Friday, April 15, 2022

Inflation and the end of illusions.

An oped at Project Syndicate

Inflation’s return marks a tipping point. Demand has hit the brick wall of supply. Our economies are now producing all that they can. Moreover, this inflation is clearly rooted in excessively expansive fiscal policies. While supply shocks can raise the price of one thing relative to others, they do not raise all prices and wages together. 

A lot of wishful thinking will have to be abandoned, starting with the idea that governments can borrow or print as much money as they need to spray at every problem. Government spending must now come from current tax revenues or from credible future tax revenues, to support non-inflationary borrowing. 

Stimulus spending for its own sake is over. Governments must start spending wisely. Spending to “create jobs” is nonsense when there is a widespread labor shortage. 

Unfortunately, many governments are responding to inflation by borrowing or printing even more money to subsidize energy, housing, childcare, and other costs, or to hand out more money to cushion the blow from inflation – for example, by forgiving student loans. These policies will lead to even more inflation. 

Expanded social programs and transfers must be funded from stable long-run tax revenues, from taxes that do not impose undue costs on the economy. These facts will make it much more difficult for policymakers to continue ignoring budgets and the disincentives that are embedded in many social programs. 

The bailout bandwagon will end. The 2008 financial crisis was met with a torrent of borrowed and printed money to stimulate the economy and bail out banks and their creditors. The COVID-19 recession was met with a tidal wave. Once again, government money went to bail out creditors, prop up asset prices, and provide more stimulus. 

Given these precedents, our financial system now firmly trusts that the government will borrow or print money in the event of any future crisis. But once fiscal space has run out and given way to inflation, the government’s ability to stop the next crisis may evaporate. When people no longer have confidence that the borrowed money will be repaid, or that the printed money will be soaked up again, they will not lend more. Today’s small (so far) inflation is a taste of this fundamental change. 

The “secular stagnation” debate is settled. Since 2000, long-term growth has fallen by half, representing one of the great unsung economic tragedies of the twenty-first century. After rising by an average of 3.6% per year between 1947 and 2000, US real (inflation-adjusted) GDP growth has since averaged just 1.8% per year. 

Was this sclerosis a case of demand-side “secular stagnation” that, given persistently low interest rates, had to be addressed with oodles of “fiscal stimulus?” Or did it follow from a reduction in supply owing to the corrosive effects of protected and over-regulated industries, or to deeper problems such as the erosion of educational performance or a lack of innovation? 

We now know that it was supply, and that more stimulus will bring only more inflation. If we want growth – to reduce poverty; to pay for health, environmental protections, and transfers; or for its own sake – it will have to come from unleashing supply. Tariffs, industrial protections, labor-market distortions, restrictions on skilled immigration, and other supply-constraining policies have direct costs that cannot be offset by printing more money. 

The return of inflation and Russia’s war in Ukraine signal the end of stupendously counterproductive energy and climate policies. Our governments have been pursuing a dangerously myopic strategy of shutting down US and European fossil-fuel development before alternatives are available at scale, strangling nuclear energy, and subsidizing grossly inefficient (and often carbon-intensive) projects such as California’s high-speed train to nowhere. 

The folly of this approach is now plain to see. After blocking the Keystone XL Pipeline and limiting oil and gas exploration, US President Joe Biden’s administration has now gone begging to Venezuela and Iran to make up for a shortfall in energy supply. Similarly, although cracks have appeared, the Germans still can’t bring themselves to allow nuclear power or fracking for natural gas. Efforts to strangle domestic fossil-fuel companies via financial regulation continue unabated. For example, on March 21, just as Russia’s attack on Ukraine was driving gas prices sharply higher, the US Securities and Exchange Commission decided to announce expansive new climate-related disclosure rules designed to discourage fossil-fuel investment. 

For years, climate regulators have repeated the mantra that fossil-fuel companies would soon be bankrupt – stuck holding “stranded assets” – because of such regulation, and that this justified measures to force banks to stop lending to them. But reality must now remind everyone of a lesson from Economics 101: when supply is restricted, price (and profits) go up, not down. Those who have been insisting that climate change is the greatest risk to civilization, or to financial markets, surely must now acknowledge that there are other more likely near-term threats, such as pestilence, military aggression, and now possibly even nuclear war. 

