Streetwise Professor

June 23, 2021

I Never Did Acid in the 70s, But I’m Experiencing Flashbacks Anyways

Filed under: Commodities,Economics,Financial crisis,Politics,Regulation — cpirrong @ 7:18 pm

I grew up in the 70s. I never did acid then (or ever!), but man am I experiencing flashbacks. Feckless progressive Democrat presidents. (Though Carter, while an idiot, was at least compos mentis, which is more than can be said of Señor Senile Joe Biden.) Crime. (I’m betting on a comeback of the Charles Bronson revenge and Clint Eastwood Dirty Harry genres.) All in all, the 70s sucked, and I am not nostalgically hoping for a reprise–I’m dreading it actually.

One of the things that sucked worst was inflation. The 1970s were the inflation decade (although it peaked in 1980-1981). In recent months, the price level measured by the CPI, PPI, and GDP deflator has been up substantially. CPI, for example, is up about 4.5 percent on a year-on-year basis. This has raised concerns about a return of 70s-style inflation. Are these concerns justified?

The jury is out, but there is reason for concern.

First, it is important to distinguish between one time changes in the price level and inflation. Inflation is a long term upward trend in the price level, rather than a single stair-step jump in the price level.

The impact of the pandemic (or, more accurately, the draconian policy response to the pandemic) has created the conditions for a one-time step up in the price level. The economic recovery from the pandemic is a positive aggregate demand shock. Moreover, it has occurred against the backdrop of constrained supply conditions that resulted from the pandemic. Upward shifts in supply and demand lead to a higher price level, ceteris paribus.

One would think that these are effectively one-time shocks–hopefully the pandemic is a one-time thing, and therefore the recovery from it is too. Furthermore, supply conditions should ease. (We are already seeing that in some sectors, such as lumber, though not in others, such as semiconductors. Policy, namely paying people not to work in some states, may impede the easing of supply conditions). Thus, one would expect that this is one time, and at least partially transitory, jump in the price level rather than inflation qua inflation.

That said, there are reasons for concern. Most notably, the fiscal diarrhea in the US, and the willingness of the Fed to finance (i.e., monetize) that spending is freighted with inflationary potential.

In the post-Financial Crisis era, the Fed mitigated the inflationary impact of QE and other expansive monetary policies by paying interest on reserves. So the inflationary threat that I worried about in 2009 (and asked Ben Bernanke about) never materialized. But that’s no reason for complacency. We dodged a bullet once, but that doesn’t mean we will always do so. Massive deficit spending accommodated by the monetary authority is highly likely to result in inflation, sooner or later. (I am inclined to favor Thomas Sargent’s fiscal theory of the price level.).

Part of the reason that inflation didn’t occur post-2008 was that money velocity plunged. Part of this was due to the Fed paying interest on reserves, which led banks to hold them (lend them to the Fed in effect) rather than lend them to private individuals and firms. But expectations, and the self-fulfilling nature thereof with respect to inflation, likely played a role too. In the gloomy aftermath of 2008 people expected low inflation (or even deflation), which made them more willing to hold rather than spend money balances–which results in low inflation, thereby validating the expectations and perpetuating the equilibrium.

But expectations are fickle things, and as a result there can be multiple equilibria. Fed board members have strenuously argued that the recent spurt in prices is a one-time stair step phenomenon, not the harbinger of inflation. But if the spurt results in an upward shift in inflationary expectations by the hoi polloi, people will be less willing to hold money balances at the existing price level, so they will try to reduce (i.e., spend) them, which leads to inflation–thereby validating the expectations.

Thus, it’s not so much what the Fed believe that matters. It’s about what you and me and other individuals and firms believe. Combine a negative fiscal picture with a surge in prices and it’s quite possible that inflation expectations soon will no longer be “anchored” at low levels, but will surge to higher levels, which would result in inflation no longer being anchored at low levels.

So although I think that the recent surge in the price level is of the one-time variety, that doesn’t mean everyone will think the same way. And if everyone doesn’t think the same way we may see a 70s rerun. The dire fiscal picture contributes to such worries.

When the subject of inflation comes up, as Dr. Commodities I’m often asked whether commodities are a good hedge. Intuitively it makes sense that they should be, but historically, they have not been. Commodity prices are much more volatile than the price level, and not that highly correlated. That is, relative prices move around a lot even when the price level trends upwards.

I think that availability bias is a big reason why people focus on commodity prices–they are readily observable, on a second-by-second basis, because they are actively traded on liquid markets. Other goods and services, not so much. But just because we can see them easily doesn’t mean that they are reliable beacons for the price level overall, or changes therein.

This brings to mind why we should really fear a return of 70s-style inflation (or worse, heaven forfend).

When sitting in (the great) Sherwin Rosen’s Econ 302 course at Chicago on a cold morning in February, 1982, I was startled when Sherwin’s normal rather droning delivery was interrupted by him shouting and pounding his right fist into his left palm: “And that’s the problem with inflation. IT FUCKS UP RELATIVE PRICES!!!!”

Some prices are stickier than others, meaning that inflation pressures can impact some goods and services more and sooner than others–thereby causing changes in relative prices.

