Thursday, June 30, 2022

Levy Economics Institute MMT Seminar Post-Mortem (Part II)

Last week, I wrote part I of a post-mortem from a fantastic MMT seminar at the Levy Institute earlier this month. There is a TON of material to cover, so I am sharing what I consider to be the most important takeaways. Last week I wrote about the Fed; below are notes on inflation. Without further ado:


Inflation has been all over the news for the past 6-9 months, and the public's discourse around it has intensified. Inflation is an incredibly emotional/moral/political topic, which I suspect is because it effectively serves as a tax on rich and powerful people. As we have written about in the past, modest inflation and low rates helps low-income people who are net debtors: they generally experience higher incomes while their debt obligations remain fixed. Rising rates and unemployment are devastating for this cohort, which is why it is so shameful that people in positions of power and privilege are demanding the Fed to hasten its rate hikes in order to put people out of work. It's astonishingly cruel and out of touch with the American people to be spewing this rhetoric. I will never understand how intentionally putting people out of work can possibly give us a collective better quality of life in real terms. But that is a discussion for another day.

Anyway, the most important fundamental takeaway from our roundtable on inflation came from Randy Wray, who put it concisely, "money is a stock; spending is a flow." This is critically important. Most of us think of inflation as a general rise in prices due to an increase in the supply of money (i.e. all things being equal, increasing the supply of money makes it less valuable and depreciates its purchasing power). However, Wray's point is an important distinction. Prices going up (or down) reflect transactions. Transactions reflect spending, where money flows from one party to another. We use transacted prices (and some imputed ones, based on surveys) in order to come up with a reasonable guess of the rate of inflation (e.g. CPI, PCE). So using concepts like the "money supply" (as most mainstream economists and analysts do) is nonsensical for the purposes of predicting and analyzing inflation. The water in a bathtub does not magically become "faster" when one has increased its supply; however once the drain pipe is pulled, the increased mass would cause the flow rate of the water moving through the drain pipe faster. Gravity forces the water through the drain pipe, and the additional force from the added water mass causes it to move through the pipe faster. Arguing that increasing the stock of money causes inflation is like arguing that increasing the quantity of water in a tub makes it faster. It's a ridiculous assertion, because if the drain hasn't been pulled, then the velocity of that water is still zero, just as it was before!

Two additional points on the money supply myth. First, the panel confirmed my proposal that, to the extent there may be periods when both inflation and increases in the money supply are high (which is questionable at best), analysts and economists have the cause and effect backwards: increasing the supply of money doesn't by itself make prices go up, but an increase in the real costs of goods and services may be the cause, rather than the effect, of new money creation. The example I used is if a retailer normally buys a product from a wholesaler with a four-week lead time, and supply chain disruptions suddenly causes that same product to have a four-month lead time, then the retailer can't realize a sale of the product until it is actually delivered, and will need additional credit to make up for the shortfall in cash flows it would normally generate. The real shortage of that product, combined with the additional money/credit required to finance it may be reflected in a higher price.

This example provides a bridge to the second point, which is that the demand for money is equal to the supply. Because modern money is simultaneously one party's asset and another's liability, the demand for money must equal supply. There must be a party willing to have a money deficit in order for another to have a money surplus. This is why the "increased money supply causes inflation" trope is so ridiculous. Increasing the money supply requires a party to simultaneously be in deficit, so the aggregate change in financial assets and liabilities is zero! What matters is how that money is spent. Looking at things like M2 as a measure of the money supply is misleading, because it assumes money exists on its own. The Fed defines M2 as:

 "A measure of the U.S. money stock that includes M1 (currency and coins held by the non-bank public, checkable deposits, and travelers' checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds."

It ignores the fact that currency and coins held by the non-bank public, checkable deposits, travelers' checks, savings deposits, small time deposits, and shares in retail MMMFs are assets for their owners but liabilities for their issuers! It's this dual-entry accounting, "two sides of the same coin" reality that most people fail to understand. Increasing one person's supply of money requires an increase in someone else's deficit. So unless the government, as the monopoly supplier of money, is willing to run a deficit, then the only way for a person to have a surplus of money is for someone else to be willing to take on debt. Therefore, treating money as if it were a fixed, scarce commodity that follows simple supply/demand curves is incorrect. Money supply is equal to demand.

Some may argue that the American Rescue Plan may not have caused inflation but it increased the "potential" for inflation. Going back to our bathtub water analogy, the money printing is akin to doubling the supply of water, causing an increase in potential energy that, once the drain was pulled, created conditions for higher kinetic energy output. The problem with this argument is that the US federal government already has an unlimited amount of money it can create. Thus, there is already infinite "potential" monetary energy in our modern money system. Actually converting that potential energy into kinetic energy requires a political process. If the votes are there, the checks will clear. If the new money is used productively, we all experience a raise in living standard. If not, we don't.

