Saturday, January 16, 2010


Mankiw Gives Himself an Out on Inflation

Phil Maymin emails me Mankiw's op ed and wants commentary. Some excerpts:
IS galloping inflation around the corner? Without doubt, the United States is exhibiting some of the classic precursors to out-of-control inflation. But a deeper look suggests that the story is not so simple.

Let’s start with first principles. One basic lesson of economics is that prices rise when the government creates an excessive amount of money. In other words, inflation occurs when too much money is chasing too few goods.

A second lesson is that governments resort to rapid monetary growth because they face fiscal problems. When government spending exceeds tax collection, policy makers sometimes turn to their central banks, which essentially print money to cover the budget shortfall.
To be sure, we have large budget deficits and ample money growth. The federal government’s budget deficit was $390 billion in the first quarter of fiscal 2010, or about 11 percent of gross domestic product. Such a large deficit was unimaginable just a few years ago.

The Federal Reserve has also been rapidly creating money. The monetary base — meaning currency plus bank reserves — is the money-supply measure that the Fed controls most directly. That figure has more than doubled over the last two years.

Yet, despite having the two classic ingredients for high inflation, the United States has experienced only benign price increases. Over the last year, the core Consumer Price Index, excluding food and energy, has risen by less than 2 percent. And long-term interest rates remain relatively low, suggesting that the bond market isn’t terribly worried about inflation. What gives?

Part of the answer is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.
Now Phil was exasperated by the part I put in bold, thinking that Mankiw was saying good intentions will somehow neutralize money's ability to raise prices. I think Phil is correct that Mankiw is being very naive here--in fact I have a Mises Daily coming out soon which shows how the Fed's operations really are equivalent to a king running the printing press to cover the budget deficit.

However, just to clarify, what Mankiw means is that investors aren't freaking out (yet) because they think Bernanke is only doing what he needs to, to rescue the economy. So they view the recent growth in the monetary base as a one-off event, as opposed to a willingness of the Fed to cover health care reform and Social Security.

Mankiw then goes on to talk about the Fed's ability to rein in price inflation when the time comes, through selling off assets and paying higher interest rates on excess reserves. I have dealt with Mankiw's views in this article.

But what intrigues me about Mankiw's latest is this conclusion:
Investors snapping up 30-year Treasury bonds paying less than 5 percent are betting that the Fed will keep these inflation risks in check. They are probably right. But because current monetary and fiscal policy is so far outside the bounds of historical norms, it’s hard for anyone to be sure. A decade from now, we may look back at today’s bond market as the irrational exuberance of this era.
I think those of us not in the annals of power forget the constraints that these guys (and gals) are under. If Mankiw thinks we're screwed, he can't just come out and say it.

Instead, he has to give a very neutral, let's-cover-all-the-bases article, and then almost as an afterthought say, "By the way, yields on bonds right now are insane."

The only way these two statements can simultaneously be true:

1) "what Mankiw means is that investors aren't freaking out (yet)"

2) "[Mankiw] say[s], 'By the way, yields on bonds right now are insane.'"

is if investors are not freaking out yet, but should be. Which defeats the whole purpose of his op-ed. Correct?
Large deficits, doubled monetary base, classic ingredients for inflation ... but CPI<2%, low long-term rates, and the printed money's not for govt spending but for the financial system. As the economy recovers, banks lending reserves may trigger inflation.

I wonder if the govt taxing away reserves would trigger inflation?
Dear Dr. Murphy, I apologize for being OT here, but then again this is sorta related.

I was wondering if you'd be interested in checking out an AWESOME one hour blog talk radio show tonight. The topic is the very latest news on the bailout, Treasury, and Fed front--and you know how that's been heating up these days! Both the host and guest REALLY know their stuff (no, neither of those are me, ha ha).

More info here:

It would be AWESOME if you could join in the chat room and/or call in a comment/question! If you can't make it, the podcast can be downloaded anytime via the No Quarter or Sense on Cents websites.
Dr. Murphy, I was just curious: you are convinced that very high inflation is just around the corner. You even made a rather large bet with David Henderson about it.

So if you're right and all of mainstream economics is wrong, what are the implications? Will this be a triumph of Austrian analysis? Is this a strong litmus test for the correctness of your general economics viewpoint?

And what about if you're wrong - is the reverse true?

