The Biden Administration is having a tough time explaining exactly why inflation is rampaging throughout the economy at more than 8% annualized after a long period when the rate of price inflation was tepid at about 1.6%, on average. The surge in prices has been blamed on a variety of factors, including corporate greed, the oil industry, Putin, tight labor markets, and supply chain disruptions. Excluded from the list, so far, is bad karma, but with time, that too may change.
The reason for all the flailing and finger pointing is not just political. Actually, it’s theoretical. The administration’s playbook is based on the ninety-year old Keynesian economic model that was spawned during the Great depression of the 1930’s. In that model, markets do not operate efficiently; people do not react to new information and incentives play no role in shaping how people go about deciding whether and where to produce or not produce.
Instead, government spending is seen as the principal fuel source propelling economic growth. In the circuitry of that model, such spending is good until it becomes bad and it becomes bad when the various pools of resources necessary for production, such as labor, thin out. At that point in the Keynesian model buyer’s markets for previously ample resources become seller’s markets for increasingly scarce resources, which then become more costly to hire and less efficient to employ.
That’s why Keynesian economists worry so much about how much slack there is left in the economy. In econ-speak, the fear is that if aggregate supply (AS) is overwhelmed by aggregate demand (AD) the result will be a rising price level as higher production costs get embedded into higher finished goods prices.
In reality, while it’s true that higher production costs can contribute to menu price markups for a single company, the story is different on an economy-wide basis. If the price of any particular item is rising in the economy, then somewhere else in the economy some other item’s price must be falling in relative terms.
The reason is that labor cannot be in two places at the same time. An hour devoted to the production of Good A must come at the expense of Good B and vice versa. Prices in the market reflect such trade-offs.
In comparison, Keynesians theorize that all prices will rise when the cost of production goes up. This leads them to conflate the relative price of output with the nominal price of output. To see the nature of the error, suppose at a moment in time that oil is selling at $100/barrel and bread is selling at $2 per loaf.
Dividing one dollar price by the other gives us the relative price of oil as measured in physical units of bread, and vice versa. In this particular case, the bread-price of oil, that is, how many loaves of bread would be required in payment if someone wished to acquire a barrel of oil at the corner trading store, is seen to be 50 bread loaves per barrel. Reciprocally, the oil-price of bread works out to be 1/50th of a barrel per loaf.
This means that in the same amount of time that an incremental barrel of oil could have been produced, 50 bread loaves could have been produced instead and vice versa. Otherwise prices and quantities would have to further adjust to restore balance between buyers and sellers for each of these products.
Now suppose that oil rises in dollar price to $150 per barrel due to an increase in demand and that oil’s relative price doubles to 200 loaves of bread per barrel in the real goods market. Will this increase in price cause inflation? The answer is, no. Since all prices are relative, bread in this example will decline to 1/200th of a barrel per loaf, or $.75 per loaf.
In effect, an increase in the demand for oil will draw resources into the oil patch and away from the bakery, where, simultaneously, a relative decrease in demand for the production of bread will be experienced. Likewise, on the supply side, if the capacity to produce oil were to decline, say, due to onerous regulations, we will get similar results. In this case, however, an absolute decline in how much oil can be produced will leave oil pricier in terms of bread and vice-versa and by implication, unless resources let go from the oil business are able to find jobs in the bread business, the economy as a whole will contract. [Editor’s note in italics added on 6/16.]
The takeaway is that rising relative oil prices cannot cause inflation any more than falling relative bread prices can cause deflation. The same holds true at the macro level of analysis.
We live in an age of online ordering and 3rd-party deliveries. If, nationwide, more delivery drivers are taking to the roads but not enough lanes are being added to accommodate the extra traffic, then we can expect delivery times to increase in the economy. The “time-price of output” - output’s relative price - established at the intersection of aggregate demand and supply in the real goods market, will rise. Will this be inflationary? Of course not.
To understand how changes in the price level come about it’s necessary to separate what is taking place in the real goods market, where relative prices are established, from what is taking place in the market for money, where the value of the dollar is established.
