Academic Agent has got into another row on MMT, but this time with someone called “Adam Friended.”
In brief, “Adam Friended” responded to Academic Agent in the following video on the issue of MMT and price inflation:
Academic Agent then produced this response on MMT here:
Academic Agent is correct that Covid welfare payments and furlough schemes were not the fundamental drivers of inflation in some goods. It is also true that the Western world is far from full employment (though wage rises clearly can be a driver of price inflation through cost-based mark-up prices).
Unfortunately, “Adam Friended” did not correctly describe the causes of the price inflation in certain goods at the moment, and worse still he does not himself properly understand MMT or Post Keynesian economics, and fails to understand that the naïve Quantity Theory of Money is rejected in MMT and Post Keynesian economics. So this debate between Academic Agent and “Adam Friended” stems from the failure of the latter to correctly state MMT or Post Keynesian theories.
The fundamental causes of the inflation seen in certain goods recently are as follows:
(1) disruption to supply chains because of Covid and lockdowns has caused supply-side inflation, especially in factor inputs. Some nations have also restricted exports of key goods, and lockdowns, in some cases, badly affected production in places like China. In other cases, some nations hoarded supplies of certain food and medical supply products, which restricted overseas exports and caused some inflation.
(2) the price of oil has been rising sharply since last year, and since energy is a fundamental factor input cost, the rise in costs is passed on via cost-based mark-up prices;
(3) there has been disruption of agricultural production and inflation in certain food products and in some agricultural inputs. For example, lockdowns and closing of borders have disrupted production and processing of agricultural goods.
So, in other words, the recent inflation in certain goods prices is mainly and fundamentally caused by real factors like supply disruptions, lockdowns, hoarding and shortages, not monetary factors. Some demand-pull inflation after supply disruptions has happened, but the real factors are more important, and, as we will see below, Austrians like Academic Agent fail to understand the true extent of demand-pull inflation.
However, it is important to put this into perspective via the general price indices.
American and UK inflation is historically low, as we can see here for the US and here for the UK (just click on the “25Y” or “Max” tabs above the graphs to see the long-run historical inflation rates). None of this has caused high or even moderate general price inflation.
Academic Agent’s fundamental claim in his video (see his comments from 35:18 and 36:09) appears to be that expansion of the money supply via central banks is the fundamental driver of the price inflation in some goods today. This is absurd, and the actual evidence, as I stated above, shows real factors were the driver of the inflation because of supply disruptions, lockdowns, hoarding and shortages.
Worse still, Academic Agent in his reply video makes other errors and fails to understand MMT and even his own Austrian theory.
Let’s review these errors below.
The Austrian Theory of Price Inflation
Academic Agent is so ignorant he actually states in his video that the “Austrian theory would say ... inflation is always a monetary phenomenon” (see 11:36–11:42). By “inflation” Academic Agent clearly means “price inflation” and not merely expansion of the money supply.
Academic Agent is blatantly wrong about Austrian theory.
The idea that “inflation is always and everywhere a monetary phenomenon” is a Monetarist theory on the basis of the Quantity Theory of Money.
In reality, the Austrian school does not wholly subscribe to the Quantity Theory of Money, but have their own criticisms of it, because of the issue of Cantillon effects, as well as other criticisms.
Academic Agent is apparently unaware that the Austrian school actually has serious criticisms of the orthodox Quantity Theory of Money.
First let us take the view of Ludwig von Mises:
“ [sc. Mises] … agreed with the classical ‘quantity theory’ that an increase in the supply of dollars or gold ounces will lead to a fall in its value or ‘price’ (i.e., a rise in the prices of other goods and services); but he enormously refined this crude approach and integrated it with general economic analysis. For one thing, he showed that this movement is scarcely proportional; an increase in the supply of money will tend to lower its value, but how much it does, or even if it does at all, depends on what happens to the marginal utility of money and hence the demand of the public to keep its money in cash balances. Furthermore, Mises showed that the ‘quantity of money’ does not increase in a lump sum: the increase is injected at one point in the economic system and prices will only rise as the new money spreads in ripples throughout the economy. If the government prints new money and spends it, say, on paper clips, what happens is not a simple increase in the ‘price level,’ as non-Austrian economists would say; what happens is that first the incomes of paperclip producers and prices of paper clips increase, and then the prices of the suppliers of the paper clip industry, and so on. So that an increase in the supply of money changes relative prices at least temporarily, and may result in a permanent change in relative incomes as well” (Rothbard 2009: 15).
In other words, Mises denied that a given increase in the money supply (say, 5%) would lead to a direct, proportional and mechanistic rise of 5% in the general level of prices.
