradictory views."

What I meant to say was that Russ and Don don't understand the classical definition of inflation and the Austrian Business Cycle Theory. They understand Hayek's insights on the information problem, but they don't understand how this relates to money/inflation/business cycle.

"Second, according to your own quotation using your definition of inflation would be similarly useless because "one of my main difficulties is that nobody knows what the total quantity of money is, money has so many different meanings."

This seems to undercut your own argument."

It does undercut my argument. But it doesn't change my opinion on money, which is my main argument. I - just like Hayek and Mises - want a free market in money, i.e. no monopoly on legal tender, and free banking. Under these circumstances, it would be useless to discuss inflation/deflation and increases/decreases in money supply because the market would regulate it. So let's say that the idea of a CPI is useless and we can't even measure the money supply. At least we know that the fractional-reserve banking system is by definition inflationary during times of economic growth.

Discussions on monetary policy and inflation/deflation are useful only for central planers of money (keyenesians, monetarists - people suffering from epistemological arrogance, as Nassim Taleb would say) and investors who try to predict which asset classes will benefit from inflation.

I don't understand quantum mechanics at all, but I know that it's a theory which is used to build things people want to buy. So obviously the market has decided that it's useful.

I don't think that econometrics is useful. By the way, former central bankers have (paradoxically) acknowledged this. If you want, I can find you the exact quotes by Greenspan and Arthur Burns. If econometrics was useful, we could build predictive models of the economy based on econometrics. And if we were able to build predictive models for the whole economy, it would be even easier to build predictive models for asset classes. If I had such a model, I would just sit at home and make a lot of money trading. The truth is that no such models exist. I can find you the quote by Greenspan on this, if you want.

I'm not saying that all aggregate data is useles. Private firms collect aggregate data and try to use it to get an advantage in the market place. Let the market decide which data is useful and which isn't.

Let's have free money and free banking and those who issue money can decide which aggregate data they want to use. I don't know of any period in history where free money and free banking has led to bad results. But I know of many instances where central planers of money and bank regulators have created economic crises, high volatility in asset prices and economic output, and hyperinflations.

Rob Moll writes:

I'm not an economist, but I do love econtalk. So, this question may come out of left field, but in your discussion of deflation in the late 19th century, I'm shocked that you didn't bring up the fact that the period of deflation--called the Great Depression at the time--was felt painfully by great numbers in society. It fueled the Democratic party for 40 years. No one mentioned the attempts to create a bi-metal standard which would inflate the money supply. William Jennings Bryan's cross of gold speech at the Democratic National Convention led him to three straight presidential runs. In the speech he assailed the city folks, bankers especially, (he would, no doubt, include economists today) who forced the gold standard on farmers whose debts stayed the same while the price of their crops fell. This was an incredibly painful period, even if living standards rose over generations as folks left their farms for factory jobs. I don't think this was an increase in the standard of living if you left your 40 acres because of bankruptcy and got a job in a factory to support your family in a tiny tenement.

Secondly, you neglected to mention the pain caused by falling interest rates in the early 90s. Indeed the same pain that can be caused by deflation happens when the rate of inflation falls. Banks let out mortgages in the 80s at high rates. When rates fell, home owners refinanced, hitting the banks hard. I believe this contributed to the S&L crisis which led to a recession.

Indeed bad policies should not be pursued simply because people expect them to be. But the transition to better policies have tremendous costs.

AHBritton writes:

Madugiallo,


"What I meant to say was that Russ and Don don't understand the classical definition of inflation and the Austrian Business Cycle Theory."

The first Boudreaux addressed, and the second was not the topic of this podcast, unless you are referring to another episode of EconTalk, or EconTalk as a whole.

"Under these circumstances, it would be useless to discuss inflation/deflation and increases/decreases in money supply because the market would regulate it."

I am skeptical that people would lose interest in inflation simply because "markets" are handling it.

"At least we know that the fractional-reserve banking system is by definition inflationary during times of economic growth."

