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Wednesday, April 25, 2007

Robert Samuelson: Inflation Terminology and the Upside of Recessions

I'm afraid I am going to have to take issue with Robert Samuelson on both of his main themes. He says:

The Upside of Recession?, by Robert J. Samuelson, Commentary, Washington Post: It's increasingly clear that much of our standard economic vocabulary needs revising, supplementing or at least explaining. The customary words we use don't fully convey what's happening in the real world. Let me illustrate with two basic economic terms: inflation and recession. There are also larger lessons.

Start with inflation. ... We all know about oil. Prices are about $60 a barrel. They seem unlikely to return to $28, the 2000 level. The real surprise involves food prices. In the past three months, they've risen at a 7 percent annual rate. We may be seeing the first adverse effects of the ethanol boom. Corn is a main feed grain for poultry, cattle and hogs. Corn is also the main raw material for ethanol... Competition for grain has pushed up corn prices..., almost double a typical level. High feed prices have discouraged meat producers from expanding. The resulting tight meat supplies raise retail prices.

"Poultry is the best example," says economist Tom Jackson of Global Insight. "In the past 40 years, we almost never have year-to-year decreases in production. In the past few months, we've seen production go down." ...

So the government's subsidies for corn-based ethanol are worsening inflation, perhaps permanently. ...

Now switch to recession. ... We've been conditioned to think of recessions as automatically undesirable. The labeling is simplistic.

Hardly anyone likes what happens in a recession. Unemployment rises, production falls, profits weaken, stocks retreat. But the obvious drawbacks blind us to collateral benefits. Downturns check inflation -- it's harder to increase wages and prices -- and low inflation has proved crucial to long-term prosperity. Downturns also punish and deter wasteful speculation. When people begin to believe that an economic boom won't ever end, they start to take foolish risks. Partly, that explains the high-tech and stock bubbles of the late 1990s and, possibly, the recent housing bubble.

Some sort of a recession might also reduce the gargantuan U.S. trade deficit... Almost everyone believes that the U.S. and world economies would be healthier if Americans consumed less, imported less, saved more and exported more. The corollary is that Europe, Japan, China and the rest of Asia would rely more on domestic spending -- their own citizens buying more -- and less on exports.

Ideally, this massive switch would occur silently and smoothly. Realistically, the transition might not be so placid. ... Almost no one wishes for a recession, but the consequences might not be all bad. The larger lessons here involve perceptions. Our regular vocabulary often fails to describe the complexities of a changing economy. We must be alert to new possibilities. Things are not always what they seem.

Let's start with what he calls inflation. His point was about the language of core versus overall inflation and he tries to question that usage, but as he notes:

Since the early 1980s, the two indexes (the CPI and the core CPI) have recorded -- despite many monthly differences -- virtually identical increases.

So he rebuts his own point effectively and I left that part out (though he should be talking about the overall and trimmed mean PCE instead of the CPI and core CPI). The rest of his point is just speculation about core inflation and not worth addressing since I want to move on to his point about economic terminology, in this case his use of the term inflation which isn't technically correct.

I'll use some hypothetical numbers for illustration. Suppose that when the price of oil is $28, the price level is 100, and also suppose that when the price of oil increases to $60, the price level increases to 120 all else equal (again, these are not intended to be realistic numbers).

Now, let the spike in oil prices happen quickly, but due to sluggish wage and price adjustment suppose the resulting 20% increase in the price level takes more time, say 2 years. During this two year period, as the price level rises from 100 to 120, inflation will be reported in the news.

But this is not what economists mean by inflation when they say, for example, that "inflation is always and everywhere a monetary phenomena." To see this, suppose that the change in oil prices and the price level are both instantaneous rather than having the change in the price level drawn out over two years as before. That is, the price level jumps from 100 to 120 instantaneously and stays at the higher level from then on.

In this case, there is no inflation. Prices were stable before the instantaneous jump in the price level, and prices are stable afterward. From that day forward prices remain at 120 and do not increase any further. There is no inflation.

When the change in the price level is drawn out over two years it doesn't really change anything except that the change is no longer instantaneous and hence looks like an ongoing inflation. That is, it looks just like (and is easily confused with) the continual rise in prices that occurs with a continual increase in the money supply beyond what is needed to accommodate economic growth. But at some point, after two years in the example here, the price level will stabilize at 120 and after that there will be no further change in prices and no inflation.

Whether the change is instantaneous or drawn out, it is technically a change in the price level, not inflation, though economists (myself included) are not very careful when they talk about inflation to distinguish changes in prices that reflect drawn out adjustment to factors such as increases in oil prices (which eventually end) and those that arise from excess growth in liquidity (which do not necessarily end).

Now to Samuelson in particular. First, he calls the change in the price level resulting from a change in the price of oil from $28 to $60 inflation. But as just explained, even if the oil price change causes a drawn out adjustment in the price level that looks just like inflation, the increase in the price level will end once it reaches the higher level and there will be no inflation after that. These kinds of changes where the price of oil moves from one level to another do not cause permanent changes in the inflation rate, only temporary changes during the adjustment period.