Yet the spin continues. One still hears that inflation comes from vulnerable supply chains, nefarious price gouging, profiteering, monopoly, and greed. The Biden administration’s latest effort to brand inflation “Putin’s Price Hike” is both comically inept and patently false. Inflation is widespread and has been surging for a year, while Russian President Vladimir Putin wants nothing more than to sell us lots of oil to finance his military. Such spin trivializes a war that is a fight for the soul of Europe and for the security of the world; it is not about Americans’ inconvenience at the gas pump. 

The era of wishful thinking is over. Those who come to grips with that fact now will look a lot less foolish in the future. 


30 comments:

  1. "Demand has hit the brick wall of supply. Our economies are now producing all that they can." Are you saying that expanding the money supply (that is, financing govt spending by selling debt to the Fed) wouldn't produce inflation if we had high unemployment?

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    1. It will not end until voters in enough places elect a majority of officeholders who understand these basic principles of economics AND who are willing to vote in accordance with those principles. As long as a politician can stay in office by claiming to have put more cash in peoples' pockets (rather than value), we are doomed to continue this Modern Monetary Theory theft.

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  2. Well said, prof Cochrane.
    Bowles Simpson 2.0?

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  4. "When people no longer have confidence that the borrowed money will be repaid, or that the printed money will be soaked up again, they will not lend more. Today’s small (so far) inflation is a taste of this fundamental change." John Cochrane

    I agree with most of this post. But this business of the Fed selling off its balance sheet has always puzzled me.

    As it is, the Fed balance sheet helps the US government meet its IOUs.

    There is also the Bank of Japan situation. No inflation in Japan.

    I would like to see this topic addressed.

    This is a paper from the Dallas Fed, and it suggests the Fed's balance sheet is perhaps anti-inflationary.

    https://www.dallasfed.org/~/media/documents/research/eclett/2014/el1406.pdf

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    1. There is a ton of inflation in Japan if inflation is defined by loss of purchasing power. The Yen has lost 80% of it's value to gold since 2,000. It is down 20% to the dollar this year alone.

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  5. I would suggest another lesson to be learned.

    Globalization has its risks that we have ignored over the years and now, since we never prepared for them, we are paying for them.

    Why did growth in America slow down? Globalization. We sent our productive jobs overseas.

    Maybe it is not inflation that we are experiencing but rather a return to the costs of products prior to the overuse of globalization.

    Maybe the lesson we need to learn is that we must protect ourselves from the risks of globalization as well as taking advantage of its rewards.

    And in terms of your comments re: oil let me ask you a question: Is oil an infinite resource? If not what is your plan for when it runs out.

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    1. Also interesting: Japan's lost decades coincided with heavy offshoring of Industry to Southeast Asia and China.

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    2. "Is oil an infinite resource? If not what is your plan for when it runs out."
      Oil, like diamonds, will never run out - but the market price will increase until, at some point, the price of alternatives is less. That point is not now. Nor in the next 5, nor 10 years.

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    3. There are about 1.5 billion cars/trucks in the world today. About 300 million in the US. You are right that oil will never run out but you are also right that it will rise in price.

      Considering the size of the market for oil, not only for vehicles but also for other industrial uses a horizon of 5 to 10 years is not enough time to solve this huge problem.

      So what is your plan to move away from oil when it increases in price like diamonds?

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    4. So what is your plan to move away from oil when it increases in price like diamonds? My solution is compact Nuclear power plants using old coal producing plants.

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    5. The solution is the same one that solved the great whale oil crisis that every expert predicted in the mid-1850s. It's the same solution that solved the great horse manure crisis that every expert predicted was about to bring massive death and disease to our cities in the early 1900s.

      Stan Brown

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  6. “Right now, Americans are experiencing the highest level of job security on record by many measures.”

    — Aaron Sojourner, University of Minnesota economist
    [REAL TIME ECONOMICS, The Wall Street Journal 4/16/2022]

    There is a silver lining in every cloud.



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    1. Perhaps we will all soon agree that what our country needs is a lean, efficient and honest government.

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    1. Well said, even if I had to read it three times. I've never heard of conditional expectations before this, although it makes perfect sense once you explained it. Thanks for the post.

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  8. I am curious why Trump tax cuts are not blamed for inflation. The argument conservative economists use to justify tax cuts is that they will help everyone: rising tide lifts all boats. If true, then lower taxes on corporations resulted in higher wages. Employees started spending extra income contributing to inflation. I don't think it makes a difference whether a person gets a $1000 check from the Government or from employer.