If, in the real goods market, more delivery orders are getting completed, then more currency will be needed to support the total growth in transactions. Thus, regardless of whether the time-price of output is rising (there is less time for play) or falling (there’s more time for play) absent an increase in the money supply, economic growth will be innately deflationary - not inflationary as the Keynesians would have us believe.
Today, the unemployment rate is 3.6% and the rate of inflation is 8%. Flash back to December 2019 when the unemployment rate was the same, 3.6%, but the rate of inflation was just 1.8%. What has stayed the same and what has changed?
We know that the 2017 tax rate reductions enacted during the Trump administration, that narrowed tax wedges between buyers and sellers, have remained in place. However, the tariffs on China, that worked in the other direction, are also still in effect.
In comparison, under the Biden administration’s policies, energy independence has given way to a 9% decline in oil production. Also, a massive $1.9 trillion spending bill was passed in March 2021.
So the puzzle to be resolved distills down to this: Has the economy continued to grow through early 2022 due to the extra spending? Or is the continued growth better explained by the long-wave net positive effects that the tax rate reductions have had, despite the combined impact of the tariffs and the increased spending?
In the Keynesian model, the answer is that it’s the former. The reason is that in the Keynesian model when the government spends a dollar the consequence is that more spending will then ensue. This is commonly referred to as the multiplier effect. In the algebra of the model, person A, upon receiving money from the government will then spend a percentage of that money on person B , who will then spend that same percentage on C and so on until there is no one left to hire, that is, as long as the amount of spending by the government was large enough in the first place. Call this what it is: critical spending theory, CST.
In contrast, in the Supply-side formulation, the GDP is really just the sum of all trades measured in dollars. Therefore, in order for growth to occur due to an increase in government spending, either more goods and services must be brought to market from the private sector to trade for the government’s product, or increases in the government’s product must act in such a way that more trades are facilitated than would have occurred without the spending. To date, no evidence has been offered that the spending spree was responsible for either.
By focusing on what’s taking place in the real goods market in relation to what is taking place in the market for money, a vastly different conclusion about the cause of today’s inflation is reached and we gain insight into where we are heading from here.
In the Supply-side framework the value of the dollar, literally, the goods-price of money, is established at the intersection of demand and supply in the market for money. The demand for money is largely based on the market’s confidence in the current and future trajectory of output relative to the trajectory of the supply of money, the province of the Federal Reserve.
If output is waning or expected to wane, while at the same time the Fed is pumping outsized increases in the amount of money into circulation, you just know the result will be a sinking dollar. The evidence is more than anecdotal.
As early as the day after the 2020 election, crypto currency prices began their steep ascent alongside skyrocketing real estate, gold, commodities, art and even used cars.
Crypto Prices:
Such market concerns were reinforced by the sheer magnitude of the Federal Reserve’s continued monetary intervention during 2021 when the economy was well on its way to full recovery. The dollar amounts of debt monetization are nothing short of breathtaking.
For perspective, consider that between 2011 and 2021 the national debt doubled by $14.0 trillion from $14.7 trillion to $28.7 trillion. In the two years between 2019 and 2021, owing to increased government spending and the pandemic-related loss of tax revenue, $6.2 trillion was added to the national debt. Of that $6.2 trillion increase, 49.1% or, $3.0 trillion, was purchased by the Fed.
The Fed also purchased $1.1 trillion in non-Treasury securities. So, all told, in just two years the Fed added $4.16 trillion in total liquidity to the economy or 2.56x the change in GDP. That’s a whole lot of money to add to the economy in a short period of time.
In the normal course of events, when the Federal Reserve purchases securities through open market operations the funds received by note holders will be deposited in the banking system. At that point they become available for reintroduction into the system through ordinary collateral-backed commercial lending — the process through which goods and assets that are being brought to market are monetized.
In a perfect world, the growth of money and the growth in output would match up close to a ratio of 1 to 1 and the rate of inflation would approach zero. In fact, as shown below, between 2011 and 2019, the growth in M2 in relation to the growth in nominal GDP was 1.1x and inflation was low, averaging just 1.6% per year, even as the national debt was ballooning. So, it’s fair to say the Fed and the commercial banking system were pretty much doing their jobs properly between 2011 and 2019 -- the national debt was not getting monetized.
