Inflation
Electricity network companies profit gouging because government regulatory oversight has failed
It’s Wednesday, and today I discuss a recently published analysis that has found that Australian privatised electricity network companies are recording massive supernormal profits because the government has been to slack in its regulatory oversight. Electricity prices have been a major driver of the current inflationary episode and we now have analysis that shows where…
Inflation as a tax
Last week I explored how Henry VIII resorted to coin debasement as a way to raise revenues in order to fight his wars. This provided Henry with the financial firepower to annex the city of Boulogne from the French in 1544, albeit at the price of England experiencing one of its greatest inflations ever.
Zoom forward five hundred years and Rishi Sunak, the Prime Minister of the UK, has ignited a controversy by referring to inflation as a tax, and further suggesting that the "best tax cut I can deliver for the British people is to halve inflation." His BBC interviewer disputed the claim, saying that inflation isn't a tax, a stance that the BBC upholds on its fact checking page.
Rishi Sunak, "The best taxt cut that I can deliver for the British people is to halve inflation."
Laura Kuenssberg, "Inflation is not a tax"
Rishi Sunak, "Inflation is a tax" pic.twitter.com/6LgMbeaprY
— Farrukh (@implausibleblog) October 1, 2023
If you recall, my previous article showed how Henry VIII's debasement functioned very much like a tax, say a new customs duty on wine or a beard tax. It did so by incentivizing people to flock to English mints to have their precious metals turned into coinage, Henry extracting a small fee on each coin. But the 21st century monetary system is very different from that of the middle ages. Is Rishi Sunak right to characterize inflation as a tax?
First, we need to better define our terms.
What do the BBC interviewer and Sunak mean by inflation? In the western world, prices have been rising at a regular pace of 2-3%
each year for decades as result of central bank policy, which targets a
low and steady inflation rate. Is this the definition they are using? Alternatively, Sunak and his interviewer may be referring to inflation as a *change in the change* in price. Since 2022 or so, that 2-3% rate has leapt to 8-9% all over the western world. Is it this jump that Sunak and his interviewer are talking about?
For the sake of this article, we'll assume that the conversation between Sunak and the BBC refers to the latter, a spike in the rate of inflation.
Secondly, what is meant by the word tax? Sometimes when we say that something is a tax we mean that it causes suffering. That is, inflation is taxing: it makes people's lives harder by increasing the cost of living, with salaries failing to keep up. It creates unfair changes in winners and losers.
Fair enough. But the more precise view I want to broach in this article is that inflation is actually a tax, where we define a tax as a formal charge or levy, set by the political process, that leads to cash flowing from the population to the government.
What does the data show?
Interestingly, a surprise jump in inflation leads to the very same effects as a new tax. All things staying the same, a new tax leads to an increase
in government revenues. This improves the government's fiscal balance,
or the difference between its revenues and expenses. A recent IMF paper by Daniel Garcia-Macia using data from 1962 to 2019 shows how an inflation shock typically achieves this exact same end result, boosting government revenues and improving its fiscal balance. This effect lasts for a few quarters, even up to two or three years, then recedes.
The IMF's chart below breaks down exactly how an inflation shock tends to improve government finances using quarterly data going back to 1999:
Charts source: IMF
Total tax revenue (the first panel) immediately begins to rise after the inflation shock at about the same rate as inflation.That's because most taxes are set by reference to values or prices, say like the prices of goods and services, or the price of labor, or the value of corporate profits. Since inflation pushes these amounts higher, this gets quickly reflected in tax revenues.
Income taxes and profits taxes (the second panel) rise particularly fast. Inflation is presumably pushing tax payers into higher income tax brackets, a process known as "bracket crreep," and so the government very quickly starts to collect a proportionally-larger amount of income tax.
Meanwhile, the government's total expenditures, the third panel, typically stay flat or only marginally rises in the quarters after the inflation shock hits. Notably, the amount of wages that are paid to government employees and social benefits (panels 4 & 8) tend to fall.
The net effect is an improvement in the government's fiscal balance. More specifically, for a 1% increase in inflation, the government's overall balance tends to improve by about 0.5% of GDP. And so an inflationary shock ends up at the same endpoint as a new tax: higher revenues and a better budget. That doesn't necessarily mean that inflation is itself a tax. Taxes have a degree of intentionality. They get implemented through a political process that has a certain set of goals in mind. By contrast, the extra revenue that an inflation shock raises is often (though not always) accidental, the result of external forces rather than political decision making.
So while it may not fall under the dictionary definition of a tax, the tax implications of a modern inflation shock resemble that of a new tax.
Everything I've written above applies to an inflation shock, say a rise from a 2-3% to 8-9%. Next I want to show that even constant 2-3% inflation can have the same revenue implication as a tax. Here's how.
Banknotes and seigniorage
Governments usually have a monopoly over the issuance of two key financial instruments: banknotes and settlement balances (also known as reserves). We all know what banknotes are, but what are settlement balances? Commercial banks find it useful to keep a stock of settlement balances on hand to make crucial large-value payments to other banks. The central bank, which the government controls, is the monopoly provider of these balances. (Sometimes banks are required by law to keep a a fixed number of settlement balances on hand, often above and beyond their day-to-day needs, a policy referred to as required reserves.)
Historically, interest rate on both types of central bank-issued money have been set at 0%. At the same time, the rates on short-term credit instruments (Treasury bills, commercial paper, bankers acceptances, etc) are determined by the market, typically hovering at a positive rate ranging between 0.25% to 5% over the last thirty years. These yields are priced to compensate investors for inflation.
The interest rate gap this gives rise to allows central banks to earn a steady stream of revenues, borrowing at an artificially cheap rate of 0% from both the banknote-using public and banks, and reinvesting at, say, 3%. Most of the revenues that the central bank collects from this interest margin flows back to the government. Economists usually refer to these revenue stream as seigniorage.
So seigniorage performs the same function as a consumption tax or an income tax: it takes resources from the public and gives it to the state. Likewise, a reduction in seigniorage would be very much like a tax cut.
If politicians wanted to, they could do away entirely with this form of raising government revenues. They have two ways of going about this. One way would be to have the central bank reduce price inflation to zero. By doing so, the interest rate on short-term credit instruments like Treasury bills would also fall to 0%, or thereabouts, since these instruments no longer need to compensate investors for inflation. And so the gap between the 0% rate at which central bank fund themselves and the rate at which they reinvest would cease to exist, seigniorage effectively shrinking to zero.
Over the last few decades, governments have taken a second route to removing seigniorage: they have begun to pay a market-linked yield on settlement balances. Canada, for instance, adopted this policy in 1999, and the Bank of England did so in 2006. By paying a market-based return, central banks no longer extract seigniorage from banks by forcing them to hold 0% assets.
However, that still leaves banknotes as a significant source of seigniorage. We can calculate how much the UK government roughly earns from banknote seigniorage. With £95 billion in banknotes outstanding in October, and interest rates at 5.1%, the Bank of England's banknote-related seigniorage comes out to around £5 billion per year, much of which flows back to the government. That sounds like a lot, but it's only a small chunk of the £790 billion in taxes the UK government collected last year.
Banknote seigniorage isn't set in stone. It's a policy choice. If governments wanted to, they could reduce this form of seigniorage by paying interest on banknotes. One way to go about this would be to introduce a banknote serial number lottery. This lottery would offer around £5 billion in cash prizes to holders of winning banknote serial numbers, equating to a 5% interest rate on banknotes. Doing so would be akin to enacting a tax cut on British citizens.
To sum up, the fact that both an inflation shock and steady 2-3% inflation have implications for government revenues suggests that while inflation may not quite qualify as a tax, it is certainly tax-like.
In Praise of Profiteering
Of the usefulness of the concept, that is.1
In my comments on inflation, I’ve emphasized supply disruptions more than market power. But as I’ll explain in this post, I think the market power or profiteering frame is also a valid and useful one.
Thanks in large part to Lindsay Owens and her team at the Groundwork Collaborative, the idea that corporate profiteering is an important part of today’s inflation is getting a surprising amount of traction, including from the administration. So it’s no surprise that it’s attracted some hostile pushback. This sneering piece by Catherine Rampell in the Washington Post is typical, so let’s start from there.
For critics like Rampell, the profiteering claim isn’t just wrong, but “conspiracy theory”, vacuous and incoherent:
The theory goes something like this: The reason prices are up so much is that companies have gotten “greedy” and are conspiring to “pad their profits,” “profiteer” and “price-gouge.” No one has managed to define “profiteering” and “price-gouging” more specifically than “raising prices more than I’d like.”
The problem with this narrative is that it’s just a pejorative tautology. Yes, prices are going up because companies are raising prices. Okay. This is the economic equivalent of saying “It’s raining because water is falling from the sky.”
