Streetwise Professor

July 24, 2023

Deflated Thinking on Inflation

Filed under: Economics,Politics — cpirrong @ 12:15 pm

When inflation reared its ugly head in 2021, the administration, and various running dog economists, pronounced that it was “transitory.” Then in a defeat for Team Transitory, it lasted for months and months, before beginning to abate in recent months. But now TT is declaring victory–“See! It was transitory after all! It just lasted a little longer than we expected.” (Redolent of “two weeks to flatten the curve”, no?)

No, actually. This reflects the sloppy thinking about and descriptions of inflation.

This is something of a pet peeve of mine, probably originating from a standard Chicago econ prelim exam question back in the day (when inflation was last a big deal) about the difference between a one-time increase in the price level and inflation.

The argument that the transitory people (read that how you wish!) made was that the spike in prices in 2021 was due to an adverse supply shock–a shift of the aggregate supply curve to the left, for you Keynesian types–due to COVID. Once the supply shock ended, they said, inflation would end.

Wrong! The end of the supposed supply shock should have caused the AS curve to shift back to the right, leading not just to an end of inflation, but an actual decrease in the price level, i.e., a deflationary period. That is, the supply shock should have led to a one time increase in the price level (smeared out over time due to price stickiness) followed by a one time decrease in the price level (smeared out over time due to price stickiness.) with the price level ending up roughly equal to its pre-shock level.

An increase in the price level, followed by an abatement in the rate of increase but no decline in the price level–which is what we have experience recently–is contrary to the predictions of the mental model that TT relied on. We have had a permanent increase in the price level.

The pattern we have observed is in fact much more in keeping with the predictions of the Fiscal Theory of the Price Level (developed initially by Thomas Sargent: advanced students can tackle John Cochrane’s recent excellent book on the subject–great timing, John!)–something that the administration and its acolytes are desperate to deny. In that theory, a large increase in government expenditure–like that which occurred during the COVID policy botch, and a whole-of-government botch it was–unaccompanied by a belief that the government would run larger surpluses in the future to pay for it, leads to a permanent increase in the price level. That is, government spending excess caused the large and permanent increases in prices.

In a model with completely flexible prices and one-period government debt, the price level jumps up at the time of the fiscal shock and stays there. In a more realistic model with sticky prices and long-term government debt, the increase in the price level is spread out over time, leading to a period of month-on-month inflation, with the rate of inflation damping out as the fiscal shock recedes further into the past and the price level reaches that consistent with the new level of government debt that results from the spending shock.

That’s pretty much what we’ve observed in the past couple of years.

So the good news is that the impact of past policy blunders on the price level is abating. The bad news is that the price level impact has not gone away and will not go away. The worse news is that the deflated thinking about inflation that pervades the conventional wisdom not only fails to understand what the policy error was, but aggressively denies it. Which means that it is all the more likely to be repeated.

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  1. Noted that the “CPI for Urban Wage Earners and Clerical Workers” was at 255.296 when the Biden Administration began. The last reading was 299.394. That is more than a 17% increase in the “price level.”

    Comment by George Sladoje — July 24, 2023 @ 4:39 pm

  2. Yeah, but the government has a wokeista-approved quota of DEI and transgender appointments, which mean that no matter what happens or the level of incompetence, it’s not their fault and forgiveness is theirs because their intentions were ever so socially just.

    When deliberate stupidity is augmented by an insane ideology, the ride will be terminally bumpy.

    Comment by Pat Frank — July 24, 2023 @ 7:57 pm

  3. I’m no economist but I do do our domestic budget. So while the Bank of England was pooh-poohing the idea of an inflation problem I pencilled in 10%. I suppose a successful guess like that should be promoted to “an estimate”, even “a forecast”.

    What next for my pencil? My guess is that the UK inflation rate won’t fall to the BoE’s target of 2%, or if it does it won’t linger there for long. Months ago I read an investment manager who said he was planning on the basis that inflation would prove “volatile”. I have, I hope, adopted a budget that will cope in that case.

    Why, you might wonder, should I have proved better at guessing than all those highly paid economists? I suppose Economics has its answer: “incentives matter”.

    Comment by dearieme — July 25, 2023 @ 10:19 am

  4. I think it started with Deng Xiao Ping. He released the Chinese capitalist genie out of the bottle.
    The result was a flood of ever cheaper tat exported to the West, which had – surprise! – a deflationary effect.
    This deflation was not home grown, so should have been treated as a windfall for consumers. Instead, central banks got hysterical about the threat of Deflation! and crushed interest rates.
    All this free money caused predictable effects: asset bubbles, malinvestment, zombie companies and the rest.
    Now the West is hooked on Chinese exports. But the twin elements of high level of youth unemployment and plummeting fertility in China suggests that we are likely to get some even worse news soon enough.

    Comment by philip — July 25, 2023 @ 5:51 pm

  5. @ philip: Years ago my prediction was an inflationary period followed by deflation/depression. I was wrong in the sense that the inflation took far longer to emerge than I had expected. I think I now understand why the inflation showed up as asset price inflation rather than consumer price inflation.

    Mind you I am appalled at the recklessness of governments and central banks in the “developed world”. But at least I recognised sooner than they did that the consumer price inflation was now upon us.

    Comment by dearieme — July 26, 2023 @ 5:58 am

  6. When I was an undergrad, I was taught Keynesian economics. ISLM curves blah blah blah. When I earned my MBA at Chicago, I was taught classical economics with a math equation (C+I+G)….to explain price levels. Gary Becker in a blog post when he was alive said, “The multiplier effect of government spending is 0, or close to 0. Govt spending, G, only can increase inflation. It was revelatory to me.

    Cochrane loves to needle the Keynes crowd and I relish it when he does. “Where did you get that dollar you want to spend?” Hence, the multiplier effect for G, or govt, is ZERO. Those dollars can only be spent via taxation, debt (which is a pledge against future income) or pure money creation which is hyperinflationary.

    During Covid, the government spent like drunken sailors. My gut says the underlying goal wasn’t to help people, but to create a universal basic income and higher minimum wage. The fight for $15 became the fight for $20. The spending disincentivized work. It was inflationary, and frankly might have been transitory if they would have stopped in their tracks but they didn’t. Biden spent another trillion.

    The mainstream media outlets rarely if ever put classical economists on television. They rarely quote them. When the classical ones are on, they aren’t as direct as the Keynesians. I wish they would be. Uncle Miltie was direct.

    Comment by Jeff Carter (@pointsnfigures1) — July 26, 2023 @ 8:32 am

  7. To be fair to the smug old pooftah Keynes, he was describing a buyers’ strike. If people hoard money the velocity of circulation declines, and V being a component of the price level, deflation ensues. The “cure” is deficit spending (possible under a gold standard) or money printing (for fiat currency). Or, of course, to wait, but economists seem to have a time horizon equivalent to mayflies.

    Trouble is, the evidence for a decline in V is disputable. Did we all stop buying Chinese tat because of covid or banking crises? Not that I can see. So printing money would start to inflate asset prices (bailing out lenders and borrowers) and leak into the general price level, screwing everyone.

    But that’s history. I’m more concerned with the future. Why, for instance, are we importing LNG from Qatar, which costs 20% of the energy value in liquifying and degassing, when we have ample supplies under our feet that could be piped into the grid within a couple of miles? The greens should be ashamed of themselves, promoting such waste.

    Comment by philip — July 28, 2023 @ 2:13 pm

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