Fractional reserve exists with or without government control and central banking. If a bank makes its own currency, theoretically backed with assets I'd imagine, there is no doubt that they would print more currency than the value of the underlying assets.

"Discussions on monetary policy and inflation/deflation are useful only for central planers of money (keyenesians, monetarists - people suffering from epistemological arrogance, as Nassim Taleb would say) and investors who try to predict which asset classes will benefit from inflation."

It's funny, from what I can tell from hearing Taleb speak he is very interventionist when it comes to the economy. He talks a lot as if all debt should be criminalized or something along those lines. I'm surprised none of that comes up on EconTalk.

"I don't understand quantum mechanics at all, but I know that it's a theory which is used to build things people want to buy. So obviously the market has decided that it's useful."

The whole "markets determine value" or "usefulness" idea is somewhat strange to me. I mean I understand the basic concept but it seems at least theoretically to be absurd.

If HYPOTHETICALLY markets perpetuated the emissions of a poisonous gas (because in the short term it was very profitable and useful to do so) but the poisonous gas accumulated in the environment to the point of making the earth barely inhabitable, are you claiming that this would still be fine because the market determined it?

Markets are great in many ways, but markets don't strive for any inherent goals or purposes. Many social animals have developed wonderfully complex and beneficial social orders that end up highly destructive in the wrong circumstances.

"I don't think that econometrics is useful. By the way, former central bankers have (paradoxically) acknowledged this. If you want, I can find you the exact quotes by Greenspan and Arthur Burns."

I'd be interested to see these. One way or another Greenspan and Burns both relied on them heavily… so for me it seems the proof is in the pudding on that one.

"If econometrics was useful, we could build predictive models of the economy based on econometrics."

This is false. Weather forecasters have a very weak ability to forecast for more than a day or two into the future with accuracy. Yet I still think they are useful and want to have one around if a hurricane is coming. That argument is completely invalid.

"And if we were able to build predictive models for the whole economy, it would be even easier to build predictive models for asset classes. If I had such a model, I would just sit at home and make a lot of money trading. The truth is that no such models exist. I can find you the quote by Greenspan on this, if you want."

Who claimed that one can build predictive models for the whole economy? I didn't. That's simply a straw man.

I do believe however in boom periods in the economy people with lots of capital and financial knowhow ARE able to basically make money doing nothing. By using computers and creating mind bogglingly complicated derivatives they are able to convince people that various assets are much more valuable than they actually are.

Even these people I don't think can predict the economy very well however.

"I'm not saying that all aggregate data is useles. Private firms collect aggregate data and try to use it to get an advantage in the market place. Let the market decide which data is useful and which isn't."

What makes useless data suddenly useful merely by market involvement?

All this would prove is the ability to monetize its value. There are plenty of things of value that cannot be monetized, and I would guess plenty of societal goods that people place great vale in that are hard to monetize and/or nearly impossible to create an efficient profit model off of.

"Let's have free money and free banking and those who issue money can decide which aggregate data they want to use. I don't know of any period in history where free money and free banking has led to bad results. But I know of many instances where central planers of money and bank regulators have created economic crises, high volatility in asset prices and economic output, and hyperinflations."

I must admit as a former anarchist I am HIGHLY sympathetic to the free-banking mentality.

In the end though I am very skeptical, I definitely need to look into the history more, but it seems that there is very little true "free banking" to look at that it is nearly impossible to tell what its stability might be.

In addition it seems hyperinflation is somewhat rare and mostly as the result of catastrophic circumstances with unstable governments (Germany) or an autocratic dictatorial ruler in an economically ravaged country (Zimbabwe)… hardly circumstances where the lack of free banking was likely their biggest problem.

Madugiallo writes:

AHBritton,

“"What I meant to say was that Russ and Don don't understand the classical definition of inflation and the Austrian Business Cycle Theory."
The first Boudreaux addressed, and the second was not the topic of this podcast, unless you are referring to another episode of EconTalk, or EconTalk as a whole.””