This is a bad thing–and why Sherwin dropped the F-bomb about it–because relative prices guide resource allocation. If you fuck up relative prices, as inflation does, you interfere with resource allocation, leading to lower incomes and growth. Inflation has adverse real consequences.

So we should definitely fear an acid flashback to 70s inflation. And although I do not believe the recent surge in prices is a harbinger thereof, I think that there is a material risk that we may all experience such a flashback–even if you didn’t grow up in the 70s.

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  1. I did grow up – if college counts as growing up in the early 70’s and it was no fun at all. Mushrooms, however did help. The thing that worries me is that we may face the situation similar to right after WW II: a 50% haircut of the dollar to “deal” with debt. Have you ever looked at what happened post war? Obviously our situation re trade and industry is radically different, but payments to ex GI’s seen to echo the enhanced unemployment payments we have now. Any thoughts would be greatly appreciated.

    Comment by Sotos — June 23, 2021 @ 9:08 pm

  2. I know a girl – oh all right, a woman – who in the early seventies left her job to become a post-graduate student. She withdrew the money in her pension (which was legal for her British pension scheme) and used the money as the deposit for a mortgage loan on a flat. The eventual sale of the flat released money for another deposit, this time for a house. The mortgage on that was paid off years ago: the house is now worth roughly a thousand times the size of her original early seventies deposit. This is a triumph for inflation, for leveraged property purchase, and for paying down your mortgage every month. Will we ever see its like again?

    (P.S. There is a downside: her estate may end up paying Inheritance Tax. But not if the cost of “Care” consumes enough of her capital.)

    Comment by dearieme — June 24, 2021 @ 6:33 am

  3. Another 70s feature—shortages, back logs, rising prices. Cooktops are in short supply, months long waits, as are standby generators, plastic shotgun wads, hunting dogs, veterinary services. “Too much money, chasing too few goods” as my econ professor Dr. Kim would say back then. Oh, there’s talk of price controls, channeling Nixon. Maybe Biden will just skip to the Carter malaise era and save us from WIN buttons.

    Comment by The Pilot — June 25, 2021 @ 1:54 pm

  4. On reflection we have already had a teal taste of the Nei 70’s; what was Obama but Jimmy Carter as interpreted by the Cook County Democratic Party?

    Comment by Sotosy1 — June 25, 2021 @ 2:55 pm

  5. ‘I grew up in the 70s. I never did acid then (or ever!), but man am I experiencing flashbacks.’


    Comment by Ex-Global Super-Regulator on Lunch Break — June 25, 2021 @ 6:05 pm

  6. I’m with Sotos on this. I think they realise that the best way to get out of the debt hole they’ve dug themselves into is to print whatever is needed to repay the debt and reduce its real cost, grabbing real resources for themselves at the expense of the debtholders. ‘Buy bonds, wear diamonds’ LOL! Buy bonds, wear a cheetoh on a piece of string around your neck.

    At the same time, the hangover from two decades of neglect, distraction and adventuring in the sandbox will require immense sums to be spent on infrastructure, social programmes, and bringing the military up to the task of warding off the increasingly cocky Russians while holding a line in Asia against a determined and resurgent China.

    There’s no way that the Fed can contain all of the necessary money creation within the banking system: it is going to escape into the savings accounts all across America, where a combination of the Dean Martin Theory of the Price Level (‘money burns a hole in my pocket’) and Real Balances Theory will see velocity shoot up as people rid themselves of excess cash.

    E voila! Bonds junked (the Japanese won’t mind so long as the Chinese are getting kneecapped, the Russians parachuted out a while back), everybody has lotsa new stuff, shiny new infrastructure and all the jobs that go with it, and the military is happy to be doing a real job again, chasing Russians and Chinese with their new equipment rather than raiding yet another goat-herding village or guarding a poppy field in the graveyard of empires.

    It won’t be all bad. Maybe we’ll get disco all over again. Will a slimmed-down Prof be taking his purple nylon flares out of storage for a turn on the dance-floor? Just don’t leave your money in your bank account or in cash for one second longer than necessary.

    Comment by Ex-Global Super-Regulator on Lunch Break — June 25, 2021 @ 11:00 pm

  7. Chicago Skool econ? They got no idea on inflation.

    The best lesson you can get on the dynamics of inflation is to study the political economies of the Southern Cone and Brazil. An external (exogenous) adverse shock (e.g. a massive increase in the price of imported oil) causes a real loss to the polity. Inflation is how the various constituencies within the polity fight over who is going to bear the loss. Is it capital? In this case, wages rise faster than product prices eroding margins. Or it the proles? In which case, wages fail to keep up with the cost of living and living standards for proles fall.

    The winners and losers are decided not in an economic battle but in a political contest wherein the State decides who is the chump to bear the burden. Remember it was NIXON who introduced wage and price controls!! 🙂

    Anyone who thinks wages are going to keep pace with prices in 2021 and beyond hasn’t been paying attention. Unions … nowheresville. Amazon decides the wages. Hahaha!!

    Comment by Simple Simon — June 27, 2021 @ 9:58 am

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