Strictly speaking, then, Mises denied the orthodox Quantity Theory of Money.
The naïve monetarists believe that there is a “monocausal” explanation of inflation: money supply growth which will cause direct, proportional increases in the price level, at the very least in the long run, even if Monetarists will accept short-run non-neutrality of money.
Friedrich von Hayek believed that a simple form of the quantity theory was a “helpful guide,” but was nevertheless a critic of the theory, both in the version of it propounded by Irving Fischer and the restatement of it by Milton Friedman (Arena 2002).
In particular, “Hayek criticized Friedman for concentrating too much on statistical relationships (between the quantity of money and the price level), claiming that matters are not quite that simple” (Garrison 2007: 3).
Modern Austrians continue to be critical of Quantity Theory of Money, like Jesús Huerta de Soto, who has the following to say:
“[sc. The equation MV=PT of the quantity theory] contains an undeniable element of truth inasmuch as it reflects the notion that variations in the money supply eventually influence the purchasing power of money (i.e., the price of the monetary unit in terms of every good and service). Nevertheless its use as a supposed aid to explaining economic processes has proven highly detrimental to the progress of economic thought, since it prevents analysis of underlying microeconomic factors, forces a mechanistic interpretation of the relationship between the money supply and the general price level, and in short, masks the true microeconomic effects monetary variations exert on the real productive structure” (Huerta de Soto 2009).
The Austrians think that quantity theory is inadequate because it ignores their theory that increases in the money supply distort relative price and the productive structure of an economy, which is, in essence, the Austrian Business Cycle Theory (ABCT).
If we dig deeper into Austrian view of inflation, we can find some surprisingly sensible analysis.
Frank Shostak has this view:
“the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services .... While increases in money supply (i.e., inflation) are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant – i.e., inflation is high – prices might display low increases.” Frank Shostak, “Defining Inflation,” Mises Daily, March 6, 2002.
The statement that prices “are determined by real and monetary factors” is empirically correct, but requires that the Monetarist view – defended by Academic Agent – that “inflation is always and everywhere a monetary phenomenon” is false.
So Academic Agent does not even understand the Austrian theory he comically defends!
Of course, even the Austrian view of Frank Shostak is seriously flawed in that it does not understand endogenous money or the widespread existence of cost-based mark-up prices.
In reality, most prices are cost-based mark-up prices which are relatively inflexible with respect to demand, either as compared with the 19th century or in the grossly unrealistic models of the worst sort of Neoclassical economics and Austrian theory. This means that increases in demand or purchases of goods via new money (most of which is simply created by private banks anyway via new loans) simply do not bid up prices rapidly or significantly in the way Austrians imagine, precisely because of relative price rigidity. This means that the extent of demand-side price inflation – though it does exist – is grossly exaggerated by Austrians.
To be clear: demand-pull inflation certainly exists, but it is often not the main cause of price inflation in the modern world, and its extent is much more limited.
Changes in the general price level are a highly complex result of many factors, and not a simple function of money supply.
Businesses will raise their prices for all sorts of reasons independently of a money supply expansion.
Often general price inflation is a cost-push phenomenon, in which
(1) workers or unions demand higher wages and businesses agree to these increases and/or
(2) prices of other factor inputs rise, and then businesses raise prices to reflect higher unit costs.
While a long-run, sustained price inflation does need a growing money supply to sustain it, the money supply is often not the causal factor in such price inflations, but the intermediary factor. Often, it is business and corporate use of cost-based mark-up prices and their pricing decisions, on the basis of the need for more profit or higher unit costs, which drive price inflations.
Monetarists make the mistake of thinking that the intermediary medium (money supply) is the only and fundamental driver of price inflation, when real factors underlie many movements in prices.
The MMT Job Guarantee
Academic Agent asks how a Job Guarantee will not cause high inflation under MMT.
The answer is that the MMT job guarantee is designed to pay a minimum wage, so that workers can be bid away from it to the private sector with higher private sector wages.
In cases where private sector employment already pays above minimum wage (which is very many sectors), there is no significant inflation issue.
It is true that there might be some wage inflation where private sector employment already pays a minimum wage and private businesses have trouble finding workers, but this process happens already, and is not going to cause the type of huge or significant inflation Austrian-school supporters like Academic Agent pretend will happen.
Quite simply, low-level price inflation is better for a modern economy than price deflation, since price deflation causes devastating macroeconomic effects, like profit deflation in the face of money wage rigidity, debt deflation, deferral of purchases of goods, and pessimistic business expectations.
The Austrian complaint that the MMT job guarantee might cause some low-level inflation is utterly spurious, since low-level price inflation is far better than price deflation.