Just curious.
I am always left feeling like I am missing something really obvious, or the world of economics is populated by ignoramuses (or, more likely, liars).

Every time this comes up, Fed/Government apologists (I am talking about you Krugman) always bring up present market interest rates rates being very low, meaning that inflation really isn't a problem we have to worry about, but what was the market thinking 3 years ago? If you had gone allin on 30 year treasury bonds 3 years ago, you would have made a nice bit of money by last winter, and if you went allin then, you would have had a haircut and a scalping by now.

And, what was the market thinking in terms of interest rates in 1970 that would have predicted 1973-1980?

Yeah it's a tough one. On the one hand, if I turn out to be right I want to be able to say, "See! Austrian economics has predictive power, so on your own terms mainstream guys, our verbal analysis is better than your fancy models!"

On the other hand, I'd much rather lose $500 to Henderson than have publicly put Austrian monetary theory on the line or something.

Since I don't have the authority to bet Austrian theory--i.e. I don't own it, and there are a bunch of self-professed Austrian fans and maybe even professional economists who are forecasting price deflation--I really don't want to go that route. It would be devious of me to claim I'm wagering Austrian econ against Mankiw's mainstream stuff, because if I win then every Austrian will say, "Murphy called it!" whereas if I lose Austrians can say, "Our theory was never about predictions, Bob was shooting his mouth off."

So what can I say? I am informed by Austrian theory, and I think we're getting large price inflation. However, I think it's not so much Austrian theory as my libertarianism that makes me think Mankiw is being a fool on this. I.e. we all understand the forces at work here, it's just that Mankiw thinks the Fed wants to help the economy whereas I think they might be trying to do something dastardly and in any event I know the government is a blunt instrument.

Last point: For SURE it was Austrian econ that showed me that a big recession was coming. (I realized it much later than people like Mark Thornton, but only because I hadn't been using ABCT. Up until the summer of 2007 I had just been responding to critics who were saying things like, "The big trade deficit means the economy is done for," which by itself is a non sequitur.)

But on the inflation/deflation stuff, I think what really puts me apart from someone like Mish is that (I think!) I understand money and banking better than he does. You could say that's due to my Austrian background, since Mises and Rothbard are so anal about the distinction between money & credit etc., but I don't know how much of it is an Austrian background versus how much of it is simply careful thought. In other words I think guys like Mish and Mankiw are just firing off their conclusions after taking the thought process down a few steps, without following through or without subjecting their views to a "stress test" and making sure various thought experiments check out.
Austrian theory just says that inflation (asset inflation, capital goods and or consumer price inflation) will be higher than otherwise, not what level of CPI inflation will there be.

Till now, tow effects works has deflationary: share capital increases in banks are quantitative deflationary (and they have been large) and the shrink of total commercial banks credit is also quantitative deflationary.

This should be on of the reasons why M2 has been so stable.
Trying to think through the implications of paying interest on reserves makes my brain hurt.

Wouldn't paying interest, in order to prevent inflation, be inflationary in itself? The Federal Reserve would be adding to the monetary base by crediting the banks' accounts with the interest. In order to achieve its stated goal of preventing massive inflation, the Fed would have to remove money from circulation - i.e. sell back all the stuff that it added to its balance sheet. Right?
Daniel Hewitt wrote:

Wouldn't paying interest, in order to prevent inflation, be inflationary in itself?

I think so too Daniel, but you and I are apparently the only two.

It wouldn't be inflationary in the sense that it would immediately add to M1 or M2, but if the problem is excess reserves starting to leak out, I don't see how it's a fix to make the excess reserves grow more quickly.
Daniel and Bob, now three. :-P

I am not an profesional economist, I am selft taugh, but I think is very obvious that this mesure of the Fed is not going to prevent inflation, but only has the capacity of delaying it (at the cost of having a bit more inflation). The Fed knows this and the only reason why they are doing it is because they are not worried about rising prices, they are ok with that, its the way they want out of the crisis.

They are going to use this to CONTROL the rate at wich prices raise during the next years. They know hiper-inflation has a important psicologic component. That once and so they want to be able to control the amount of new credit/money that goes into the economy. They want stagflation and not hiperinflation (although if they wanted hiperinflation they could use this tool to get it too).

Basically, with this they are just controlling the rate at wich the new money goes into the real economy, and that is what they want because they have no intention on stoping the rising prices, because they know they can not avoid it wihtout letting the big banks fail.
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