The interesting thing about the profiteering story, to me, is precisely that it’s not a tautology. As a matter of logic, one might just as easily say “prices are going up because consumers are paying more.” It is not an axiomatic truth that businesses are who decide on prices. It is not a feature of textbook economics (where firms are price takers) nor is it an empirically true of all markets. As for profiteering, there is a straightforward definition — price increases that don’t reflect any change in the costs of production. Both economically and in the common-sense morality that terms like “price gouging” appeal to, there’s a distinction between price increases that reflect higher costs and ones that do not. And there’s nothing novel or strange about policies to limit the latter.
These two points are related. If prices were set straightforwardly as a markup over marginal costs, it wouldn’t make sense to say that “companies are raising prices.” And there wouldn’t be any question of price-gouging. The starting point here is, that’s not necessarily how prices are set. And once we agree that prices are a decision variable for firms, rather than an automatic market outcome, it’s not obvious why there shouldn’t be a public interest in how that decision gets made.
Think about water. It’s a commonplace that big increases in the price of bottled water in a disaster zone should not be allowed. The marginal cost of selling a bottle of water already on the shelf is no higher than in normal times. Nor are high prices for bottled water serving a function as signals — the premise is precisely that the quantity available is temporarily fixed. And everyone agrees that in these settings, willingness to pay is not a good measure of need.
What about water in normal times? In most of the United States, piped water is provided by local government. But in some places, it is provided by private water companies. And in those cases, invariably, its price is tightly regulated by a public utility commission, with price increases limited to cases where an increase in costs has been established. According to this recent GAO report, states with private water utilities all “rely on the same standard formula … to set private for-profit water rates. The formula relies on the actual costs of the utility …. including capital invested in its facilities, operations and maintenance costs, taxes, and other adjustments.”
The principle in these types of regulations — which, again, are ubiquitous and uncontroversial — is that in the real world prices may or may not track costs of production. Price increases that reflect higher costs are legitimate, and should be permitted; ones that do not are not, and should not.
Rent control is very controversial, both among economists and the general public. But I have never heard “water rate control” brought up as an example of an illegitimate government interference in the market, or seen a study of how much more water would be provided if utilities could charge what the market would bear. (Maybe some enterprising young economist will take that on.)
The same goes for many other public utilities — electricity, gas, and so on. Here in New York, a utility that wants to raise its electricity rates has to submit a filing to the Public Service Commission documenting the its operating and capital costs; if the proposed increase doesn’t reflect the company’s costs, it is not allowed. Obviously this isn’t so simple in practice, and the system certainly has its critics. But the point is, no one thinks that electricity — an industry that combines very high fixed costs, concentration and very inelastic demand, and which is an essential input to all kinds of other activity — is something where prices can be left to the market.
So the the question is not: Should prices be regulated or controlled? Nor is it whether some price increases are unreasonable. The answers to those questions are obviously, uncontroversially Yes. The question is whether the price regulation of utilities, and the economic analysis behind it, should be extended to other areas, or to prices in general.
*
People like Rampell are not thinking in terms of our world of production by large organizations using specialized tools and techniques. They are imagining an Econ 101 world where there is a fixed stock of stuff, and the market price is the one where people just want to buy that much. There are, to be sure, cases where this is a reasonable first approximation — used car dealers, say. But it is not a good description of most of the economy. Markets are not allocating a given stock of stuff, but guiding production. This production is carried out by large enterprises with substantial market power. They are not price takers. For most goods and services, price is a decision variable for producers, involving tradeoffs on a number of margins.2
In the models taught in introductory microeconomics, producers are price takers; they choose a quantity of output which they will sell at the going price. Given rising marginal costs — each additional unit of output costs more to produce than the last one — firms will carry out production just to the point where marginal cost equals the market price. This model is in principle consistent with the existence of fixed as well as marginal costs: Free entry and exit ensures that revenue at the market price just covers fixed costs, plus the normal profit (whatever that is).
The usual situation in a modern economy, however, is flat or declining marginal costs. Non-increasing marginal costs, nonzero fixed costs, and competitive pricing cannot coexist: In the absence of increasing marginal costs, a price equal to marginal cost leaves nothing to cover fixed costs. Modern industries, which invariably involve substantial fixed costs and flat or declining marginal costs at normal levels of output, require some degree of monopoly power in order to survive. This is the economic logic behind patents and copyrights — developing a new idea is costly, but disseminating it is cheap. So if we are relying on private businesses for this, they must be granted some degree of monopoly.3
The problem is, once we agree that some degree of market power is necessary in order for industries without declining returns to cover their fixed costs, how do we know how much market power is enough? Too much market power, and firms can make super-normal profits by holding prices above the level required to cover their costs, reducing access to whatever social useful thing they supply. Too little market power, and competing firms will be inefficiently small, drive each other to bankruptcy, or simply decline to enter, depriving society of the useful thing entirely. Returning to the IP example: To the extent that copyrights and patents serve an economic function, it is possible for them to be either too long or too short.
The problem gets worse when we think about what fixed costs men concretely. On the one hand, the decision to pay for a particular long-lived means of production is irreversible and taken in historical time; producers don’t know in advance whether their margins over costs of production will be enough to recoup the outlay. But on the other hand, the form these costs take is financial: A company has, typically, borrowed to pay for its plant, equipment and intellectual property; the concrete ongoing costs it faces are debt service payments. These may change after the fact, by, for example, being discharged in bankruptcy — which does not in general prevent the firm from continuing to operate. So there may be a very wide space between a price high enough to induce new firms to enter and a price low enough to induce existing firms to exit.
In addition, concerns over market share, public opinion, financing constraints, strategic interaction with competitors and other considerations mean that the price chosen within this space will not necessarily be the one that maximizes short-term profits (to the extent that this can even be known.) A lower price might allow a firm to gain market share, but risk retaliation from competitors. A higher price might allow for increased payments to shareholders, but risk a backlash from regulators or bad press. Narrowly economic factors may set some broad limits to pricing, but within them there is a broad range for strategic choices by sellers.
*
These issues were central to economic debates around the turn of the last century, particularly in the context of railroads. In the second half of the 19th century, railroads were the overwhelmingly dominant industrial businesses. And they clearly did not fit the models of competitive producers pricing according to marginal cost that the economics profession was then developing.
Railroads provided an essential function, for which there were no good alternatives. A single line on a given route had an effective monopoly, while two lines in parallel were almost perfect substitutes. The largest part of costs were fixed. But on the other hand, a firm that failed to meet its fixed costs would see its debt discharged in bankruptcy and then continue operating under new ownership. The result was cycles of price gouging and ruinous competition, in which farmers and small businesses could (much of the time) reasonably complain that they were being crushed by rapacious railroad owners, and railroads could (some of the time) reasonably complain they were being driven to the wall by cutthroat competition. Or as Alfred Chandler puts it,
Railroad competition presented an entirely new business phenomenon. Never before had a very small number of very large enterprises competed for the same business. And never before had competitors been saddled with such high fixed costs. In the 1880s fixed costs…averaged two-thirds of total cost. The relentless pressure of such costs quickly convinced railroad managers that uncontrolled competition of through traffic would be “ruinous”. As long as a road had cars available to carry freight, the temptation to attract traffic by reducing rates was always there. … To both the railroad managers and investors, the logic of such competition would be bankruptcy for all.4
As Michael Perelman explains in his excellent books The End of Economics and Railroading Economics (from which the following quotes are drawn), the problem of the railroads was the problem for the first generation of American professional economists. As these economists were developing models in which prices set in competitive markets would guarantee both a rational allocation of society’s resources and a normatively fair distribution of incomes, it was clear that in the era’s dominant industry, market prices did not work at all.
Already in the 1870s, Charles Francis Adams could observe:
The traditions of political economy,…notwithstanding, there are functions of modern life, the number of which is also continually increasing, which necessarily partake in their essence of the character of monopolies…. Now it is found that, whenever this characteristic exists, the effect of competition is not to regulate cost or equalize production, but under a greater or less degree of friction to bring about combination and a closer monopoly. This law is invariable. It knows no exceptions.
Arthur Hadley, an early president of the American Economic Association, made a similar argument. Where railroads competed, prices fell to a level that was too low to recover fixed costs, eventually sending one or both lines into bankruptcy. In the absence of competition, railroads could charge monopoly prices, which might be much higher than fixed costs. Equating prices to marginal costs made sense in an economy of small farmers or artisans. But in industries where most costs took the form of large, irreversible investments in fixed capital, there was no automatic process that would bring prices in line with costs. In Perelman’s summary:
In order to attract new capital into the business, rates must be high enough to pay not merely operating expenses, but fixed charges on both old and new capital. But, when capital is once invested, it can afford to make rates hardly above the level of operating expenses rather than lose a given piece of business. This “fighting rate” may be only one-half or one-third of a rate which would pay fixed charges. Based on his knowledge of the railroads, [Hadley] concluded that “survival of the fittest is only possible when the unfittest can be physically removed—a thing which is impossible in the case of an unfit trunk line.”
