“Inflation … has left many observers scratching their heads as to why the current level … does not match the current state of the real economy …” said ex ECB board member Sabine Lautenschläger in a recent speech. The Economist discerns “strange new rules”, devotes a special report to “The End of Inflation?” and concludes that inflation is losing its meaning as an economic indicator … (so) economic policy must adapt.”
“So what’s (not) up with inflation?” Ask David Wessel, Olivier Blanchard, Loretta Mester, Ben S. Bernanke and Paul Krugman as they explore the policy implications of its “unusual behavior”.
Click here for more mainstream experts exploring more explanations and implications at the Brookings Institute event October 3rd 2019
“It seems that inflation is responding less to the slack in the economy than would be expected,” argues Lautenschläger “This disconnect between the real and nominal sides of the economy is the subject of intense debate. … In very general terms, there might be two forces at play.
First, the Phillips curve might have changed. It might, for instance, have flattened, or it might have shifted downwards. Empirically, it is very hard to determine which. … (This leads to) “… the second point, which is that we cannot be sure whether we are measuring slack correctly in the first place.”
Meet The Phillips Curve
A. W. Phillips developed the curve based on empirical evidence …” writes investopedia’s Lisa Smith. “The concept was initially validated and became widely accepted during the 1960s. … The movement along the curve … led to the idea that government policy could be used to influence employment rates and the rate of inflation … (and) achieve a permanent balance between employment and inflation. …
E. Phillips and M. Friedman presented a counter-theory. They argued that employers and wage earners based their decisions on inflation-adjusted purchasing power. Under this theory, wages rise or fall in relation to the demand for labor. In the 1970s … stagflation … seemed to validate the idea. … Today the “expectations augmented Phillips curve” …. is still used in short-term scenarios, with the accepted wisdom being that government policymakers can manipulate the economy only on a temporary basis. It is now often referred to as the “short-term Phillips curve” or the ” The reference to inflation augmentation is recognition that the curve shifts when inflation rises.
This shift leads to a longer-term (non-accelerating rate of unemployment or NAIRU ) theory that there is …. a rate of unemployment that occurs in which inflation is stable. But even with the development of the long-term scenario, the Phillips curve remains an imperfect model. Most economists agree with the validity of NAIRU, but few believe that the economy can be pegged to a “natural” rate of unemployment that is unchanging.
The dynamics of modern economies also come into play, with a variety of theories countering Phillips and Friedman because monopolies and unions result in situations where workers have little or no ability to influence wages. While the academic arguments … rage back and forth, new theories continue to be developed.
Outside of academia, the empirical evidence of employment and inflation challenges and confronts economies across the globe, suggesting the proper blend of policies required to create and maintain the ideal economy has not yet been determined.”
A growing number of economists now agree with Larry Summers that the curve has flattened so much it “appears to have broken down”. It “… may be broken for good”, agrees The Economist but … “Central bankers insist that the underlying theory remains valid.”
The curve is broken, says the Financial Post’s Mitchell Thompson, and “here is why that is keeping economists up at night. (Because it) … is central to macroeconomic modelling and the Bank of Canada, the Federal Reserve and any other large central bank use this as a core component in its forecasting models to capture excess capacity. It’s key to any standard monetary outlook,” TD economist Brian DePratto said.
The SF Fed’s Dr Econ concludes that “… economists and policymakers are far from speaking with one voice on the usefulness and validity of the Phillips curve framework. The topic has been one of the most controversial ones in macroeconomics for a few decades now. Yet, the relationship between inflation and unemployment is probably one of the most important ones that macroeconomists think about.”
“Conservatives love to bash Phillips curve thinking “, writes Scott Sumner. “They are right that the model is flawed, but they are criticizing it for the wrong reason. It is a model that works under extremely limited conditions …(which did not apply in 2009 when people nonetheless thought that “… it was “normal” for inflation to fall … as unemployment soared …” whilst in fact it showed “… gross negligence by the Fed. Instead of conservatives bashing the Phillips curve model, they should have been saying “the fact that we are observing the typical Phillips curve pattern suggests that we need massive monetary stimulus.” But of course that’s not what they were saying.”
Hmm – the real versus nominal method of begging the question (of value).
Not sure that will help with the itch. But Sumner’s reading resonates with Steve Keen’s admonition : “I wish people dismissing the Phillips Curve would actually read Phillips … It was a three argument function in a non-linear system dynamics model.”