BIBLIOGRAPHY
Arena, R. 2002. “Monetary Policy and Business Cycles: Hayek as an Opponent to the Quantity Theory Tradition,” in J. Birner, P. Garrouste, T. Aimar (eds.), F. A. Hayek as a Political Economist: Economic Analysis and Values. Routledge, London.
Garrison, R. 2007. “Hayek and Friedman: Head to Head”
http://www.auburn.edu/~garriro/hayek%20and%20friedman.pdf
Huerta de Soto, J. 2009. “A Critique of the Mechanistic Monetarist Version of the Quantity Theory of Money,” Economicthought.net
http://www.economicthought.net/2009/07/a-critique-of-the-mechanistic-monetarist-version-of-the-quantity-theory-of-money/
Rothbard, M. N. 2009. The Essential von Mises. von Mises Institute, Auburn, Alabama.
Shostak, F. 2002. “Defining Inflation,” Mises Daily, March 6
http://mises.org/daily/908
Academic Agent had a livestream here criticising my blog post that was a critique of his original video against MMT:
This stream is a train wreck. Academic Agent and his Austrian-school libertarians struggle to even accurately grasp Modern Monetary Theory (MMT).
I will not correct all the errors and misrepresentations here, or bother to correct every strawman argument.
But, first of all, let us just provide a knockout blow to Academic Agent and his minions. Throughout the earlier part of this stream, Academic Agent cannot understand how in a fiat money world, taxes and bonds do not, technically speaking, finance government spending. It appears that Academic Agent cannot imagine a state of affairs where a central bank directly monetised part of a government budget deficit, without concomitant bond issues, even though this has happened on numerous occasions since the abolition of the gold standard, as in Japan, Germany and New Zealand in the 1930s, America in World War II, and in post-1945 “tap systems” at central banks.
Under the historical “tap system” of issuing government bonds after the abolition of the Gold Standard after WWII, a number of Western countries (like Australia) for many years actually had their central banks purchase government bonds directly when such bonds were not all bought by private bondholders.
The system is explained by MMT economist Bill Mitchell at his blog:
“[around 1981] the Australian Office of Financial Management was set up as a special part of the Federal Treasury to manage federal debt. Previously, bond issues were made using the “tap system”, whereby the government would announce some volume of debt it wanted to issue at a particular rate and then sell whatever was demanded at that yield. Occasionally, given other rates of return in the financial markets the issue would not be fully subscribed – meaning some of the Government’s net spending would be covered in an accounting sense by central bank buying treasury bills (government lending to itself!). The neo-liberals hated this system and regarded it providing no fiscal discipline on government. They knew that by linking deficits $-for-$ with private debt they could more easily mount the debt hysteria and maximize their pressure on government to cut deficits and withdraw from the market.” Bill Mitchell, “D for Debt Bomb; D for Drivel,” Bill Mitchell - Modern Monetary Theory, July 13, 2009.
That is to say, Australia once had a “tap system” of direct purchases of Treasury bonds by the national central bank when the private sector did not wish to buy all bonds at some issue of government debt, which means, in layman’s terms, on various occasions the Australian central bank was just “printing money” to fund part of the government’s budget deficit. Did Australia collapse into hyperinflation when this happened? Did the Australian dollar totally collapse? No.
Even the US Federal Reserve originally had the power to directly buy US government debt, and this was done in 1942 (during WWII) and some other years after WWII as well.
Most recently, in Britain as hit by the coronavirus pandemic, the Bank of England has increased the “Ways and Means facility” (a kind of government overdraft with the central bank) that can allow the British Treasury to finance spending without direct and immediate bond issuing. This would effectively be short-term “printing money” to finance UK government spending and allow the British Treasury to temporarily bypass the bond market:
While at the moment, the British government says it will later this year borrow any money spent now unbacked by private bond issues, this is effectively a type of short-term MMT in action right now! How does Academic Agent explain all this if MMT is impossible?
Now let us go on to address the following major points:
(1) Quantitative Easing (QE)
Post Keynesians and MMT advocates do not advocate QE as a major policy tool.
The primary tool is fiscal policy. In a serious recession/depression, Keynesian deficit stimulus in the form of new, or improved, public infrastructure, public utilities, R&D and social spending is the primary method to get people back to work, and stimulate private investment and employment growth.
Money would be paid directly to any unemployed people hired by the state or to any business from which the state buys resources, and hence money would be spent into the economy as newly-hired workers and businesses spend money.
(2) The Purpose of Taxes in MMT
According to MMT, taxes function to:
(1) regulate aggregate demand; (2) free up real resources for the government to purchase when there is a high level of economic activity, or for people to whom government pays money (that is, state employees, or welfare recipients) (3) dampen inflation at times of inflationary pressures (4) address moral issues like gross inequality of wealth, and prevent a plutocratic system where highly wealthy people have so much money they can control democracy and governments.