Perelman continues:
The root of the problem, for Hadley, was that to build a new line, owners had to expect rates high enough to cover not only the costs of operating it but the costs of constructing it, the financing charges, and a premium for risk; while to continue running an existing line, rates only had to cover operating costs. And these costs were essentially invariant to the volume of traffic on the line.
Or as John Bates Clark put it in 1901: “There is often a considerable range within which trusts can control prices without calling potential competition into positive activity.”
These were some of the leading figures in the economics profession around the turn of the century, so it’s striking how unambiguously they rejected the Marshallian orthodoxy of equilibrium prices. When the American Economics Association met for the first time, its proposed statement of principles included the line: “While we recognize the necessity of individual initiative in industrial life, we hold that the doctrine of laissez-faire is unsafe in politics and unsound in morals.” Politically, they were not socialists or radicals. They rejected competitive markets, but not private ownership. That however left the question, how should prices be regulated?
For a conservative economist like Hadley, the answer was social norms:
This power [of the trusts] is so great that it can only be controlled by public opinion—not by statute…. There are means enough. Don’t let him come to your house. Disqualify him socially. You may say that it is not an operative remedy. This is a mistake. Whenever it is understood that certain practices are so clearly against public need and public necessity that the man who perpetrates them is not allowed to associate on even terms with his fellow men, you have in your hands an all-powerful remedy.
Unfortunately, in practice, the withholding of dinner party invitations is not always an operative remedy.
In principle, there are many other ways to solve the problem. Intellectually, one can assume it away by simply insisting on declining returns to scale; or one can allow constant returns but have firms rent the services of undifferentiated capital, so there are no fixed costs. If the problem is not assumed away — a more practical option for theorists than for policymakers — it could in principle be solved by somehow ensuring that producers enjoy just the right degree of monopoly. This is what patents and copyrights are presumably supposed to do. Another possible answer is to say that where competition is not possible, that is an activity that should be carried out by the public. That was, of course, where urban rail systems ended up. For someone like Oskar Lange, it was a decisive argument for socializing production more broadly.5
Alternatively, one can accept cartels or monopolies (perhaps under the tutelage of dominant banks) in the hopes that social pressure or norms will limit prices, or on the grounds that a useful service provided at monopoly prices is still better than it not being provided at all. This was, broadly, the view of figures like Hadley, Ely and Clark, and arguably a big part of how things worked out.
But the main resolution to the problem, at least in the case of railroads, came from the increasing public pressure to regulate prices. The Interstate Commerce Commission was established to regulate railroad rates in 1887; its authority was initially limited, and it faced challenges from hostile Gilded-Age courts. But it was strengthened over the ensuing decades. The guiding principle was that rates should be high enough to cover a railroad’s full costs and a reasonable return, but no higher. This required railroads, among other things, to adopt more systematic and consistent accounting for capital costs.
Indeed, there’s a sense in which the logic of Langean socialism describes much of the evolution of private markets over the 20th century. The spread of cost-based price regulation forced firms to systematically measure and account for marginal costs in a way they might not have done otherwise. Mark Wilson, in his fascinating Destructive Creation, describes how the use of cost-plus contracts during World War II rationalized accounting in a broad range of industries. Systems of railroad-like rate regulation were applied to a number of more or less utility-like businesses both before and after the war, imposing from above the rational relationship between costs and prices that the market could not. Many of these regulations have been rolled back since the 1970s, but as noted earlier, many others remain in place.
*
Late 19th-century debates over railroad regulation might not be the most obvious place to look for guidance to today’s inflation debates. But as Axel Leijonhufvud points out in a beautiful essay on “The Uses of the Past,” economics is not progressive in the way that physical sciences are — we can’t assume that the useful contributions of the past are all incorporated into today’s thought. Economists’ thinking often changes for reasons of politics or fashion, while the questions posed by reality are changing as well as well, often in quite different ways. Older ideas may be more relevant to new problems than the current state of the art. History of economic thought becomes useful, Leijonhufvud writes,
when the road that took you to the ‘frontier of the field’ ends in a swamp or blind alley. A lot of them do. … Back there, in the past, there were forks in the road and it is possible, even plausible, that some roads were more passable than the one that looked most promising at the time.
The road I want to take from those earlier debates is that in a setting of high fixed costs and pervasive market power, how businesses set prices is a legitimate question, both as an object of inquiry and target for policy. One of the central insights of the railroad economists is that in modern capital-intensive industries, there is a wide range over which prices are, in an economic sense, indeterminate. Depending on competitive conditions and the strategic choices of firms, prices can be persistently too high or too low relative to costs. This indeterminacy means that pricing decisions are, at least potentially, a political question.
It’s worth emphasizing here that in empirical studies of how firms actually set prices — which admittedly are rather rare in the economics literature — an important factor in these decisions often seems to be norms around price-setting. In a classic paper on sticky prices, Alan Blinder surveyed business decision-makers on why they don’t change prices more frequently. The most common answer was, “it would antagonize customers.” In a recent ECB survey, one of the top two answers to the same question from businesses selling to the public was, similarly, that “customers expect prices to remain roughly the same.” (The other one was fear that competitors would not follow suit.)
This kind of survey data supports the idea, relied on by the Groundwork team, that businesses with substantial market power might be reluctant to use it in normal times. Those inhibitions would be lifted in an environment like that of the pandemic recovery, where individual price hikes are less likely to be seen as norm violations, or to be noticed at all. (And are more likely to be matched by competitors.)
Even more: It suggests that the moralizing language that critics like Rampell object to can, itself, be a form of inflation control. If fear of antagonizing customers is normally an important restraint on price increases then maybe we need to stoke up that antagonism! The language of “greedflation,” which I admit I didn’t originally care for, can be seen as an updated version of Arthur Hadley’s proposal to “disqualify socially” any business owner who raised prices too much. It is also, of course, useful in the fight for more direct price regulation, which is unlikely to get far on the basis of dispassionate analysis alone.
And this, I think, is a big source of the hostility toward Groundwork and toward others making the greedflation argument, like Isabella Weber.6 They are taking something that has been understood as a neutral, objective market outcome and reframing it as a moral and political question. This is, in Keynes’ terms, a question about the line between the Agenda and the Non-Agenda of political debates; and these are often more acrimonious than disputes where the legitimacy of the question itself is accepted by everyone, however much they may disagree on the answer.
By the same token, I think this line-shifting is a central contribution of the profiteering work. The 2022-23 inflation seems on its way to coming to an end on its own as supply disruptions gradually revolve themselves, just as (albeit more slowly than) Team Transitory always predicted. But even if the aggregate price level is behaving itself, rising prices can remain burdensome and economically costly in all kinds of areas (as can ruinous competition and underinvestment in others). Prices will remain an important political question, even if inflation is not.
My neighbor Stephanie Luce, who spent many years working in the Living Wage movement, often points out that the direct impact of those measures was in general quite small. But that does not mean that all the hard work and organizing that went into them was wasted. A more important contribution, she argues, is that they establish a moral vision and language around wages. Beyond their direct effects, living wage campaigns help shift discussions of wage-setting from economic criteria to questions of fairness and justice. In the same way, establishing price setting as a legitimate part of the political agenda is a step forward that will have lasting value even after the current bout of inflation is long over.
How to debase the coinage in order to pay for wars
Henry VIII, after Hans Holbein the Younger
It's fun to imagine traveling back in time and engaging with the then-prevailing technologies. Would you be able to ride a boneshaker or use a counting board? It's probably harder than you think: kids today can't even use a 1980s rotary phone. In this post I'm going to write about one specific techno-institution, the mint, and a particular function that it sometimes played many centuries ago; funding wars.
If you had to go back to 16th century Europe, and you were asked to operate the mints in a way such that they raised enough revenues so that your patron, the king, could wage war against a neighbouring country, how would you go about that?
I think the general sense that most of us have is that you'd need to somehow "debase" the coinage. The majority of coins back then were made of precious metals. If you could sneakily remove some of the silver and gold from each coin, and replace it with cheaper copper, then you'd be able to amass a hoard for the king (albeit at the expense of the public), and he could use that to hire an army.
Now, if you went back in time with the above hazy notion of debasement, you wouldn't have much luck, and might even get your head chopped off. There's a grain of truth to it, but much of it won't work.
So before you head off in a time machine, here's what you need to know about the business of minting.