Keen’s contrarian reading of Phillips’ work contrasts sharply with that of the mainstream and deserves to be read in full . Here are the most relevant highlights of
Misunderstanding Bill Phillips, wages and “the Phillips Curve” (1)
“Bill Phillips’ famous “… MONIAC put into mechanical – hydraulic form the principles of dynamics that Phillips had learnt as an engineer , and it was this approach which he tried to communicate to economists , on the sound basis that their preferred methodology of comparative statics was inappropriate for economic modeling :
“RECOMMENDATIONS for stabilizing aggregate production and employment have usually been derived from the analysis of multiplier models, using the method of comparative statics . This type of analysis does not provide a very firm basis for policy recommendations, for two reasons .
First , the time path of income , production and employment during the process of adjustment is not revealed … Second , the effects of variations in prices and interest rates cannot be dealt with adequately …”( Phillips 1954 : 290 )
Phillips instead proposed that economists should build dynamic models of the economy … (and he) “… drew … a diagrammatic representation “… (recasting) “… the standard comparative – static , multiplier – accelerator models of the time into dynamic form. This model was only the starting point of a project to develop a complete dynamic model of the economy , in which the feedback effects and disequilibrium dynamics … ignored by the conventional ‘ Keynesian ’ models of the time could be fully accounted for.
In particular , Phillips extended his model to consider the impact of expectations upon prices . Given how much his work has been falsely denigrated by neoclassical economists for ignoring the role of expectations in economics , this aspect of his model deserves attention … (nor did he) merely talk about expectations : he extended his model to incorporate them (and) … hypothesized that there was a nonlinear relationship between ‘ the level of production and the rate of change of factor prices’ …
The role of this relationship in his dynamic model was to limit the rate at which prices would fall when unemployment was high , in line with ‘ the greater rigidity of factor prices in the downward than in the upward direction ’ ( ibid . : 308 ) . In a dynamic model itself , this does not lead to a stable trade – off between inflation and unemployment – which is the way his empirically derived curve was subsequently interpreted – but rather limits the volatility of the cycles that occur compared to what a linear relationship would yield .
This was hard for Phillips to convey in his day , because then functional flow block diagrams … didn’t let you simulate the model itself . But today , numerous computer programs enable these diagrams to be turned into active simulations . There is also an enormous analytic framework for analyzing stability and incomplete information supporting these programs : engineers have progressed dramatically in their capacity to model dynamic processes , while economics has if anything gone backwards .
9.6 A modern flow – chart simulation program generating cycles , not equilibrium
Figure 9.6 illustrates both these modern simulation tools , and this difference between a linear and a nonlinear ‘ Phillips Curve ’ in Goodwin’s growth cycle model . One of these programs ( Vissim ) turns the six – step verbal description of Marx’s cycle model directly into a numerical simulation , using a linear ‘ Phillips Curve . ’ This model cycles as Marx expected , but it has extreme , high – frequency cycles in both employment and wages share .
Embedded in the diagram is an otherwise identical model , which has a nonlinear Phillips Curve with the shape like that envisaged by Phillips . This has smaller , more realistic cycles and these have a lower frequency as well , closer to the actual frequency of the business cycle .
What this model doesn’t have – and this is a very important point – is an equilibrium ‘ trade – off ’ between inflation ( proxied here by the rate of change of wages ) and unemployment . Instead the model economy is inherently cyclical , and Phillips’s overall research agenda was to devise policy measures – inspired by engineering control theory – that might attenuate the severity of the cycles .
Had Phillips stuck with just a sketch of his hypothesized nonlinear relationship between the level of production and factor prices , it is possible that he would be known today only for these attempts to develop dynamic economic analysis – and possibly relatively unknown too , given how other pioneers of dynamics like Richard Goodwin ( Goodwin 1986 , 1990 ) and John Blatt ( Blatt 1983 ) have been treated .
Instead , he made the fateful decision to see whether he could find such a relationship in the UK data on unemployment and the rate of change of money wages . This decision led to him being immortalized for work that he later told a colleague ‘ was just done in a weekend ’ while ‘ his best work was largely ignored … (and a) … simplistic , static ‘ trade – off ’ interpretation of Phillips’s empirically derived curve rapidly came to be seen as the embodiment of Keynesian economics , and since the 1960s data also fitted the curve very well , initially this appeared to strengthen ‘ Keynesian ’ economics . But in the late 1960s , the apparent ‘ trade – off ’ began to break down , with higher and higher levels of both inflation and unemployment .