Maybe Boudreaux addressed the classical definition of inflation, but then they continued to use the old one, which is misleading. If you had Hayek or Mises there, they would have dismissed the modern definitions of inflation/deflation as irrelevant. Given that Boudreaux was explaining the Austrian Business Cycle Theory in another podcast and that he’s blogging together with Russ at Café Hayek, I would have expected him to do the same.

“"Under these circumstances, it would be useless to discuss inflation/deflation and increases/decreases in money supply because the market would regulate it."
I am skeptical that people would lose interest in inflation simply because "markets" are handling it.”"

People wouldn’t lose interest in it. But given that prices would be falling even if there was inflation, they probably wouldn’t notice the inflation. At the end of the 19th century in the US, there was inflation AND falling prices, because output was rising faster than the money supply (there was still fractional reserve banking). I’m sure that not all prices were falling at the same pace. This is an example of why we need the old definition to understand what’s going on.

“"At least we know that the fractional-reserve banking system is by definition inflationary during times of economic growth."
Fractional reserve exists with or without government control and central banking. If a bank makes its own currency, theoretically backed with assets I'd imagine, there is no doubt that they would print more currency than the value of the underlying assets.”

There would be some banks doing this. But if people were suspecting that a bank had too little reserves, competitor banks would redeem the notes of this bank and force it into bankruptcy. So the market would impose a lot of discipline.

“It's funny, from what I can tell from hearing Taleb speak he is very interventionist when it comes to the economy. He talks a lot as if all debt should be criminalized or something along those lines. I'm surprised none of that comes up on EconTalk.”

“Nassim Taleb Says No to Big Corporations and No to Big Government” http://www.corporatecrimereporter.com/taleb010311.htm

“"I don't understand quantum mechanics at all, but I know that it's a theory which is used to build things people want to buy. So obviously the market has decided that it's useful."
The whole "markets determine value" or "usefulness" idea is somewhat strange to me. I mean I understand the basic concept but it seems at least theoretically to be absurd.
If HYPOTHETICALLY markets perpetuated the emissions of a poisonous gas (because in the short term it was very profitable and useful to do so) but the poisonous gas accumulated in the environment to the point of making the earth barely inhabitable, are you claiming that this would still be fine because the market determined it?
Markets are great in many ways, but markets don't strive for any inherent goals or purposes. Many social animals have developed wonderfully complex and beneficial social orders that end up highly destructive in the wrong circumstances.””

I agree that markets aren't perfect. Let’s say that quantum mechanics is used to build things people want to buy. On the other hand, I don't see any practical use for econometric models. They probably wouldn’t exist without government regulation of money (and banking). Nobody would probably buy an econometric model today - maybe in the 1970s:

"I worked directly for Chief Economists at two major banks, First Interstate in the late 1980's, and KeyCorp in the 1990's. While it would be nice to know when the next recession or interest rate move will happen, no one thought the economist knew better than other random members of the executive committee. Economists are good at presenting the information that seems useful, but as per tying it together, they can't and most people making important decisions know that. This is why economists are always on TV and not in boardrooms. It is also why economics departments at banks have gone from large staffs in the 1970s (at the height of the Keynesian modeling boom), to basically one guy, because it was discovered his or her only value is getting the company name on TV. If someone presents himself as especially credible because he was a chief economist, I know he's a fool." http://falkenblog.blogspot.com/2010/07/chief-economists-are-for-pr.html

""I don't think that econometrics is useful. By the way, former central bankers have (paradoxically) acknowledged this. If you want, I can find you the exact quotes by Greenspan and Arthur Burns."
I'd be interested to see these. One way or another Greenspan and Burns both relied on them heavily… so for me it seems the proof is in the pudding on that one."

It’s an illusion to think that Greenspan or Burns have conducted monetary policy based on outputs from econometric models. A central banker is first and foremost a politician. Even the FED acknowledges that it’s not independent on their website.