The first thing you need to know is that the King (or Queen) owns the royal mints, which they rent out to private parties to operate. Another important fact is that the public brings their own personal supply of precious metal – raw silver, silver cutlery and dishes, old coins, etc – to the mint, and then after waiting a week or two for the order to be processed, walks out with the final product; newly-minted coins.
But the mint's customers don't leave with as much silver (or gold) as they arrived. For each ounce of precious metals that gets minted into coin, the King collects a fee, known as "seigniorage", usually around 5% in the case of silver. The private individual who runs the mints gets a much smaller cut too, called brassage.
If you're scrambling for a modern analogy, I suppose you could think of the medieval business of minting as very much like a modern laundromat, where customers bring their clothes, have them processed, and leave with their clothes, paying a small fee to the laundromat owner, who in turn pays a big chunk of this to the franchisor.
Like a laundromat owner, the monarch would have earned a fairly steady stream of revenues from their mints. Coins were more useful and liquid than raw silver, so there was an ever-present demand to convert raw silver into coin for transactional purposes. But remember, the challenge you face isn't just to generate regular profit. The king wants a massive surge in revenue. He's got a war to wage. How are you going to repurpose the mints to provide this gusher?
Your first attempt to raise money for the king might be to boost the minting fee from the low single digits to 20-25%. That might work. And you wouldn't be the first to go this route. For centuries, the English seigniorage rate on silver typically hovered around 5%, as illustrated in the chart below from a paper entitled The Debasement Puzzle, by Rolnick, Velde, and Weber. For gold, the minting fee was typically at 0.5% to 2%. To help fund his war against the Scots and the French, Henry VIII raised the seigniorage on silver to a remarkable 50-60% in the 1540s. Gold fees skyrocketed to 15%.
Source: Rolnick, Velde and Weber [pdf]
Mind you, fee hikes alone aren't going to work. Dissuaded by sky-high costs, many people will stop bringing their silver and gold to the mint to be coined, and the King's seigniorage revenues will dry up. A bothersome coin shortage will probably develop, too. Off with your head! says the King.
After thinking about it some more, you realize that, like a modern laundromat owner keen to make more revenue, you need to dramatically increase the amount of material going through the mint. How to do so?
You've got a few levers to increase throughput. One option is to introduce new products. If you offer new denominations of coins, for instance, people may bring more silver to the mint because those denominations are useful to them.
There's certainly precedent for that. To help pay his armies, Henry VIII brought back the testoon, a coin worth 12 pennies (or a shilling) in the hope that there would be significant demand for them, and that this would boost throughput and thus mint revenues. Testoons complemented Henry's silver halfpennies, pennies, groats (4 penny pieces), and sixpence (six pennies), in addition to a range of high denomination gold coins.
Below is an example of one of Henry's testoons, first minted in 1542. Because they had so much copper in them (more on that later), many of the testoons that exist today have a greenish tinge (due to copper oxidation). In the 1540s, Henry VIII's silver coins still hadn't turned green, but had a reddish tinge, which tended to reveal itself on his nose. Which is why Henry's nickname was Old Coppernose.
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English groat (4 pence) issued 1547-49. Source: The British Museum
But introducing new denominations probably isn't going to generate a huge rush to the mints, since a new denomination will to some extent cannibalize existing demand for other denominations. Anyone who orders more testoons is likely to order fewer groats, for example. You'll have to do more.
In addition to introducing new coins, another strategy you might try is to cancel old ones. By having the King demonetize a popular coin, or declare it to be "no longer current," those coins will cease being legal tender or acceptable for taxes. The public will be forced to bring their demonetized coins to the mint to be converted into legal coins, the rush to do so creating a revenue windfall for the King.
And indeed, Henry VIII's successor Edward VI (who continued his father's wars) did this exact same move in 1548, declaring the testoons his father had reintroduced just four years before to be no longer current, as recounted in a paper by C.E. Challis (1967). I've clipped the relevant part below:
The demonetization of testoons is announced. Source: C.E. Challis
But we still haven't broached the main method: debasement. This is where the gusher begins.
Together with the King, you announce to the public that anyone who brings precious metals to the mint will now get more coins than before, for the same weight of precious metal. So for example, if someone used to be able to bring, say, 10 grams of pure silver to the mint and got 100 pennies minted, now they can bring 10 grams and get, say, 200 pennies. Same amount of silver, more coins.
As the operator of the mint, you could enact this change by cutting the weight of each penny by half, or, if you wanted to be more clever, maintain the same weight but reduce its fineness by 50%, by introducing more cheap copper to the mix. Either way, you've just debased the currency.
But how exactly does this raise revenues for the King?
Let's think about this change from a merchant's perspective. Say that our merchant owes a supplier 1 pound (a pound is 240 pennies). He's about to pay his debt off with everything he has, 240 pennies, when the debasement is announced. He can now bring his 240 pennies to the mint and have them recoined into 480 pennies. That allows him to pay off his debt, which is still denominated at 1 pound, and still have 240 pennies for himself. What a great opportunity! The merchant heads off to the mint with his silver.
Or imagine our merchant need to buy some property that's priced at 10 pounds, or 2,400 pennies. If he has only 1,200 pennies on hand, he can't afford it. But with the debasement having just been announced, the merchant can now convert those 1,200 pennies into 2,400 pennies and make the purchase.
Congratulations, you've created a revenue gusher! What you've effectively done is offer a short-term arbitrage opportunity to those who are paying attention, most likely the rich and well-connected, at the expense of the not-so-aware. To take advantage of a profitable situation, these enterprising individuals will immediately bring all their silver and gold to the mint. And you'll collect a toll on all that metal as it passes through.
But that arbitrage opportunity won't last forever. Debts will be recalibrated to account for the 50% decline in the penny's silver content. Prices of things like property will eventually double to reflect the new true value of the penny. At that point it will no longer be advantageous to bring one's silver to the mint to be recoined, and the revenue gusher you've created will subside.
You might try announcing debasements every few years or so, thus milking your mint's throughput on a continual basis. Too many debasements, though, and this trick will stop working, since that portion of the population that is the victim of the arbitrage you've created – the less aware – eventually wises up and protects itself by quickly increasing prices whenever a debasement occurs.
A constant series of debasements is exactly what Henry VIII and his son
Edward enacted between 1542 and 1551 to keep paying their soldiers.
Using data from a paper by John Munro, The Coinages and Monetary Policies of Henry VIII,
I've charted out (above) how the penny's silver content changed over that time
period. Going into the 1500s, an English penny contained 0.72 grams of
pure silver. At the end of the Great Debasement, (the term used for
Henry VIII's operations on the coinage) the penny contained just 0.11
grams of silver, constituting an 85% reduction in silver content.
We can further split out how Henry VIII's debasements were distributed between changes in fineness and changes in weight. Going into 1542, the English penny was 92.5% fine. Nine years later its purity stood at just 25% silver, the other 75% being base metal such as copper. As for weight, a penny weighed 0.79 grams in the early 1500s, but only 0.43 grams by 1551.
These changes are illustrated in the chart below.
Thus it was diminutions in purity, not weight, that drove the biggest chunk of the penny's debasement, although weight did have a role to play.
How successful were these policies in creating a financial gusher for Henry and his son?
The charts below from Rolnick, Velde, and Weber (which I've clipped from a second paper authored by the trio) show how the combination of mintage policies enacted in the 1540s – debasement, new testoons, and a demonetization of the testoon – led to a large influx of silver and gold to the English mints.
Source: Rolnick et al
According to Challis, the combination of these inducements, along with a big boost in fees, resulted in minting profits of £1.3 million for the two kings from 1542 to 1551. This would have paid for a big chunk of the £3.5 million in military expenditures over that same period, much more than actual taxation, which only yielded £976,000.
Of course, the final result of all this was a significant number of deaths, and what one account describes as "an episode of sixteenth-century ethnic cleansing which in its aims and
implementation was not dissimilar from ...the former Yugoslavia in the 1990s or, most recently, with the Myanmar government’s actions against the Rohingya." It also caused one of the worst episodes of price inflation that England had ever seen. According to Munro, the English consumer price level rose by 123% between 1541 and 1555.
So there you have it. If you had a time machine, you now know how to go back to medieval Europe and operate the royal mints in order to fund big ticket items like wars. (Whether you should actually do so is another question.)
The damage of monetary tightening is about to begin
[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]
The past weeks brought us four pieces of news on the inflation front. Well, actually, two pieces of news and two non-news. Let’s start with the latter. It is no longer news that central banks continue with their strategy of monetary tightening. Both the Fed and the ECB have raised rates by a quarter point, and the two presidents, Powell and Lagarde, are not revealing what will happen in September. What is certain is that, after the ninth consecutive hike, the rate for the eurozone is at its highest since 2001 when the ECB sought to support the value of the newborn single currency with high interest rates.