Since the belief that there was a trade – off had become equivalent in the public debate to Keynesian economics , the apparent breakdown of this relationship led to a loss of confidence in ‘ Keynesian ’ economics – and this was egged on by Milton Friedman as he campaigned to restore neoclassical economics to the position of primacy it had occupied prior to the Great Depression . Phillips’s empirical research recurs throughout the development of macroeconomics …” (which) …” to a large extent , proceeded from the starting point of the trade – off interpretation …
However , even his empirical research has been distorted , since it has focused on just one of the factors that Phillips surmised would affect the rate of change of money wages – the level of employment (whilst) Phillips in fact put forward three causal factors :
‘The relation between unemployment and the rate of change of wage rates is therefore likely to be highly non – linear .’ Phillips then added that the rate of change of employment would affect the rate of change of money wages … (and thirdly) “…he considered that there could be a feedback between the rate of inflation and the rate of change of money wages . ( Phillips 1954 : 283 ) .”
(Anticipating George Soros’ “reflexivity” Phillips also) “… considered that attempts to control the economy that relied upon the historically observed relationship could change the relationship itself …
Phillips didn’t consider the other two causal relationships in his empirical work because , … with the computing resources available to him …” ( at the time) “… it was impossible to do so . But today it is quite feasible to model all three causal factors , and adaptive learning as well , in a modern dynamic model of the kind that Phillips had hoped to develop .
Unfortunately , Phillips’s noble intentions resulted in a backfire : far from helping wean economists off their dependency on static methods , the misinterpretation of his simple empirical research allowed the rebirth of neoclassical economics and its equilibrium methodology – and ultimately , the reduction of macroeconomics to applied microeconomics .”
It’s the money (delusion), stupid
We are moving beyond The Mainstream’s head scratching, ready to deal with the real causes of the itch, i.e. those lice and maggots. If the lice can be read as the lazy dogmatism that depends on power point presentations and can’t be bothered to read even the canonized originals (let alone anything off syllabus) , the maggots are the veiled secrets the authorities have labelled taboo and of interest only to perverts.
Having combed out some lice with the help of self declared mainstream de-bunker and Post Keynesean Steve Keen we shall now enlist de-mystifyer and physicist David Orrell to remind us (1) that inflation got something to do with money (and not just relative prices). All emphases in abridged text below mine. Read the unabridged excerpt here.
“As described theoretically in textbooks such as Mankiw’s , fractional reserve banking apportions most of the job of creating money from the sovereign to the private banking system, but the central bank is still firmly in control .” (2) … “The problem with fractional reserve banking … is not (just that) … credit money is … (as Soddy warned) … free to grow exponentially until , the gap between the virtual and the real reaches breaking point… (but that) … it turns out not to be a true description of the financial system .
As Joseph Schumpeter … complained ‘It proved extraordinarily difficult for economists to recognize that bank loans and bank investments do create deposits.’ Bizarrely … this fact was only formally acknowledged by central banks quite recently . Indeed , as economist Richard Werner remarks , ‘ The topic of bank credit creation has been a virtual taboo…’ and the BoE … created a considerable stir … when it broke this taboo by noting that ‘The reality of how money is created today differs from the description found in some economics textbooks … the central bank does not fix the amount of money in circulation , nor is central bank money “ multiplied up ” into more loans and deposits.’
(This) also explains why money seems to dry up in a recession … as … the money … disappears when the debts are repaid … (and) unless new loans are constantly created to replace these funds , the money supply will shrink , further exacerbating a downturn .
Of course one might ask why … the topic of money … was largely ‘ written out of the script of modern macro – economics ’
One reason , suggested by Werner , is ‘ the predominance of the hypothetico – deductive research methodology in economics … In other words , economists are not letting empirical facts get in the way of a good theory .
Another explanation is that the mechanistic worldview … views systems as being built up in an ordered fashion from individual parts …(so) it makes sense to see the central bank as a central control unit for the financial system. …(H)owever , the parts are better viewed as making up a coherent whole , whose function is characterized by feedback loops , so there is no single central node .
The most obvious reason for omitting the pivotal role of banks , though , was because economists wanted to keep money out of the equation . Only by doing so could they maintain the pretence that the economy is some kind of barter system based on rational exchange .
To see how … money creation works in practice , let’s (take) the example of purchasing a house – an entity which in many ways exemplifies the real / virtual split , since it combines the psychological properties of owning a ‘ real ’ home with the financial properties of an estate ( hence real estate ) .
So what actually happen(s) in monetary terms (when you buy a house with a mortgage)?