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    1. Simply because the meteoric rise in inflation did not begin until Trump was replaced by Biden. New, or old and failed, policies were put in place by the new, and failing administration.

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    2. If you can not understand the difference between money earned in a job, and money given to you by a government, then we have a little problem.

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  9. I am curious why Trump tax cuts are not blamed for inflation. The argument conservative economists use to justify tax cuts is that they will help everyone: rising tide lifts all boats. If true, then lower taxes on corporations resulted in higher wages. Employees started spending extra income contributing to inflation. I don't think it makes a difference whether a person gets a $1000 check from the Government or from employer.

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    1. Trump tax cuts were actually quite small. The argument conservative economists use is that they increase incentives -- it's incentives, not the keynesian story of spreading money around and hoping it trickles here and there. Higher wages that come from higher productivity (say, corporations invest more and get better machines) do not cause inflation, because supply increases as much as demand.

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    2. Valter Buffo. Recce'd, MilanApril 18, 2022 at 5:03 AM

      I am not sure about the "quite small": maybe a reconsideration based on the increase in the debt-to-GDP ratio would help in qualifying "small". Moreover, "incentives": the margin-to-revenues ratio was at historically high leveld in 2017 already, and became even more extreme afterwars. Is this the "incentive" needed in 2017 to "increase productivity"? Not really sure. Not sure even about the distinction between Keynesians and ... non Keynesians. Both parties in the New Millenium agree, that deficit spending makes life easier and governing even easier. In many parts of South America, they already knew, ad since a long time.

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    3. The problem isn't the tax cuts, the problem is the increased spending without enough government income. Restricting specific US industries from having product to sell equates money going to foreign countries Instead of staying here because someone will provide the product.
      Oil is a perfect example of the issue. Spending dollars to buy foreign oil is dollars that would, and should have been spent in the USA. That is tax money going to other countries.

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  10. Valter Buffo. Recce'd, MilanApril 18, 2022 at 4:55 AM

    Thank you John, excellent recap, and conclusions which I fully agree upon. Offering here a little contribution about "Once again, government money went to bail out creditors, prop up asset prices, and provide more stimulus". This, is less obvious than it sounds: it was not necessary, it was not commonsensical, it was not the only option, it was instead a deliberate policy choice. A choice that as I see it was the product of a specific moment in time (in history, I would say), the product of a way of thinking, of reasoning, the product of conventional assumptions, derived from mainstream theory (level and stock of asset prices). I insist on this point, since in my opinion today the core of the issue lays exactly there. In your oped you say: "The 2008 financial crisis was met with a torrent of borrowed and printed money to stimulate the economy and bail out banks and their creditors." Yes: exactly that, as if the "amount" if leverage in the economy is irrelevatnt to its functioning. It is worth reminding that the 2008 crisis was generated, itself, by excesses in the financial sector. My conclusion: we have to understand how central bankers felt they were allowed to do what has recently been defined, by some, as "the largest policy error in their whole history", and for an extended period of time.

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  11. Cutting taxes and trickle down economics is a farce sold by republicans since Reagan. National debt has increased under every republican administration that cut taxes. It benefits the wealthy the most and a key reason why their wealth has skyrocketed the past 40 years while working class incomes have stagnated. Supply doesn’t create demand, duh! This country’s greatest success came post WWII when the federal government paid off its national debt and invested heavily in infrastructure, education, social and civil rights initiatives. Investing in the majority of working class people who in turn spend and stimulate the economy…demand creates supply, duh! The Biden Adminstration is investing like FDR, Truman, and Eisenhower, the debt is coming down, growth is at record highs driven by demand from the working class who’s incomes and savings has doubled the past year. This is a tide that lifts all boats.

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  12. John, this analysis never once mentions the starting point of a recession and high business and job losses including in the supply industry, caused by a global pandemic. What would you recommend as economic policy coming out of the recession to stimulate businesses to reopen, hiring to create job growth, with resulting economic growth to reverse the recession? Tax cuts? Cutting business regulations? More earned profits invested in buying back stock?