He makes the same mistake with subsidies. It's just not possible that "the government's subsidies for corn-based ethanol are worsening inflation, perhaps permanently" as Samuelson claims. A one time increase in subsidies could change relative prices and fuel a short-term inflation, but it cannot fuel a long-term inflation (but it may not change inflation at all - see point three).

Second, looking at individual sectors and noting whether their prices or quantities have gone up or down is not how we assess inflation, that is done by looking at aggregate demand. When there is an oil price shock, it will ripple through the economy and cause a general realignment of prices, i.e. general changes in relative prices. Some relative prices will move such that resources are drawn into the sector, while other will move such that resources move away, so you don't learn much from looking at just a few sectors.

The distributional consequences and potential hardships for lower income households from changing relative prices are certainly worthy of our attention. But learning that the demand for corn is up and the production of chicken is down doesn't necessarily inform us about what is happening to the average of all prices in the economy (and there are, of course, many other confounding factors that affect sectoral relationships). Again, to assess pressures on prices generally you look at the aggregate level - i.e. how aggregate demand and aggregate supply are affected and how they are likely to move in the future. Now it is true that, all else equal, an increase in the price of oil will increase the price level, but you don't look (or need to look) at the price of chicken to figure that out.

Third, subsidies to ethanol do not necessarily increase aggregate demand (and hence inflation) as Samuelson claims, the subsidies have to be paid for somehow and that reduces demand in other areas. They could be paid through deficit spending and the new spending would affect aggregate demand, but in any case it's the aggregate effect that matters and it's not necessarily the case that subsidies increase demand.

More generally, a long-term, 10 or 20 year inflation cannot be driven by increases in government spending and cuts in taxes (which includes increased subsidies). The increase in government spending that would be required to fuel such an increase in aggregate demand and inflation would eventually eat up all of GDP, and the tax cuts that would be required would quickly run into a lower bound, zero in the limiting case, and after that there could be no further stimulus and prices would stabilize. Long-run inflations are driven by increases in the money supply because the money supply, unlike increasing government spending or decreasing taxes, can be increased pretty much without bound and hence sustained in the long-run if a government decides to permanently turn up the printing presses. [Update: More on inflation here.]

Okay, next let's turn to the silliness about the virtues of recessions. Samuelson says:

We've been conditioned to think of recessions as automatically undesirable. The labeling is simplistic.

It's not the labeling that is simplistic here. He also says there are hidden virtues to recessions:

Hardly anyone likes what happens in a recession. Unemployment rises, production falls, profits weaken, stocks retreat. But the obvious drawbacks blind us to collateral benefits.

And one of the main benefits he cites is that it punishes speculators for taking too much risk, i.e. that:

Downturns ... punish and deter wasteful speculation.

This is what Krugman calls the Hangover Theory. I've posted this before, but it applies again:

Powerful as these seductions may be, they must be resisted--for the hangover theory is disastrously wrongheaded. ... The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity--of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes--investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process...

Sounds just like Samuelson's description of punishment for the excesses that caused the high-tech and housing booms, and the subsequent healing process:

Downturns check inflation ... and low inflation has proved crucial to long-term prosperity. Downturns also punish and deter wasteful speculation. When people begin to believe that an economic boom won't ever end, they start to take foolish risks. Partly, that explains the high-tech and stock bubbles of the late 1990s and, possibly, the recent housing bubble. Some sort of a recession might ... reduce the gargantuan U.S. trade deficit... Almost everyone believes that the U.S. and world economies would be healthier if Americans consumed less, imported less, saved more and exported more.

So what's wrong with this? Back to Krugman:

Except for that last bit about the virtues of recessions, this is not a bad story about investment cycles. Anyone who has watched the ups and downs of, say, Boston's real estate market over the past 20 years can tell you that episodes in which over-optimism and overbuilding are followed by a bleary-eyed morning after are very much a part of real life.

But ... nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives... But moderates and liberals are not immune to the theory's seductive charms--especially when it gives them a chance to lecture others on their failings. ...

The point is that Samuelson implies unemployment is the necessary cost of attaining this virtue of reigning in speculators, curing the trade deficit, lowering inflation, and so on. But why do workers have to pay this cost through higher unemployment? Why shouldn't the government step in and stimulate employment and the use of idle capacity rather than having the idle workers watch the idle capital creatively rot and destruct? We can build new capital while the old capital is still operating, there is no requirement that old capital be destroyed before new capital can be "creatively constructed." There is simply no need to let workers pay the costs of punishing and deterring wasteful speculation, let the speculators pay those costs themselves.

Samuelson says in his first sentence that:

It's increasingly clear that much of our standard economic vocabulary needs revising, supplementing or at least explaining.

And he's right. He's made a pretty good case that there's confusion about these basic economic terms.

    Posted by on Wednesday, April 25, 2007 at 12:15 AM in Economics, Press, Unemployment | Permalink  TrackBack (0)  Comments (21)

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