“As the nation's central bank, the Federal Reserve derives its authority from the U.S. Congress. It is considered an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, it does not receive funding appropriated by Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. However, the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute. Also, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government. Therefore, the Federal Reserve can be more accurately described as "independent within the government."”
http://www.federalreserve.gov/generalinfo/faq/faqfrs.htm#5

Greenspan: “A central bank in a democratic society is a magnet for many of the tensions that such a society confronts. Any institution that can affect the purchasing power of the currency is perceived as potentially affecting the level and distribution of wealth among the participants of that society, hardly an inconsequential issue. (…)The Federal Reserve's most important mission, of course, is monetary policy. I wish I could say that there is a bound volume of immutable instructions on my desk on how effectively to implement policy to achieve our goals of maximum employment, sustainable economic growth, and price stability. Instead, we have to deal with a dynamic, continuously evolving economy whose structure appears to change from business cycle to business cycle, an issue I shall return to shortly. Our monetary policy independence is conditional on pursuing policies that are broadly acceptable to the American people and their representatives in the Congress.

“The Challenge of Central Banking in a Democratic Society” http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm

“I’ve been in the forecasting business for fifty years, more than that actually. I have to think about that; but in any event I’m no better than I ever was and nobody else is. (…) Forecasting fifty years ago was as good or as bad as it is today. And the reason is that human nature hasn’t changed, we can’t improve ourselves.” », http://www.thedailyshow.com/watch/tue-september-18-2007/alan-greenspan

Burns has “confessed” everything (that in the 1970s he was monetizing government debt so the government could expand social programs, and that it was expected from him) in his 1979 speech “The Anguish of Central Banking”. http://www.perjacobsson.org/lectures/1979.pdf

It’s interesting that central bankers will give you all the arguments that discredit central banking. The FED’s brochure “The Federal Reserve System – Purposes and Functions” (http://www.federalreserve.gov/pf/pdf/pf_complete.pdf) is a great treatise on the shortcomings of monetary policy making.

Greenspan has criticized central banking in his famous essay “Gold and Economic Freedom” (http://www.usagold.com/gildedopinion/greenspan.html) from 1967. In 2002, he said “I reread this article recently – and I wouldn’t change a single word.” BONNER, William, WIGGIN, Addison, "Financial Reckoning Day. Surviving the Soft Depression of the 21st Century", Hoboken, Wiley, 2003, p. 159, cited in SHEEHAN, Frederick J., "Panderer to Power. The untold story of how Alan Greenspan enriched Wall Street and left a legacy of recession", New York, McGraw-Hill, 2010, p. 286.

Sheehan’s book is great because it shows how Greenspan is capable of saying one thing to one audience, and then saying exactly the opposite a different audience.

This is what Greenspan said in 2007: “We have at this particular stage a fiat money which is essentially money printed by a government and it’s usually the central bank which is authorized to do so. So some mechanism has got to be in place that restricts the amount of money which is produced. Either a gold standard, or currency board, or something of that nature because unless you do that all of history suggests that inflation will take hold with very deleterious effects on economic activity. (…) And there are numbers of us, myself included, who strongly believe that we did very well in the 1870 to 1914 period with an international gold standard.” http://www.youtube.com/watch?v=fwu5FiT-fOY,

“"If econometrics was useful, we could build predictive models of the economy based on econometrics."
This is false. Weather forecasters have a very weak ability to forecast for more than a day or two into the future with accuracy. Yet I still think they are useful and want to have one around if a hurricane is coming. That argument is completely invalid.”

Why is my argument invalid? I’m not talking about weather forecast, I’m talking about economy forecast. Bernanke is certainly not a good forecaster - http://www.youtube.com/watch?v=9QpD64GUoXw.
On the other hand, Peter Schiff (an Austrian economist) has forecasted the current crisis perfectly in 2006 - http://www.youtube.com/watch?v=jj8rMwdQf6k.
Marc Faber (also an Austrian economist) did the same in 2002 - http://www.financialsensearchive.com/transcriptions/2002/Faber.html
This interview is also a great discussion of inflation/deflation/hyperinflation.