Turning to MMT's view of inflation: MMT makes a distinction between true inflation (i.e. fiscal spending beyond real capacity) and bottleneck or supply-side inflation. The current bout of inflation is very clearly the latter. There is ample evidence that we are nowhere near our full productive capacity, the current inflation is supply/bottleneck-driven, and that it's real resources that matter. As Keynes wrote in How to Pay for the War, by thinking about real resources, the government can increase its spending by a large degree without causing excessive inflation. See selected slides below:

Source: Y. Nersisyan (Levy Economics Institute)

The last slide is illustrative here: between 1942 and 1944, federal government spending as a % of GDP went from 30% to 45%, while the rate of inflation collapsed from 11% to 2%. By executing a successful "war bonds" program, the US government was able to convince consumers to tighten their belts and hold off on spending until after the war. If it hadn't, and consumers kept regular spending patterns on goods, inflation would have exploded, because the supply of consumer goods was limited thanks to the government requiring producers to shift from goods to supporting the war. Indeed, I visited the Sagamore Rye distillery in Baltimore, MD a few years ago and they explained how rye distilleries were common in the area pre-WWII, but they were all forced by the government to switch to producing ethanol to help fuel aircrafts for the war. By encouraging thrift, the US government was able to free up real resources  that helped it win the war, and the savings that Americans had accumulated were spent after the war was over, leading to an economic boom. This was a far better outcome than prior instances, such as post-WWI, when an inflationary war period was followed by a huge bust as people's savings were depleted.

To further drive the point home that increased money supply does not cause inflation, consider the following, which compares the year-on-year change in M2 (blue) with the year-on-year change in CPI (red):

The change in M2 appears to be inversely correlated with the change in inflation, which runs completely contrary to the neoliberal/monetarist view. Even Fed Chair Powell admitted recently that an increase in M2 has little correlation with inflation.

Looking at the latest CPI data, it becomes overwhelmingly clear that the cause of the recent inflation is predominantly supply-driven. Most of the inflation is directly related to higher energy prices, which feed directly into food prices:

Source: M. Nikiforos, Levy Economics Institute

Energy prices are high for a variety of reasons, including declining production in the US, which is still below pre-COVID levels:

And two substantial oil refineries have been closed since December 2020:

Which has led to crack spreads (i.e. what oil refineries charge for refined product vs. the price of crude) at all-time highs:

Meanwhile, the Saudis (who are a quasi-monopolist as they are the swing producer for oil) continue to raise their prices.

The other big items are shelter and things related to transportation: new and used vehicles as well as transportation services, which have been supply-constrained thanks to a chip shortage.

Importantly, the inflation is NOT driven by higher wages, as real wages have on average declined year-on-year, so the idea of a wage-price spiral is taking place is total nonsense:

Source: M. Nikiforos, Levy Economics Institute

Meanwhile, the 10-year breakeven rate for inflation is around 2.3%, and trending lower:

Finally, Randy Wray recommended an inflation measure I had not heard of before: the Trimmed Mean PCE Inflation Rate, published by the Dallas Fed. The definition of this measure is as follows:

The Trimmed Mean PCE inflation rate produced by the Federal Reserve Bank of Dallas is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). The data series is calculated by the Dallas Fed, using data from the Bureau of Economic Analysis (BEA). Calculating the trimmed mean PCE inflation rate for a given month involves looking at the price changes for each of the individual components of personal consumption expenditures. The individual price changes are sorted in ascending order from “fell the most” to “rose the most,” and a certain fraction of the most extreme observations at both ends of the spectrum are thrown out or trimmed. The inflation rate is then calculated as a weighted average of the remaining components. The trimmed mean inflation rate is a proxy for true core PCE inflation rate. The resulting inflation measure has been shown to outperform the more conventional “excluding food and energy” measure as a gauge of core inflation.

The result is a smoothed measure of inflation that is arguably a better measure of the change in the "general price level." The latest reading for this measure is roughly 3.5% - high for recent history, but by no means extraordinary relative to the 1970s and 1980s:

As we can see, too, this is arguably a more useful measure than PCE and CPI, which are much more volatile:

Bottom line: this is a supply/bottleneck driven inflation that will prove to be a temporary setback. Unfortunately, the Federal Reserve is buckling under the political pressure to "do something" about inflation, and is hiking rates as the economy slows down. This is likely to exacerbate the slowdown and cause a recession, and unless Congress passes a new spending package, we are risk of a financial crisis. More on that in Part III.

UPDATE 7/5/22

I wanted to include this on the original post but couldn't find a source for it. Federal Reserve Chairman Jerome Powell spoke recently at the European Central Forum and said the following:

"I think we now understand better how little we understand about inflation"

This is an absolutely remarkable admission. The Fed employs over 400 Ph.D. economists, and yet here is the person in charge acknowledging that they don't even understand one of the most important topics in economics! The problem here is that these Ph.D. economists have all been taught a fraudulent form of economics, known in the MMT community as "neoclassical," "neoliberal," or "market fundamentalism" which became the standard in US universities in the 1970s thanks in large part to the influential University of Chicago economics department. They use Dynamic Stochastic General Equilibrium (DSGE) econometric modelling to make forecasts that ostensibly have a terrible track record. As one young Ph.D. economist explained to me during the week at Levy, and I am paraphrasing here, but basically these models "work very well 95% of the time...but the 5% of the time they don't work, they blow up spectacularly." I don't think it is a stretch to say that sounds like a terrible framework to use for an institution that is supposedly in charge of overseeing the economy.

A recent paper released by Jeremy Rudd of the Richmond Fed found the following (emphasis added):

"Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation. A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors."

This highlights how broken the economics institutions in this country are. The Neoclassicals are the gatekeepers to power, prestige, and influence in the economics field, and some insiders are starting to realize their profession is profoundly uncritical and lacking in analytical or empirical rigor. Debunking their ridiculous myths, and offering better, more coherent, more accurate economic models and frameworks is critical for the future prosperity of the people in this great nation. Jay Powell is admitting the quiet part out loud, acknowledging that they don't know what they're doing. This is an opportunity for the MMT community to step up and right the ship!

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