When the bank sends the vendor the money … it just makes it up by entering it in their computer system . It is like creating a brand – new tally stick . You get the foil – the short end of the stick – meaning you have to pay up over time . Meanwhile the stock – in return for title over the house – is transferred to the vendor , who is now free to go out and spend it . So when you analyse it in these terms , you see that the purchase is far more than some tit – for – tat exchange .
An entirely new money object , equal in value to the price of the loan , has been created by the bank . This money then goes out into the economy , and much of it is used for bidding up the prices of homes . The higher prices go , the more money is created , and so on in a positive feedback loop . Eventually the loan is repaid , but that might take 25 years or more , by which time many more new loans will have been created .
According to the quantity theory of money , if too much money is in circulation , the result is inflation . However , because the virtual economy is largely decoupled from the real economy , inflation can occur in the former but not the latter . And because traditional inflation metrics focus only on the real economy , it appears that inflation remains low .
This is illustrated by the (above chart) , which compares the Teranet house price index with a broad measure of money supply in Canada from 1999 … until 2017 . During this time period , both the house price index and the money supply tripled , while inflation remained negligible and gross domestic product was also relatively stagnant .
The most striking – but least remarked – empirical fact about the housing boom is that it was matched by a money boom … The point here is not that there is in general a perfect match between money supply growth and house price growth , only that the house price inflation seen in places like Canada can be largely attributed to the feedbacks between money supply and property prices .
Real estate is acting like a kind of breeder reactor for money.. To understand the dynamics of the process , computations based on the idea that supply and demand of houses drive the system to an optimal equilibrium won’t get you very far … , you need to appreciate that it is based on a foundation of debt. …
But … the narrative … supplied by … realtors , banks , and economists is that “Key drivers of record home sales include population growth , low mortgage rates , low unemployment , and above – inflation economic growth .’ (Central banker) … Stephen Poloz , agreed that the rise in house prices is due to ‘ fundamentals … The greater Toronto economy is creating five per cent per year more jobs . Population growth is continuing to be strong . …That automatically generates more demand for housing at a time when there are constraints around supply . ’
In other words , it all comes down to supply and demand , like in the textbooks .
Yet … Toronto (was) growing at its slowest rate in 40 years , while wages were increasing at the slowest rate in twenty years . Mortgage rates were very low , but total consumer debt was also at an all – time high which more than compensated . Another (newspaper) article noted that : ‘ Mortgage rates are low . Ontario’s economy is superheated … and , to make matters worse , land is in short supply . ’ In addition , ‘ owning a house is now the investment of choice for most of the middle class ’ … (but) the boom cycle eventually turns to bust (and) just as rising house prices lead to more money creation in a self – reinforcing feedback loop , so falling house prices lead to less money creation …
House prices .. can easily levitate to a point where they far exceed any sensible valuation in terms of things like the ratio of house price to rent . Instead they are better viewed as a financial asset that is hoarded not because of its productive value , but in the hope that it will go up in price . Their value is more virtual than real . As with most forms of inflation , the causes of house price inflation therefore have more to do with the basic mechanics of money creation than any of the reasons typically given. …
Banks create new money that is used to bid up the price of assets which are then used as the collateral for new loans … (and this is just one) … example of the credit cycle , whose dynamics are not particularly mysterious and have been clearly explained by a variety of people including … Hyman Minsky .
According to his … Financial Instability Hypothesis … the desire for credit tends to increase during an expansion. More money is therefore created through loans , and invested in financial assets …raising asset prices , which in turn provides collateral for further loans , and so on . … ‘ Success breeds a disregard of the possibility of failure ’ . More people are drawn in , with the ‘Ponzi borrower’ (relying) … the borrowed asset increasing in value . … On the surface , everything seems to be going well , but only if you ignore the mounting and destabilising levels of debt . (But at)… the ‘Minsky moment’ people lose faith and stop playing the game, asset prices stop rising (and the) bubble suddenly collapses .
The role of the central bank is to control this process before it gets out of hand , but its power is limited by a number of factors . One is the fact that since most of the money supply is created by private institutions , it only has indirect control over events. Another is that central banks are eager to step in during an emergency , but are understandably reluctant to spoil what seems like a good thing .
The biggest problem , though , is that mainstream economics has left them unable to correctly diagnose the problem , for the simple reason that it ignores the power of money. As a result , rather than improve the situation , their actions can even make it worse. Because their mandate to control inflation does not usually include asset prices , central banks focus instead on inflation in the real economy , a small amount of which they see as a good thing , if only to avoid … deflation …
Since the 2007 – 08 crisis , a number of countries have therefore tried to boost inflation by reducing interest rates to near – zero levels , with little success . In 2014 , for example , the Governor of the Bank of Japan forecast that inflation should ‘ reach around the price stability target of 2 per cent toward the end of fiscal 2014 through fiscal 2015 ’ but it apparently didn’t get the memo , preferring to remain well under 1 per cent .
