Feldstein’s Tunnel Vision

Martin Feldstein tries to explain low inflation despite a supposedly huge increase in the money supply by the FED. See:


The biggest error in Feldstein’s analysis can be seen here:

The absence of significant inflation in the past few years does not mean that it won’t rise in the future. When businesses and households eventually increase their demand for loans, commercial banks that have adequate capital can meet that demand with new lending without running into the limits that might otherwise result from inadequate reserves. The resulting growth of spending by businesses and households might be welcome at first, but it could soon become a source of unwanted inflation.

(emphasis mine)
He seems to have tunnel-vision on the money-supply-cause of inflation, but isn’t paying attention to why money supply increases can lead to inflation (but not always). They only lead to inflation if they trigger a net increase in prices, and they only do that if suppliers (in aggregate) feel there’s a net-positive-outcome to raising their prices. But price increases hurt sales and benefit your competitors. Suppliers won’t raise prices unless there are compelling reasons to do so. And if suppliers are operating with underutilized/excess capacity (or too much inventory), their costs will often go down (due to a return to better economies of scale and/or reduced inventory costs) upon seeing an increase in orders. When there is widespread excess capacity in the economy, the only businesses that won’t see this benefit are those that are selling goods at a loss!

This doesn’t mean that prices will go down when the real money supply increases – but it does mean they won’t go up very easily.

What all of this means is just the old-school Keynesian explanation still applies: if an economy is in a depressed state – ie, has significant underutilized capacity – increases in the money supply tend to not be inflationary. And it really has nothing to do with whether the FED is offering a tiny bit of interest on excess reserves or not.

Some will argue that this view is too simplistic – that what I’ve described may well be the case for some of the market, but that increased money tends to cause price increases somewhere in the market, sooner or later. This is the “instability” argument against easy-money, elucidated somewhat incoherently by John Taylor recently:


The problem with this view is that some price increases somewhere are not quite the same as inflation. Inflation is when the aggregate magnitude of price increases that are relevant to most people surpass the aggregate magnitude of price decreases relevant to most people.

For example, Bugatti can increase prices for a Veyron all it wants – those increases will not cause inflation because they affect so few people they are irrelevant. And even if all luxury cars see an increase in price of 10%, it still will not affect most people. But what it will do is open up an opportunity for one luxury car maker to offer a sale, undercutting her competitor’s price increases. This is the problem with inflationistas. They get lost focusing on just one side of the effects – whichever one they want to emphasize at the moment! Not even an increase in prices will cause inflation if costs did not and do not rise in step. Unless there is price-fixing going on, some sellers will decide to sacrifice the extra profit margin to boost sales and capture more of the market, forcing competitors to either lower prices, reduce costs (such as layoffs or capacity liquidation), or simply live with the smaller market share. Either way, the aggregate price is not forced up. In the case of layoffs or capacity liquidation, this will tend to further suppress prices because it allows competitors to increase their own output capacity at a cost that is a (however slight) discount from what it would otherwise be.

Again, this doesn’t mean we can “print money” all we want. It just means that it matters whether the economy is at full capacity or not. It’s a lot like a car engine. If the fuel-air mix is too rich, an increase in fuel (or pressing the gas peddle) will have a limited effect on acceleration. It might even cause the car to stall. But if the mix is lean, the increase will tend to help push the car along faster. In other words, to state what should be obvious, the current state of the system needs to be factored in to predict the outcome of changes.

Ironically, we really could use more inflation, anyway. The current 1.5% inflation rate is lower than the rate that has been previously priced into millions of loans and contracts. That means that institutions like banks are getting more than they expected from their fixed investments – at least the ones that are paying. Factor in the bailout and the lopsided legal protections for creditors – rather than viewing loans and contracts as mere investments, subject to risk, that either party may walk away from without prejudice if reality causes the terms to become unsatisfactory – and you can see why some institutions are doing all right in the current economy (ie, profits are up), while unemployment and underemployment have scarcely recovered.


About stormculture

In pursuit of reality.
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