The second non-news is that inflation continues to decrease faster than expected. Data for France and Germany showed record lows since the invasion of Ukraine, while Spain’s inflation was slightly higher than expected. The tightening, therefore, continues while inflation falls. The official line of central banks is that this needs to happen because inflation has been “too high for too long,” and the risk is that it may become chronic, affecting expectations and wage negotiations.
No price-wage spiral
This argument is extremely weak, and, unfortunately i should add, there is no sign of wages chasing inflation. The OECD confirmed this only a couple of weeks ago in its 2023 Employment Outlook, which included a chapter on the generalized decline of real wages (a sign that nominal wages have grown less than prices).
Even expectations remain under control. After the two non-news items, the first news from last week is the results of the quarterly Survey of Professional Forecasters conducted by the ECB. According to the survey, professional forecasters expect inflation to return to 2% by 2024 (and to 3% in the last quarter of 2023). The ECB, on the other hand, continues to believe that reaching 2% will not happen before 2025. As a result, even among those who have supported the restrictive turn of the ECB in the past, voices calling for a pause in rate hikes are multiplying.
The decrease in inflation is mostly not due to the ECB
The hawks, on the other hand, base see the the decline in inflation as a justification of past rate hikes and as lending support for further increases in the autumn. The argument is that the tightening works and must continue until inflation returns to the 2% target. Unfortunately, this argument is flawed. The empirical literature has extensively studied the impact of central bank decisions on the economy. This mainly happens through the credit channel: the increase in central bank interest rates is transmitted to bank interest rates charged to businesses and households for investment projects and mortgages. The higher cost of capital implies less spending and and the cooling of the economy. This process is not immediate. While it is true that bank rates react fairly quickly to central bank decisions (especially to rate increases), spending is much stickier. For example, investment is a process that takes time, often years. It is unlikely that businesses will abandon an ongoing project just because the cost of money has increased. Therefore, the rate hike is transmitted with a certain delay, only as businesses complete ongoing investment projects and decide whether to start new ones. The same can be said for the other channel, that of exchange rates. The increase in interest rates causes an appreciation of the exchange rate and thereby a deterioration in trade balances, which cools the economy. Again, this process is not immediate because there are contracts to honor, spending habits to change, and so on.
For all these reasons, the transmission lags of monetary policy are measured in semesters, if not in years. The literature is abundant. A meta-analysis published a few years back tries to summarize these findings and reports that, on average, it takes 12-18 months to see the effects of a rate change on the real economy, and for the transmission to be complete, it takes about two and a half years. The delays are particularly long for countries with more developed financial systems, because there it is more difficult for the central bank to influence credit creation by the banking sector. This means that the impact of the credit tightening started in the spring-summer of 2022 is beginning to be felt now, and central banks have little to do with the decrease in inflation.
This brings us to the last news of the week, also from a survey. The results of the latest (July) quarterly Bank Lending Survey conducted by the ECB show (for the second consecutive quarter) a sharp decline in corporate credit demand (firms, anticipating an economic slowdown, are unwilling to borrow at increasingly prohibitive rates). Even for households and consumers there is a contraction in credit.
In short, while inflation has a life of its own, influenced only marginally by central bank decisions, these decisions are pushing us into an economic slowdown, which is showing multiple signals. In Germany, the Ifo business confidence index is at its lowest since last autumn, and the economy is stagnating after two quarters of slight contraction. Things are not much better in Italy, even though a recession is not currently forecasted in spite of negative growth in 2023 Q2. The “Congiuntura Flash” report published by Confindustria on July 29 shows a slowdown in the Italian economy mainly due to the weakness in industrial production and investment, with uncertain consumption and declining exports. Only the services sector (especially tourism) is keeping the Italian economy afloat.
We need to stop relying solely on central banks.
What does this picture tell us, besides the obvious fact that central banks persist in a futile and harmful strategy? First, in the coming months, measures will need to be implemented to mitigate the impact of monetary tightening, which will begin to fully unfold and, as usual, hit the most vulnerable categories. Second, the era of delegating the solution to all our problems solely to monetary policy must end. Since at least 2010, when the sovereign debt crisis began, monetary policy has been the only player in town, for better or for worse. It’s time to rethink the policy mix, the attribution of different economic policy tools and objectives to various actors. But this subject will need to be tackled in a future post.
Jason Furman Hyperventilates about Wages and Inflation
Jason Furman has had an admirable career as an economist and policy adviser. He was on the staff of the Council of Economic Advisors in the Clinton administrations, was Assistant Director of the National Economic Policy under Larry Summers in Obama’s first term served as Chairman of the CEA in his second. I am friendly with a really smart economist who worked under Furman for a couple of years at the CEA, and he spoke glowingly about that experience in general and about Furman in particular, both as an economist and as a person. So I’m not anxious to write a critical blogpost about Furman. But a blogger’s gotta do what a blogger’s gotta do.
Following the lead of his former boss Larry Summers, Furman has, for over a year, been an outspoken anti-inflation hawk, calling for aggressive tightening by the Fed to prevent an inflationary wage-price spiral from returning us to the bad old days of the 1970s and its ugly aftermath — the 1981-82 Volcker recession. So, after the January core inflation reports showed an uptick in core inflation in the second half of 2022, Furman responded with an overwrought op-ed (“To Fight Inflation, Fed Tightening Should Go Faster and Further”) in the Wall Street Journal.
The Federal Reserve has said repeatedly that it responds to data and doesn’t set interest rates on autopilot. The data have changed dramatically. The Fed should prove it means what it says by shifting from a 25-basis-point increase at its next meeting to a 50-point increase. It should also shift expectations toward a terminal rate of around 6%.
The Fed should never react too much to any single data point, but when the annualized three-month core inflation rate jumps from 2.9% to 4.7%, the central bank must take notice. When that happens after strong jobs data and faster wage growth, the Fed should plan on action. The expectation that inflation would melt away on its own was always unjustified, but the latest economic data have been especially unkind to team transitory.
Let me first observe that Furman seems to overstate the size of the January increase in core inflation. Core inflation, which excludes volatile food and energy prices from the two broader inflation indexes: the personal consumption expenditures index (PCEI) computed by the Bureau of Economic Analysis of the Commerce Department and the Consumer Price Index (CPI) computed by the Bureau of Labor Statistics of the Labor Department. The two charts below show the 3-month and the 6-month moving averages of the core PCEI and the core CPI. Neither of the 3-month moving averages show a January increase as large as that asserted by Furman.
Yet, Furman is correct that the January increase in core inflation was significant, and also correct to observe that the Fed shouldn’t overreact to a single data point. Unfortunately, he immediately reversed himself by demanding that the Fed respond to the January increase by quickly and significantly tightening policy, because core inflation, notwithstanding the assurances of “team transitory”, has not subsided much on its own.
I can’t speak on behalf of team transitory, but, as far as I know, no one ever suggested that inflation would fall back to the Fed’s 2% target on its own. Everyone acknowledged that increased inflation last year was, at least partly, but not entirely, caused by macroeconomic policies that, during the pandemic and its aftermath, first supported, and then increased, aggregate demand.
But, as I’ve argued in many posts in the past year and a half (here, here, here, here, here, here, here, and here), increasing aggregate demand to avoid a cumulative collapse in output and income was well-advised under unprecedented Covid conditions. Because much of the income supplements provided in 2020-21 were held in cash, or used to repay debts, owing to the diminished availability of spending outlets during the pandemic, rather than spent, increased aggregate demand led not to an immediate, but a delayed, increase in inflation once the economy gradually recovered from the pandemic. Without the macroeconomic stimulus of 2020-21 that became a source of inflationary pressure in late 2021 and 2022, the downturn in 2020 would have been even deeper and lasted longer.
But aside from the underlying macroeconomic forces causing inflation to start rising in 2021, a variety of supply-chain slowdowns and interruptions appeared, just as a Russian invasion of Ukraine was becoming increasing likely, driving up oil and other energy prices well before the actual invasion on February 24, 2022. The transitory component of inflation corresponds to both the delayed spending of cash accumulated from income supplements and other spending undertaken in the pandemic, and to the supply-side problems caused by, or related to both the pandemic and Putin’s war. By the middle of 2022, both of these transitory causes of inflation were subsiding.
That leaves us with a core rate of inflation hovering in the 4-5% range, a somewhat higher rate than I would like, or recommend, as a policy target. Does that mean that further tightening to reduce overall inflation to the 2% target is required? I agree with Furman and others who think it is required, but I disagree that the tightening should be either drastic or immediate, and I find Furman’s rationale for rapid and substantial further tightening deeply misguided.