Similar policies in other countries have helped fuel , not the expected inflation , but only inequality (by) boosting asset bubbles and a destabilising global explosion in private sector debt .
Central bankers are increasingly admitting that they have no satisfactory model of inflation – as former Fed Governor Daniel Tarullo said in 2017 , ‘ We do not , at present , have a theory of inflation dynamics that works sufficiently well to be of use for the business of real – time monetary policymaking ’ – but again that is obvious , because they have no satisfactory model of money .
Economists look at the circulation of money in aggregate – for example , the quantity theory of money states that the average price level is proportional to the average amount of money in circulation , and assumes that the average velocity of money … is stable .
However , this is like a meteorologist presenting the average wind speed for a country instead of a chart showing the speed at each location .
And because money is treated as little more than a convenient medium of exchange , the main impact of inflation is to introduce some ‘ friction ’ into their models , since firms have to constantly update their prices , which leads to loss of efficiency .
Models also tend to endow the economy as a whole with perfect rationality and essentially infinite foresight , so they assume that agents take a long view of inflation rather than reacting over more reasonable timescales .
Such drawbacks may explain why central bankers have struggled with too much inflation in things like houses , and not enough in things like wages ( and why , when faced with such puzzles , they can only come up with Victorian – sounding platitudes like ‘ What we do know is the laws of demand and supply have not been repealed ’ )
Inflation is better seen as the emergent property of a complex system , whose exact course is as hard to predict as that of something like climate change . The idea that central banks can fine – tune it seems a good example of what behavioural scientists call the ‘ illusion of control ’ – but a first step to understanding it is to adequately model the flow of money , including into things like real estate .
Dissidents such as Soddy and Minsky who have drawn attention to the dynamics of money have long been dismissed as ‘ monetary cranks ’ or ‘ banking mystics ’. It is no surprise then that most central bankers have long seemed remarkably complacent about the risks in things like real estate , even when , as Dirk Bezemer and Michael Hudson note , ‘ real estate assets have grown into the largest asset market in all western economies , and the one with the most widespread participation ’ .
An exception is the former Deputy Governor of the Bank of Canada , William White , who noted in 2014 : ‘ We’ve got the potential to do so much harm by not getting the creation of fiat credit and money right . We’ve got the capacity to do so much harm that we should be focusing much more on making sure that doesn’t happen . ’
Central banks like to make sage announcements about ‘ risks to the economy ’ but one of the biggest risks is their own models . Given that the actual mechanics of money creation and the credit cycle are rather obvious , it seems strange that they don’t get more critical attention . It is like a magic trick which has been explained over and over with slow – motion demonstrations on YouTube videos , but which people are still willing to pay with their life savings to take part in .
So how do we bring the money bomb back under control ?
Can we learn to predict or even prevent its explosions , before metaphorical mushroom clouds appear once again over the financial system ?
One approach to modelling complex systems , known as systems dynamics or nonlinear dynamics , uses traditional equations similar to Newton’s equations of motion , but allows those equations to incorporate nonlinear effects , which greatly complicates their behaviour .
An example of this systems dynamics approach is the ‘ Minsky ’ model developed by … Steve Keen (4) … (which, with) … only three variables and nine parameters to model key macroeconomic variables, picked out escalating levels of private debt as a risk factor for financial crises . An important feature of the model is that it pays attention to basic accounting principles , such as the flow of money and credit , and explicitly includes the financial sector .” (3)
Taking money out of the neutral black box and into account might help to get to the cause of the itch.
And even if you are operating within “neutral money” mainstream it matters how and what you count. Like Todd White and Yuko Takeo argue on bloomberg that “Housing Prices Are the Missing Ingredient in the ECB’s Inflation Estimate”
So there. Money counts.
(1) Steve Keen Debunking Economics Part 3 : Complexities: issues omitted from standard courses that should be part of an education in economics – Let’s do the Time Wrap again. kindle loc 4675 onwards
(2) David Orrell Quantum Economics Quantum Creations kindle loc 1601
(3) David Orrell Quantum Economics The Money Bomb kindle loc 2352 onwards
(4) Steve Keen Can We Avoid Another Financial Crisis?