However, things went awry during the pandemic. Between 2019 and 2021 the growth in M2 exceeded the growth in GDP by 3.5x, with the result that by year-end 2021 there was about $4.11 trillion in excess money in circulation in the economy. In fact, there would have been even more money in circulation if the banking system was not being paid by the Fed, .4% per dollar held at the Fed, to refrain from lending out excess reserves of $3.88 trillion during 2021.
How long will it take to work our way through this money overhang? If the economy were to continue to grow at the same real rate as it did from 2011 through 2019, 2.28%, on average, it would take about 7.3 years to mop up every last excess dollar created during the previous two years and this assumes the Fed had decided to slam on the brakes ‘yesterday’... which, of course, it did not. Rather, as of today, the money spigot is still turned hard to the left.
What’s particularly disturbing about all this is that a portion of the $4.11 trillion in excess money floating in the system is undoubtedly due to the turbo-leveraging of financial and real estate assets since inflation-based gains on existing assets can serve as collateral for new loans. What we have here is a financial bubble in the making that is about to burst exacerbated by a widening wealth gap between asset holders and non-asset holders.
Small wonder that some people have felt moved to take to the streets in protest. They may not understand capitalism, but they do know when their prospects for future wealth accumulation are slipping away because the cards are stacked against them-- a form of plunder.
There are other side effects to consider as well. Whenever the Fed produces money before output has actually been produced, far from germinating more growth as per what Keynesian economists and their cousins in the MMT camp (Modern Monetary Theory) would have us believe, instead three things are likely to occur.
We can expect that 1) the value of the currency already in circulation will get diluted (some people will be helped and others hurt), 2) the next generation of taxpayers, our kids, will get encumbered with debt and 3) growth-destroying implicit taxes are likely to get introduced into the system via the redistribution of purchasing power that undermines the reason for using a common currency in the first place.
To see how this works, imagine two merchants situated at opposite ends of a town square. One sells apples; the other sells bread. Each item can be sold in smaller units, such as ½ a loaf, etc. Initially, there are no other consumers so the commerce is strictly bilateral and the merchants use a single dollar as the medium of exchange so the cost of carriage is one-way, i.e., the apple person does not have to carry apples to get bread and vice versa.
One day a third party, freebie, shows up at the market carrying a single government-produced dollar but is otherwise empty-handed. Since freebie has nothing tangible to offer in trade with the merchants already in business, total output will now get divided three ways, but since the extra dollar in the system can be used to buy either 1/2 loaf or 1/2 pound of apples, each merchant will suddenly face a tax rate of 50% when doing business with this new customer
Put yourself in the shoes of either merchant. How will you react? One possible response would be to raise prices in order to attempt to shift the burden of the monetary tax onto the new consumer by reducing the amount of goods exchanged for currency at the checkout counter. However, in order to shift the entire burden away from themselves the value of the dollar, goods per dollar, would have to approach zero. This would render the currency worthless. And that would be bad.
Another alternative would be to try to evade the tax by only accepting a particular digital currency that was not easily accessible by the consumer. At present, when using a digital currency there are time delays, conversion fees and the transaction are irreversible. However, if those conversion fees were to decline sufficiently then it would make sense for the merchants to only conduct their business via digital currency. Taken to the limit, the demand for dollars would decline to zero.
Another alternative is that the merchants can stick with using the dollar as currency, but they also have the option to reduce the amount of work they do — a classic Laffer-curve type effect in which over-taxation and regulation leads to an exodus from tax-revealed activities in the marketplace. In that case, there will be fewer goods available for more money to chase.
The moral of the story is that too much money chasing too few goods does not just mean buyers are bidding up the price of goods and services in an auction-like way. Purveyors of goods and services will also try to take evasive actions to protect their incomes and the value of their time — the ultimate scarce resource in the universe as we know it.
That’s why the Fed should be slamming on the brakes right now. This would force the Treasury to borrow at true market rates and thus end the charade that borrowing costs were ever near zero %. Also, swift action will spare the economy the brunt of the impact that taxes levied on inflation-based capital gains will have on the economy.