“"And if we were able to build predictive models for the whole economy, it would be even easier to build predictive models for asset classes. If I had such a model, I would just sit at home and make a lot of money trading. The truth is that no such models exist. I can find you the quote by Greenspan on this, if you want."
Who claimed that one can build predictive models for the whole economy? I didn't. That's simply a straw man.””

Asset prices are a sub-part of the economy, so if it was possible to predict the whole economy, it would be even easier to predict parts of the economy. What is the aim of econometrics, if not to predict the economy?

“I do believe however in boom periods in the economy people with lots of capital and financial knowhow ARE able to basically make money doing nothing. By using computers and creating mind bogglingly complicated derivatives they are able to convince people that various assets are much more valuable than they actually are.
Even these people I don't think can predict the economy very well however.”

I agree. The whole investment advisory industry is mostly about marketing and selling products clients don't understand. "A very messy Ambac lawsuit for JPMorgan" http://ftalphaville.ft.com/blog/2011/01/25/468916/a-very-messy-ambac-lawsuit-for-jpmorgan/

“"I'm not saying that all aggregate data is useles. Private firms collect aggregate data and try to use it to get an advantage in the market place. Let the market decide which data is useful and which isn't."
What makes useless data suddenly useful merely by market involvement?
All this would prove is the ability to monetize its value. There are plenty of things of value that cannot be monetized, and I would guess plenty of societal goods that people place great vale in that are hard to monetize and/or nearly impossible to create an efficient profit model off of.”

Yes, it only would prove that it’s possible to monetize aggregate data. If people think there is value in data that somebody’s selling, they can buy it. I don’t care which data is useful for whom.
It’s no coincidence that the government of Argentina – a country that experiences hyperinflation periodically – tries to suppress the publishing of “independent” aggregate data.

“All Argentine consulting firms that calculated an inflation rate higher than the official 10.9 percent have received a letter from the government today. They've been given 48 hours to explain their calculation or face a $125,000 fine, according to the FT. Independent estimates put last year's inflation rate at 25 percent, with 30 percent inflation in 2011.”
http://www.businessinsider.com/argentina-threatens-to-fine-analysts-who-predict-30-percent-inflation-2011-2#ixzz1D8zTXo7d

""Let's have free money and free banking and those who issue money can decide which aggregate data they want to use. I don't know of any period in history where free money and free banking has led to bad results. But I know of many instances where central planers of money and bank regulators have created economic crises, high volatility in asset prices and economic output, and hyperinflations."
I must admit as a former anarchist I am HIGHLY sympathetic to the free-banking mentality.
In the end though I am very skeptical, I definitely need to look into the history more, but it seems that there is very little true "free banking" to look at that it is nearly impossible to tell what its stability might be.
In addition it seems hyperinflation is somewhat rare and mostly as the result of catastrophic circumstances with unstable governments (Germany) or an autocratic dictatorial ruler in an economically ravaged country (Zimbabwe)… hardly circumstances where the lack of free banking was likely their biggest problem."

The lack of free banking is a precondition for hyperinflation. Hyperinflation is caused by the state’s monopoly on money and the central bank printing too much money. In a free banking system, there would be no central bank and hyperinflation would be impossible.

You can listen to “Selgin on Free Banking” http://www.econtalk.org/archives/_featuring/george_selgin/

AHBritton writes:

Madugiallo,

I meant to make a much more thorough response much sooner but have been very busy. As it is likely you have already stopped following these comments I will just post the unfinished fragment I had created already just incase you are interested. I might soon try to make a more complete response.


"Maybe Boudreaux addressed the classical definition of inflation, but then they continued to use the old one, which is misleading."