What makes the current inflation particularly troubling is that all the hoped-for saviors have come and gone without reducing underlying inflation very much. Inflation was supposed to go away after base effects receded, when the economy got over the Delta and Omicron surges, when the ports were unclogged, when timber prices fell, when the fiscal stimulus wore off, when microchips were available, when energy prices came back down again after the Russian invasion. All of that has happened, and yet the underlying inflation rate remains above 4.5% on just about every time horizon and every measure.
What makes Furman’s inflation anxiety particularly annoying is that, while he and others had been warning that, unless the Fed sharply tightened, inflation would accelerate — possibly to double-digit levels — he continues to hyperventilate about runaway inflation, even as headline inflation over the past year has dropped substantially, and core inflation has also fallen, albeit by much less than headline inflation. Having learned nothing from his earlier exaggerated warnings about inflation, Furman is now using a one-month uptick in inflation as a pretext for continued inflation alarmism and tight-money advocacy.
The Fed’s tightening over the past year prevented core inflation from accelerating even as the transitory factors that had raised inflation to the highest levels in 50 years gradually dissipated, causing the sharp decline in the volatile non-core items in the CPI and PCE indexes. The argument between team transitory and team non-transitory was never an all or nothing dispute, but a matter of emphasis.
Many of those opposed to rapid and severe tightening understood that responding too aggressively to temporarily high inflation carries risks of its own, potentially plunging the economy into a recession because of an exaggerated estimate of the inflationary threat, an underrated risk that is one of the 1970s lessons that many, including Furman and Summers, seem to overlook, but a risk of which the events of the past two weeks have provided an unwelcome and frightening reminder.
The modest decline in core inflation over the past year was accompanied by a gradual decline in the rate of NGDP growth since the first quarter of 2022 from over 11% to about 7%. For inflation to decline further toward the 2% target, a further modest — and ideally gradual — decline in NGDP growth to about 5% will be necessary.
Whether the decline in NGDP growth is possible without further monetary tightening is unclear, but it’s unlikely that the effects of monetary tightening over the past year have yet been fully absorbed by the economy, so it seems reasonable to postpone any decision about monetary tightening until at least the preliminary Q1 GDP report is released in about six weeks. And given the heightened risk to the banking and financial system, any increase in rates would be foolhardy.
If total domestic spending is increasing at a rate faster than 7%, further increases in interest rates might be warranted, but the current inversion of the yield curve suggests that an increase in short-term rates is presumptively inadvisable (see my posts on yield-curve inversion here and here). If long-term rates are below short-term rates, notwithstanding the incremental risk associated with holding securities of longer duration, the relatively low yield of longer-term securities suggests either that the liquidity premium on money is abnormally high (a symptom of financial distress), or that there is an expectation of sharply declining yields in the future. In the former case, a lack of liquidity and increasing default risk drive up short-term rates; in the latter, the longer-term outlook suggests that the inflation rate, or the profit rate, or both, will decline. So the watchword about policy changes should be: caution.
After that warmup, Furman, in diagnosing “underlying inflation, goes from being annoying to misguided.
Fundamentally, much of the economy’s underlying inflation had nothing to do with base effects or microchips or timber prices.
Correct! But let’s say that the underlying inflation rate really is, as Furman suggests, 5%. That would be 3% above the target rate. Not trivial, but hardly enough to impose the draconian tightening that Furman is recommending.
Furman continues with, what seems to me, a confused and confusing rationale for monetary tightening.
[Underlying inflation is] a product of extremely tight labor markets leading to rapid wage gains that passed [sic] through as higher prices. These higher prices have also led to faster wage gains. Some call it a “wage-price spiral,” but a better term is “wage-price persistence,” because inflation stays high even after the demand surge goes away.
This passage is beset by confusions, explicit or implied, that require unpacking. Having started with a correct observation that the economy’s “underlying inflation had nothing to do” with increases in any particular price or set of prices, Furman contradicts himself, attributing inflation to “rapid wage gains” that got passed through “as higher prices,” which, in turn, led to “faster wage gains.” That this ancient fallacy about the cause of inflation would be repeated by a former CEA chair, now a professor of economic policy at the Kennedy School at Harvard, is, well, dispiriting.
What’s the fallacy? An increase in one price – presumably, including the wage paid to labor — can never explain an increase in prices in general. To suggest otherwise is to commit the “fallacy of composition,” or something closes to it. (See “Fallacy of Composition”) An increase in wages relative to other prices could just as well be associated by wages remaining constant and all other prices falling; there is no logical necessity for wage increases to entail increases in other prices.
Of course, Furman might not be asserting a logical connection between wage increases and price increases. He might just be making an empirical observation that it was rising wages that initiated a series of price increases and an unending process of reciprocal wage and price increases. But even if wage increases did induce subsequent increases in other prices, that observation can’t account for an inflationary process in which wages and prices keep rising endlessly.
To account for such a continuing process, an explanation of why the process doesn’t eventually reach an endpoint is needed, but missing. There must be something that enables the inflationary process to conintue. That additional factor is, of course, the monetary or macroeconomic environment that determines aggregate demand and aggregate spending. Furman obviously believes that the process can be halted by monetary or macroeconomic policy measures, but, focused solely on wages, he ignores the role of policy in initiating and maintaining the process.
Other, related, confusions emerge in Furman’s next paragraph.
Wage growth is currently running at an annual rate of about 5%. Sustaining such wage growth with 2% inflation would require a large increase in productivity growth or continually falling profit margins. I’d root for either outcome, but I wouldn’t bet on them. Falling wage growth could bring down inflation, but in an economy with nearly two job openings for every person looking for work, don’t expect it to happen. Instead, the most probable outcome is that if the unemployment rate doesn’t rise, wages will continue to grow at that pace, which historically is associated with about 4% inflation.
In a previously quoted passage, Furman asserted that wage increases caused underlying inflation. But that was not what actually happened in the current episode. Since January 2021, just before the current inflation started, prices started rising before wages, and until the last six months or so prices have been rising faster than wages, causing real wages (i.e. adjusted for the purchasing power) to fall.
It’s one thing to say that wage increases cause the prices of things made by workers to increase; it’s quite another to say that wage increases cause the price of the things made by workers to increase faster than wages increase. By blaming current inflation on the current increase in wages, Furman is, in effect, calling for permanent real-wage cuts. Since wage increases cause “inflation persistence,” Furman proposes a restrictive monetary policy to reduce the overall demand for labor and the rate of increase in nominal and real wages.
Real wages (adjusted for the CPI) were barely higher in Q4 2022 than in Q4 2019 even though real GDP in Q4 2022 was 5.1% higher than in Q4 2019 and per-capita real GDP was 4.1% higher in Q4 2022 than in Q4 2019. If inflation is (in my view mistakenly) attributed to a distributional struggle that labor is clearly losing, then it’s obvious that it’s not wages that are to blame for inflation.
Furman makes another astonishing claim in the next paragraph.
Monetary policy operates with long and variable lags. Given that most of the tightening in financial conditions was already in place 10 months ago and, if anything, the real economy and demand have strengthened in recent months, it would be foolish to sit and wait for the medicine to work.
How long and variable the lags associated with monetary policy really are is a matter of some uncertainty. What is not uncertain, in Furman’s view, is that most of the tightening had occurred 10 months ago (May 2022). The FOMC began raising the Fed Funds target exactly a year ago in March 2022. How Furman can plausibly assert that most of the effect of the Fed’s tightening were in place 10 months ago is beyond me. The Table below shows that 10 months ago (May 2022) the effective Fed Funds rate (St. Louis Fed) was still only 0.77% and has since risen to 4.57% in Feburary.
Below is another table with the monthly average yield on constant maturity 10-year Treasuries, showing that the yield on 10-year Treasuries rose from 2.13% in March 2022 to 2.90% in May (reflecting expectations that further increases in the Fed Funds rate were likely). But the rate on 10-year Treasuries rose from slightly more than 2% to nearly 4% between March 2022 and October 2022, with rates fluctuating since October in a range between 3.5 and 4%.
So I can’t understand what Furman could was thinking when he asserted that most of the Fed’s tightening of financial conditions were already in place 10 months ago. The real economy has indeed strengthened, but that strengthening reflects the unusual economic circumstances in which both the real economy and monetary policy have been operating for the past three years: the pandemic, the partial shutdown, the monetary and fiscal stimulus, the supply-chain issues that initially obstructed and hobbled the return to full employment even as unemployment was falling to a record low rate of 3.5%.
Dramatic evidence that the effects of the tightening since January had not been fully absorbed by the economy was provided within days after Furman’s op-ed by the failure of SVB and Signature Bank and only days ago by the rescue of Credit Suisse. And there is no assurance that these are the last dominoes to fall in the banking system or that other effects attributable to the increase in rates will not emerge in the near future.