    Hiring and earned income wouldn't have recovered very quickly without demand, right? Businesses wouldn't reopen without demand. Jobs wouldn't be offered without demand. Low inflation is hardly a desired value when millions of people lost jobs, millions of businesses closed due to lack of business, and there would be little incentive to build back the supply chain.

    Stimulus was designed to jump start that process. Having stimulus money created demand that led to businesses opening and jobs increasing. But demand recovered much faster than supply, due at least in part to the fact that supply chain jobs can't be worked remotely, especially in the oil and gas sector where production had fallen in the recession, and many people didn't want to come back with infections still high. And the increases in wages to attract and retain workers in the past year to meet demand growth are also having an inflationary impact. So inflation has risen as a result of several factors, not solely demand exceeding supply. But that demand also drove record economic growth, job and wage growth and recovery in the supply chain.

    With regard to inflation caused by new laws limiting oil and gas supplies, the data doesn't support your summary. Both natural gas and crude oil production in the US peaked during March, 2020, then declined sharply to lows in May, 2020 -- down 87% in natural gas, but down 76% in crude oil. Those were pandemic recession impacts, not Administration policy. That means drilling and refining processes were shut down and people laid off. Since then, natural gas is at 99.9% of the March, 2020 peak and crude oil is at 90.8% of the March, 2020 peak. The XL pipeline did not impact crude oil or natural gas, as it was not part of the March, 2020 peak. And it was focused on transmitting Canadian natural gas to Louisiana for export.

    With the conflict in Ukraine and the embargo on Russian oil, the world oil supply is not keeping up with demand, and we're seeing record prices. Yes, short term efforts should be taken to make up for the remaining gap in supply versus March, 2020, to reduce inflationary pressure on prices, In the long term, we should simply remove the incentives in the oil and gas industry, not put obstacles in the way to future growth. I believe the renewable energy industry will be preferred by consumers without financial incentives the oil and gas industry have enjoyed for years, and demand will drive the transition from fossil fuels to renewables with less economic disruption.

    The question is, which would be better economic policy for the country and its citizens? No stimulus and a slower recovery of the economy, businesses reopening, and job growth, with low inflation: or a rapid recovery and record economic growth, high level of businesses opening, high job and wage growth, with higher inflation?

    Finally, your suggestion that stimulus should be over is right on. We should return to lower deficits, even balanced budgets, and pay for the spending we require with a smarter tax code -- particularly one that incentivizes business profits to be shared with employees, providing the working middle class income and spending growth that drives 70% of economic growth without inflationary pressures, and reduced gaps in wealth and income; and discourages profits to be invested in buying back stock, which has no benefit to what drives 70% of economic growth and increases gaps in wealth and income.

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  13. A quote...'Yet the spin continues. One still hears that inflation comes from vulnerable supply chains, nefarious price gouging, profiteering, monopoly, and greed.'

    Yes it seems as if you are quite accomplished at spinning things in what ever direction you desire. For what positive purpose... who knows?

    Someone could possibly profit from a introductory course to macro finance and macro economics. Money is created thru the banking system and US and world wide measure of growth is highly related to population growth. From classical economic prospective inflation is either demand push or supply pull. In the current situation one only needs to look at escalation in corporate profits and the rapid expansion of the wealth horded by the top 1% to have some clue as to the underlying reason.

    Finally all real world economics is subject to serious lag time.... which kind of tosses a wrench in you following comment... and some of the reason or purpose of this quote are highly speculative..

    'After blocking the Keystone XL Pipeline and limiting oil and gas exploration, US President Joe Biden’s administration has now gone begging to Venezuela and Iran to make up for a shortfall in energy supply. Similarly, although cracks have appeared, the Germans still can’t bring themselves to allow nuclear power or fracking for natural gas. Efforts to strangle domestic fossil-fuel companies via financial regulation continue unabated. For example, on March 21, just as Russia’s attack on Ukraine was driving gas prices sharply higher, the US Securities and Exchange Commission decided to announce expansive new climate-related disclosure rules designed to discourage fossil-fuel investment.'



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  14. I'm not optimistic about the public figuring this out. Today, The Predident's press secretary said cancelling student debt would fight inflation because people would have more money to spend, so they could afford the higher prices.

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  15. "Expanded social programs and transfers must be funded from stable long-run tax revenues, from taxes that do not impose undue costs on the economy." ... left unsaid 'or they [social programs] must not be created or expanded.'

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