How is it "misleading" to both explicitly present both definitions and then clearly delineate which definition will be used for the purposes of their discussion?

It seems to me that this is the precise opposite of being misleading. In addition you can even see in the summary listed above statements such as:

"The Austrian in me--and you and I both have a little or a lot--they don't like aggregates. Austrian economics was against the idea of aggregates. Aren't we playing the same error that Austrians often complain about, when we talk about the price level, as if there is a single good."

It seems to me that you are merely perturbed that they decided to entertain a price level conception of inflation at all.

There is nothing wrong with this, I just don't understand why you don't simply state it as such instead of presenting your argument in the form that Russ and Don are engaged in some sort of nefariousness or blind dismissal of opposing views.

It seems to me they were very clear, engaged the COMMON conception of price level inflation rather skeptically and presented their arguments from there. You wish to present this as some sort of betrayal of Austrian methods and traditions instead of (what I happen to believe it to be) a discussion of monetary issues in plain language regarding THEIR views on certain misrepresentations and fallacies encountered when viewing popular media representations of monetary issues, as well as various popular academic views and attitudes regarding monetary issues.

Disagree with it all you want, I just see no evidence of deception, misrepresentation, and no need for them to be beholden to any particular ideology or methodology for its' own sake.

"If you had Hayek or Mises there, they would have dismissed the modern definitions of inflation/deflation as irrelevant. Given that Boudreaux was explaining the Austrian Business Cycle Theory in another podcast and that he’s blogging together with Russ at Café Hayek, I would have expected him to do the same."

Again, IF it was Hayek or Mises talking you would definitely have a right to call them out for hypocrisy.

But it was not Mises or Hayek, it was Don and Russ giving THEIR opinions. Just because they are fans of the Austrian school of economics does not require them to address every argument as if they were Mises or Hayek (whom had disagreements between themselves).

I'm a big fan of Darwin, and if I felt compelled to write a blog about Darwin's ideas I would feel I have every right to do so. This does not mean that I must then address every future topic in the field of biology as if I was Charles Darwin himself.

"People wouldn’t lose interest in it…"

"But given that prices would be falling even if there was inflation, they probably wouldn’t notice the inflation. At the end of the 19th century in the US, there was inflation AND falling prices, because output was rising faster than the money supply (there was still fractional reserve banking). I’m sure that not all prices were falling at the same pace. This is an example of why we need the old definition to understand what’s going on."

I am less confident in my ability to predict what the aggregate price level would or would not be like in a free banking system but I will not debate it. I will point out that this instance of falling price level is far from our current situation.

Personally I don't think describing changes in money supply as inflation or deflation clarifies anything for me. If I wish to talk of changes in the money supply I will simply do so, the minor semantical change seems to have little bearing on my cognitional ability in this instance.

The very minor (in my opinion) obfuscation of the underlying unevenness of price-levels caused when one uses inflation to mean an aggregate of price-levels does not seem to me to hinder understanding.

When you watch the daily weather report (I don't know why I keep coming back to the weather) it is surely possible that one could be mislead when they describe the average wind speed as being 10mph into believing that when they leave the house they will experience a continuous and uniform breeze of precisely that magnitude. Despite my general pessimism I doubt that this is a common surprise to most individuals upon stepping out the front door.

Similarly, I doubt it would come as a great surprise to any but the most naive of people with even a modicum of interest in economics that price neither rise nor fall uniformly.

"There would be some banks doing this. But if people were suspecting that a bank had too little reserves, competitor banks would redeem the notes of this bank and force it into bankruptcy. So the market would impose a lot of discipline."

Again, in my opinion this is somewhat speculative. Although I have little doubt that it would be extremely difficult for a bank within a competitive currency situation to increase the ratio of currency to assets too far beyond that of its competitors.

Madugiallo writes:

AHBritton,

By “misleading”, I meant to say that if you use the price level definition of inflation, you will not get close to the truth because you will be “misled”. So yes, they have the right to use whatever definition they want and, yes, I am perturbed by the fact that they have decided to entertain a price level conception of inflation at all.