Furman also overlooks the permanent withdrawal of workers (mostly but exclusively babyboomers nearing retirement age) from the labor force during the pandemic. Despite a rapid decrease in unemployment (and increase in employment) since the summer of 2020, and total employment in February 2023 exceeded total employment in 2020 by only 1.9%. The labor-force participation rate has dropped from 63.3% in February 2020 to 62.5% in February 2023.
With fewer workers available as businesses were responding to increasing demand for their products, competition to hire new workers to replace those that left the labor force is hardly surprising. However, a largely transitory burst of inflation in the second half of 2021 and the first half of 2022 outpaced a perfectly normal increase in nominal wages, causing real wages to fall. But it would be shocking – and suspicious — if normally functioning market forces didn’t drive up nominal wages sufficiently to cause a real wages to recover given the increased tightness of labor markets after a significant negative labor-supply shock.
For Furman to suggest that a market adjustment to a labor-supply shock causing an excess demand for labor should be counteracted by tight monetary policy to reduce the derived demand for labor is extraordinary. There may be – and I believe that there are — good reasons for monetary to aim to bring down the growth of nominal spending from roughly 7% to about 5%. But those reasons have nothing to do with targeting either nominal or real wages.
In fact, lags are precisely why the Fed should do more now—considering it will take months for whatever the central bank does next to have a meaningful effect on inflation.
Furman seems to envision a process whereby wage increases are necessarily inflationary unless the Fed acts to suppress the demand for labor. That is not how inflation works. Inflation depends on aggregate spending and aggregate income, which is what monetary and macroeconomic policy can control. To subordinate monetary policy to some target rate of increase in wages is a distraction, and it is folly to think that, with real wages still below their level two years ago, it is the job of monetary policy to suppress wage increases.
Why the RBA should go easy on interest rate hikes: inflation may already be retreating and going too hard risks a recession
One of the stranger things about the Reserve Bank’s announcement of why it’s lifting interest rates by 0.25 percentage points is that it suggests inflation will come down by itself.
“A further rise in inflation is expected in the near term,” the RBA says, “but as supply-side disruptions are resolved, inflation is expected to decline back towards the target range of 2-3%.
So why raise rates now, for the first time in more than a decade? The bank says it is about "withdrawing some of the extraordinary monetary support that was put in place to help the Australian economy during the pandemic”, which is fair enough.
But our latest burst of inflation is weird, and resistant to rate hikes. If the Reserve Bank isn’t careful, too many more rate hikes like this might help bring on a recession.
Labor’s Anthony Albanese is as good as correct when he says “everything is going up except your wages” – not completely correct, because wages are going up, by a minuscule 2.3% per year on the official figures; but essentially correct, because when it comes to prices, almost every single one is going up.
Every three months the Bureau of Statistics prices around 100,000 goods and services. They account for almost everything we buy, the exceptions including illegal drugs and prostitution, where pricing would be “difficult and dangerous”.
Among the types of bread the bureau prices are rye, sliced white, and multigrain, from all sorts of stores in every capital city. Where the bureau doesn’t price a type of loaf, it is a fair bet its price moves in line with the loaves it does price.
Then it groups these 100,000 or so prices into “expenditure classes”, 87 of them. “Bread” is one, “breakfast cereals” is another. Furniture and rent are two others.
Rarely do the expenditure classes move as one. Typically, only 50 or so of the 87 climb in price. But in the March quarter just finished, an astounding 70 climbed in price; according to Deutsche Bank economist Phil O'Donaghoe, that’s the most ever in the 72-year history of the consumer price index.
And the prices that climbed most – by far – were the ones we had little choice but to pay.
Necessities up, treats not as much
The bureau divides the 87 classes of goods into “non-discretionary” and “discretionary”.
It classifies bread as non-discretionary, biscuits as discretionary; petrol as non-discretionary, new cars as discretionary, and so on.
In the year to March, non-discretionary inflation (the price rises we can’t avoid) was a gargantuan 6.6% – well above the official inflation rate of 5.1%, and the highest in records going back to 2006.
Discretionary inflation – the price rises on the treats we splurge on if we’ve got the money – was only 2.7%.
Not since 2011 has the gap been that wide, which makes this inflation unusual.
While price rises are extraordinarily widespread – because most things need diesel to move them, and we were hit with floods, COVID-linked supply problems and the invasion of Ukraine all at once – they don’t seem to be the result of splurging.
These price rises are more like a tax.
The usual response to the usual hike in inflation is to hike interest rates. It’s a way to take away access to cash and push up mortgage and other payments so people have less money to spend and push up prices.
But this hike in inflation is doing that by itself, as the government recognised in the budget by handing out $250 cash payments to compensate.
These price rises are like a tax
If the big price rises are beyond our control and making us poorer, hiking interest rates to make us poorer still, in the hope we will splurge less on things whose prices we can influence (and whose price rises are small) might not achieve much.
Done repeatedly, the Reserve Bank could push up interest rates because inflation is high, discover inflation is still high, push interest rates higher in response, notice inflation is still high, push interest rates even higher in response… and so on, until it had brought on a recession.
A recession is already a risk with these sorts of price rises. If big enough, they can force consumers to cut other spending to the point where the economy stagnates and creates unemployment in the face of inflation – so-called “stagflation”.
Another response would have been to wait. Seriously. The floods, invasion and supply problems pushing up prices in recent months are likely to pass, pushing down inflation and pushing down a lot of prices.
Inflation might have already fallen
It might have already happened. The oil price has fallen 11% from its peak, down 2.5% in the past two weeks alone. And inflation has fallen – on one measure, to zero.
The official Bureau of Statistics measure of inflation is produced every three months, but for 13 years now the Melbourne Institute of Applied Economic and Social Research has produced its own simpler monthly measure, which tracks the official rate pretty well.
Although missing a lot (tracking fewer types of bread, and a national rather than a city-by-city measure) it is produced quickly and more often, providing a better insight into prices in real time.
The latest, released on Monday, points to an inflation rate of zero in April.
That’s right. While some prices continued to rise as always, enough prices fell to offset that. The high inflation in the lead-up to March stopped or paused in April.
Rate hikes need only be mild
It’s different in the United States. There, inflation is supercharged by wage growth averaging 9% and the Federal Reserve is about to lift interest rates aggressively.
Here, wage growth in the year to December was just 2.3%. We’ll get the figures for the year to March in a fortnight. There’s a good case for future rate hikes to be a good deal less aggressive.
Peter Martin, Visiting Fellow, Crawford School of Public Policy, Australian National University
This article is republished from The Conversation under a Creative Commons license. Read the original article.
Peter Martin is economics correspondent for The Age and the Sydney Morning Herald.
He blogs at petermartin.com.au and tweets at @1petermartin.
The 4 economic wildcards between now and election day
There are four economic wildcards between now and the election, and we know exactly when each will be played.
The first is this Wednesday at 11.30am eastern time, when we get the official update on inflation. We’re likely to see a figure so large it will take many of us back to the 1990s, to a time before anyone under 30 was born.
With the exception of a short-lived blip following the introduction of the goods and services tax in 2000, inflation has scarcely been above 5% since 1990.
After a series of extremely large interest rate hikes in the early 1990s succeeded in taming inflation, it has been close to the Reserve Bank target of 2-3% ever since – so much so that even those of us who remember the 8% inflation of the 1980s and the 18% in the 1970s have come to regard fairly steady prices as normal.
When ABC Vote Compass asked voters to name the issue of most concern to them in the 2016 election, only 3% picked “cost of living”.
Only 4% picked “cost of living” in 2019. With inflation so low it had dropped below the Reserve Bank target band, and a good deal below slow-growing wages, there was nothing much to be concerned about.
Suddenly, the cost of living matters
That was until the last few months. Suddenly, the latest Vote Compass finds “cost of living” is voters’ second biggest concern, behind only climate change.
This election, 13% of voters – one in eight – regard the cost of living as the most important concern of the lot, ahead of accountability, defence, health, education and COVID.
It has happened because prices are climbing like they haven’t in years. The official inflation rate for December (the most recent we’ve got) had prices climbing at an annual rate of 3.5%.
Led by petrol and food, they climbed an awful lot more in the lead-up to March, with the figures to be released on Wednesday likely to show annual inflation approaching 5%.
While that’s some way short of the 6.7% inflation in Canada, the 6.9% in New Zealand, the 7% in the United Kingdom, and the 8.5% in the United States, each of these countries has begun increasing interest rates as a result, some quite aggressively.
A high inflation rate on Wednesday will confirm what the public suspects: that prices really are climbing at a pace without modern precedent, and that for those who rely on wages, it is sending their living standards backwards.