The problem is that the gain on the sale of capital assets is not adjusted for inflation. For example, suppose you buy a stock for $100 and sell it a year later at $108 owing to 8% inflation over the course of a year. At a 20% tax rate the paper gain of 8% will become a real loss of $1.60 upon selling. To achieve breakeven the stock would have to rise approximately 10% continuously. At some point, due to the cumulative losses from compounding, it will make sense to never sell, called a “lock-in effect”, until a step up in basis has taken place as would occur through an inheritance. Call this posthumous indexing.
Karl Marx said that capitalism would destroy itself by creating the conditions where workers would no longer feel they had a stake in the game and so would revolt. A variation of that thought is that investors will refrain from forming capital assets when inflation is high, productive growth low and taxes are levied regardless of whether there are actual gains on the investment.
Below we see that if inflation were to continue at 8% while real annual growth fell below 1.27% then taxes on fictitious gains would destroy the incentive to invest. Capitalists will revolt by sitting on their hands. But then, the fun, sardonically, will really begin as wages decline -- the result of diminishing returns to labor per unit of capital.
That’s why, ideally, the Fed should be setting up a mechanism that will stabilize the value of the dollar against an anchor commodity or synthetic security that people see as an inflation hedge. In the past that job went to gold.
In the meantime, just as we saw during the early ‘80’s, when Fed Chairman Volker raised interest rates to 20% to reverse the relentless inflation then underway, an aggressive course correction in monetary policy today will likely spell a recession.
The explanation, then as now, is not because the punchbowl was being taken away, but instead due to the price change upheavals that will be set in motion in the real economy as dollar changes drive up hedging costs and previous buy-sell relative-price agreements no longer make sense.
In addition to the role that the Fed’s monetary contraction played in promulgating the two recessions between ‘81 and ‘83, in the Supply side framework, these downturns also are seen as an unintended consequence of the way the Reagan tax rate reductions were phased in. Recall, the Reagan legislative program lowered marginal tax rates across-the-board from a maximum of 73% down to 50% over the course of 3-years. To the extent possible, people put off transactions during that 3-year phase-in period in anticipation of being able to conduct business at lower tax rates in 1983.
Ultimately, the policy was a success especially, upon fortification in 1986, when the highest marginal tax rate was reduced to 28%. What was then the longest peace-time expansion was set in motion. It lasted until Bush Sr. raised tax rates in 1990. Was it a coincidence that a recession arrived virtually contemporaneously with the Bush tax increases? In the Supply-side framework, no.
Since the goal today is to mop up excess currency in the system, and as we’ve seen there’s a lot of mopping to do, we should be asking ourselves what’s the best way to promote the growth of goods and services in relation to the money already in circulation?
In the Supply-side framework, there is an intuitively appealing circuitry to guide fiscal and monetary policy. By lowering over-burdensome tax rates and regulations it’s possible to drive increases in production and commerce in the real goods market, which then drives increases in the demand for money in the economy. The goods-price of money will rise and inflation will subside.
The Fed’s role in this type of framework is, therefore, banal. It should just respond to increases or decreases in the demand for money via changes in the money supply, meaning its sole purpose should be to maintain the value of the dollar.
Unfortunately, since it’s not likely the Biden administration will adopt a Supply-side fiscal platform anytime soon -- indexing capital gains would be a major step forward -- it appears that all of the inflation-fighting is going to have to be done by the Fed. Doing nothing or too little is not an option. Every month of delay is a month in which the impact of the lock-in effect will grow. Investors can only wonder: Are they happy because the nominal prices of their assets are rising or sad because when taking taxes into account they are losing money in real terms?
Voters do not like inflation. They want success to be achieved through rolled up sleeves and ingenuity; not adulterated money that helps some but not others. If the Fed completes the task of wringing out seven years’ worth of excess money growth within the next 12 months or so, the Biden administration may have a fighting chance in 2024. A lot will depend on whether the electorate believes that the administration’s fiscal policies had nothing to do with the market sell-offs and declining growth rates that have already begun.