Prices in general were falling during the late 19th century in the US (not all prices at the same pace, and some were rising – for example, if your land contained oil). This was not a free banking system and the gold standard was not 100%. So there is no reason to believe that under a free banking system (which would have had a higher gold reserve ratio) prices wouldn’t have fallen even more.

There is not just a “minor semantical” difference between the price level and the money supply definitions of inflation/deflation. There are huge differences between the rates of price increases in different products and services. If you apply the money supply definition, you won’t be fooled by Bernanke et al. saying there is no inflation, or that there is deflation. Look at what happened to commodities prices since the announcement of QE2 - http://www.barchart.com/chart.php?sym=$CRB&t=BAR&size=M&v=0&g=1&p=D&d=X&qb=1&style=technical

The S&P 500 went up significantly when money-printing programs were announced in 2008-09 - http://finance.yahoo.com/echarts?s=^GSPC+Interactive#chart1:symbol=^gspc;range=5y;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

If you use the price level definition of inflation/deflation, you will have to rely on a price index (unless you calculate your own index) which doesn’t reflect the differences in price increases and which has probably been massaged by government statisticians:

“The Boskin Commission was one scandal that economists actually denounced. Greg Mankiw, chairman of George W. Bush's Council of Economic Advisers from 2001-2003, said at the time "the debate about the CPI was really a political debate about how, and by how much, to cut real entitlements."“
http://www.safehaven.com/print/15532/economists-serving-their-political-masters

While the CPI might show that prices “in general” are falling, some prices (real estate) might be falling, while other prices (commodities) might be increasing significantly.

It is no coincidence that during episodes of high inflation and hyperinflation price increases in real estate lag significantly behind price increases in other things:

"Real estate price collapse.

Lenders—on seeing prices rising and purchasing power deteriorating in an inflationary economy—naturally raise the interest rate they charge, on the future expectation of inflation during the period of their loan. Obvious: If I lend money for a year, and expect the inflation rate to be 10% for that year, I’ll naturally lend out my money at 15% interest—or more, if I think inflation is accelerating.

Borrowers on the other hand—on seeing interest rates rise, while their wages and salaries are at best playing catch-up to rising prices—curtail their borrowing: They either borrow less, or don’t borrow at all.

Therefore, real estate sellers—who depend on lenders to provide their buyers with credit in order to sell their properties—are forced to lower their prices, in order to attract buyers. Law of supply and demand: They cannot force up the price of their real estate to match the pace of inflation, because if they do, they will simply not have any buyers.

Thus, in an inflationary environment, real estate prices either remain static or indeed fall on a nominal basis, even as inflation is debasing the currency, because real estate sellers will not find buyers willing to take on usurious debt in order to buy the property.

This is how real estate prices fall, even as prices for near-term necessities—food, fuel—rise. This is how you have a real estate collapse, even as you have inflation.

Don’t believe me? Well, I can empirically prove this. During the 1979–‘83 inflationary recession, this is exactly what happened in the United States: Nominal real estate prices were essentially flat, even as inflation peaked at 15%. The same in the UK during the early Seventies, in fact the same in every advanced economy that experienced low-double-digit inflation in the post-War period: Real estate prices remained nominally flat or even fell, as inflation rose and the currency was debased.

What about real estate in a hyperinflationary environment?

The same—only magnified: In a hyperinflationary environment, interest rates are so high that essentially, there is no lending. There’s no point to it: Most lenders will decide not to lend out their excess cash, and instead park that cash in assets which will resist inflation—they will certainly not lend out their cash to a borrower, and watch it become worthless on their books.

Therefore, since real estate buyers cannot get a mortgage loan, real estate sellers are forced to reduce their prices in a hyperinflationary episode—drastically."
http://gonzalolira.blogspot.com/2011/02/inflation-hyperinflation-and-real.html

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