It will also encourage the Reserve Bank to begin to push up interest rates in line with its contemporaries throughout the English-speaking world, eating into the living standards of Australians on mortgages.
The second wildcard: rising interest rates
That’s when the second election wildcard gets played, next Tuesday May 3, at 2.30pm eastern time, after the Reserve Bank board’s May meeting.
If inflation is especially high, there’s a chance the bank will announce it is pushing up rates, lifting its cash rate from its present all-time low of 0.10% to 0.25% or to 0.50%, and holding an afternoon press conference to explain why.
If fully passed on, an increase to 0.50% would add an extra $100 to the monthly cost of paying off a $500,000 mortgage.
The increase, and the explanation that it was much higher prices that brought it about, would be crushing for a government campaigning on what it is doing to address the cost of living. It would help Labor, which has made the cost of living a key plank of its campaign.
There ought to be no doubt that if the bank decides it needs to raise rates at its meeting next Tuesday, it will do it then, rather than wait a month until the campaign is over. It pushed up rates during the 2007 campaign, three weeks before John Howard was swept from power.
But if inflation isn’t ultra-high but merely high, and not necessarily sustainably high, the bank is likely to wait for another piece of evidence before acting.
After its last meeting it said it wouldn’t lift rates until it saw “actual evidence” that inflation was “sustainably” within the 2-3% target range.
The wages wildcard – 3 days before polling day
To get that evidence, the board would need either very high inflation, or evidence that wage growth was high enough to sustain what might otherwise be short-lived high inflation, caused by a spike in the oil price (which has since retreated 16%).
That official word on wages is the third economic wildcard, arriving at 11.30am eastern time on Wednesday May 18, three days before voting day.
To date wage growth has been frustratingly low: at 2.3% in the year to December, well below what is needed to maintain living standards in the face of inflation, and well below what would normally be needed to make high inflation self-sustaining.
High official wage growth in the year to March could make a post-election interest rate hike all but certain, if rates haven’t already gone up ahead of the election.
Continued demonstrably weak wage growth – which is probably more likely – will officially confirm that prices are racing ahead of wages, just before polling day.
The poll-eve jobs wildcard
Which leads on to the fourth economic wildcard, to be delivered the next day, two days before polling day on Thursday May 19 – about the only piece of economic news ahead that’s likely to play well for the government.
Ultra-low interest rates and massive government stimulus, originally designed to keep people in jobs during COVID but continued beyond that, have delivered an unemployment rate that rounds to 4% but is actually a touch below it at 3.95%, the lowest since November 1974, almost 50 years ago.
There’s every chance the April unemployment rate will be even lower, perhaps the 3.75% the treasury expects later in the year. If it is, the Coalition will deserve and will claim a lot of the credit. Labor will be left to talk about the cost of living.
Peter Martin, Visiting Fellow, Crawford School of Public Policy, Australian National University
This article is republished from The Conversation under a Creative Commons license. Read the original article.
Peter Martin is economics correspondent for The Age and the Sydney Morning Herald.
He blogs at petermartin.com.au and tweets at @1petermartin.
Inflation: Facts & Pernicious Myths
Edited: I meant to add a number of articles to the page on Inflation. Then it turned into more. I think readers will find it worth their time.
Are Major Central Banks Doing Enough to Fight Inflation?
— James K. Galbraith Project Syndicate April 14, 2022
He begins “Say what? Seriously? OK, I’ll give it a try, but promise me this is not a joke…The notion that central banks fight inflation is a pernicious myth, spread by their officers, acolytes, and by credulous reporters. Central banks raise interest rates. The blather about inflation is eyewash.”
Beware the Inflationary Bogeyman • Recent price increases in the U.S., and demands for a forceful response by the Federal Reserve, have brought back memories of the 1970s and all of the economic and political disasters of those years.
— James K. Galbraith Common Dreams, Project Syndicate – November 20, 2021
CPI, commodity charts Quite a few price increases, which the media now calls ‘inflation’ even though inflation is a continuous increase in the price level.
— Warren Mosler (@WBMosler) Mosler Economics/Modern Monetary Theory Nov 12, 2021
An MMT Perspective: Interest Rates and Inflation with Warren Mosler
— Warren Mosler (@WBMosler) Real Progressives June 26, 2021 (01:05:31)
Manhattan Project to prevent Hyper-Inflation
— J.D. Alt New Economic Perspectives March 26, 2020
Why Australia’s Reserve Bank won’t hike interest rates just yet
The biggest question relating to the management of the economy right now has nothing to do with next week’s budget. It has everything to do with the Reserve Bank and the board meetings that will follow it.
The question facing the board – the biggest there is when it comes to how the next few years are going to play out – is whether to hike interest rates just because prices are climbing.
On the face of it, it seems like no question at all. It is widely believed that that’s what the Reserve Bank does, mechanically. When inflation climbs above 3% (it’s currently 3.5%) the board hikes interest rates to bring it back down to somewhere within the bank’s target band of 2-3%.
It’s what it did the last time inflation headed beyond its target zone in 2010.
But the inflation we’ve got this time is different, and failing to recognise that misreads the bank’s rationale for pushing up rates, and what it is likely to do.
Inflation, but not as we’ve known it
The Reserve Bank does indeed target an inflation rate of 2-3%. The target is set down in a formal agreement with the treasurer, renewed each time a new treasurer or governor takes office.
Just about the only tool the bank has to achieve its inflation target is interest rates. If inflation is below the target, it can cut interest rates to make finance easier in the hope the extra money will encourage us to spend more and push up prices.
If inflation is above the target, it can push up rates so it becomes harder to borrow and interest payments become more onerous, taking money out of the economy and giving us less to push up prices with.
Here’s how the bank itself puts it:
If the economy is growing very strongly, demand is very buoyant and that’s pushing up prices, we might need to raise interest rates to slow the economy, to get things back onto an even keel.
Note the qualifier: “if demand is very buoyant and that’s pushing up prices”.
Buoyant demand (spending) is most certainly not the main thing pushing up prices now. The main things are beyond the Reserve Bank’s power to control.
Petrol prices have skyrocketed because of an invasion half a world away. It’s also the reason the global prices of wheat, barley and sunflower oil are climbing.
Food processors such as SPC say higher oil and food prices combined threaten to push up the price of a can of baked beans more than 20%.
The price of a set of tyres is set to climb from A$500 to $750 because tyres are made from oil.
Everything that is shipped and trucked using oil is set to cost more.
And trucks and cars themselves are climbing in price because of a global shortage of computer chips.
And it might get worse. Last week China locked down the high tech hub of Shenzhen, said to be the source of 90% of the world’s electronic goods, among them televisions, air conditioning units and smartphones. It reopened the city this week after testing its 17.5 million residents for COVID.
It’s easy to see why prices have shot up, and easy to see why they might not come down for a while. What is harder to see is how pushing up interest rates to crimp demand, to force Australians to spend less, would do anything to stop it.
What’s missing is inflation psychology
It’s a view Reserve Bank Governor Philip Lowe seems to endorse. He said this month that what he is on the lookout for is “inflation psychology” – the view that price rises will lead to wage rises, which will lead to price rises in an upward spiral.
It used to be how things worked. Australians who are old enough will remember when, if they saw something at a price they liked, they rushed out to buy it before it climbed in price. Australians born more recently have learnt not to bother.
The old psychology could come back, but wages growth – which would have to be high if that sort of thing was to happen – has remained historically low at 2.3%, little more than it was before COVID.
When surveyed, trade union officials expect little more (2.4%) in the year ahead.
It is true that these days most Australians aren’t in trade unions. So the Reserve Bank seeks out the views of ordinary households. On average, those surveyed expect wage growth in the year ahead of just 0.8%, which is next to nothing. The psychology hasn’t taken hold.
Until it does, it is best to think about most of what has happened as a series of isolated externally-driven price rises that have dented our standard of living.
Pushing up interest rates to dent living standards further won’t stop them.
The Reserve Bank is right to be on the lookout for internally-driven, self-sustaining inflation. We will know it when we see it – but we’re not seeing it yet.
Asked on ABC’s 7.30 this week whether there was a role for higher interest rates in an oil crisis, a former Reserve Bank board member, Warwick McKibbin, said
the worst thing a central bank can do in a supply shock or an oil crisis is to target inflation, because by targeting inflation you push downward pressure on the real economy
He went on to say that if the bank did it without success and then kept doing it, it would bring on a recession. I am sure the bank doesn’t want to do that.
Peter Martin, Visiting Fellow, Crawford School of Public Policy, Australian National University
This article is republished from The Conversation under a Creative Commons license. Read the original article.
Peter Martin is economics correspondent for The Age and the Sydney Morning Herald.
He blogs at petermartin.com.au and tweets at @1petermartin.