MMT does not advocate the abolition of taxes because they still have an important role to play.
(3) Relative Price Rigidity
First of all, Academic Agent persistently commits a comical strawman argument when he is confronted with the reality of relative price rigidity: Academic Agent pretends this means that no prices ever change, or that all prices are rigid for long periods of time.
This is a pathetic and pathologically dishonest tactic. Academic Agent, at this point, is simply forced to use this tactic, probably because he cannot think of a plausible response to the widespread reality of relative price rigidity.
This strawman leads Academic Agent to his risible attempt to refute me by citing price data from 1972 (which, in point of fact, was a period of strong supply-side inflation!). Merely showing that prices change does not refute anything I said about relative price rigidity, because “relative price rigidity” doesn’t mean that no prices ever change. Of course, cost-based mark-up prices do change, but often because unit costs rise or businesses demand higher profits.
Moreover, what does widespread “relative price rigidity” actually mean?
It means this:
In the real world, there is a high degree of relative price rigidity, but relative to the models of Austrian or Neoclassical theory, where prices are assumed to be highly flexible, rapidly responsive to demand changes, and are flexible enough to cause a rapid and effective tendency towards market clearing in product markets.
Note well: this does not mean there is no flex-price sector (where prices are highly flexible) or no auction or auction-like markets.
This does not mean there are no goods whose production is inelastic and hence supply and demand have a greater role in determining prices.
For example, on world markets for many years oil prices were set by the cartel OPEC. But in recent decades, OPEC’s power has weakened and prices are much more influenced by production decisions by “swing producers”. Thus oil prices are much more flexible than cost-based mark-up prices used in industrial manufacturing and the service sector.
Some goods like fresh produce, petrol, and seafood clearly have much more flexible prices than other goods, especially when goods are perishable.
In the retail sector, there is a higher degree of flexible prices, given retail sales. However, in the service sector and manufacturing sector, many prices are highly inflexible with respect to demand changes. Since both the service and manufacturing sectors together dominate most market economies, the use of widespread cost-based mark-up prices in these sectors are the fundamental cause of relative price inflexibility.
So the fundamental point here is that the size and prevalence of flex-price markets are grossly exaggerated.
Academic Agent’s fellow Austrian called “Radical Liberation” in this stream also commits gross strawman arguments. “Radical Liberation” claims that I asserted or showed that there is only “a little bit of [price] stickiness.” This is utterly false.
“Radical Liberation” also claims I assert that I think prices need to change instantly to changes in demand. This is also false. In Austrian theory or more dogmatic Neoclassical models, prices must change relatively quickly and rapidly to achieve an effective tendency to supply and demand equilibrium in product markets, not instantly.
In the real world, there is a very high degree of relative price rigidity, and this has been admitted for decades even in mainstream Neoclassical research literature. For example, here is some literature on the empirical evidence for relative price rigidity:
Means, G. 1935. “Industrial Prices and their Relative Inflexibility,” Senate Document 13, 74th Congress, lst Session, US Government Printing Office, Washington, DC.
Means, G. C. 1936. “Notes on Inflexible Prices,” American Economic Review 26 (Supplement): 23–35.
Means, G. C. 1939–1940. “Big Business, Administered Prices, and the Problem of Full Employment,” Journal of Marketing 4: 370–381.
Hall, R. L. and C. J. Hitch. 1939. “Price Theory and Business Behaviour,” Oxford Economic Papers 2: 12–45.
Stigler, G. J. and J. K. Kindahl. 1970. The Behavior of Industrial Prices. New York.
Means, G. C. 1972. “The Administered Price Thesis Reconfirmed,” American Economic Review 62: 292–306.
Beals, R. 1975. “Concentrated Industries, Administered Prices and Inflation: A Survey of Empirical Research,” Council on Wage and Price Stability, Washington.
Carlton, Dennis W. 1986. “The Rigidity of Prices,” The American Economic Review 76.4: 637–658.
This paper presents an analysis of price rigidity in America, and finds that for “many transactions, prices remain rigid for periods exceeding one year” (Carlton 1986: 637) and it “is not unusual in some industries for prices to individual buyers to remain unchanged for several years” (Carlton 1986: 638).
Cecchetti, Stephen G. 1986. “The Frequency of Price Adjustment: A Study of the Newsstand Prices of Magazines,” Journal of Econometrics 31: 255–274.
This is a study of price rigidity in the prices of magazines.
Bils, M. 1987. “The Cyclical Behaviour of Marginal Cost and Price,” American Economic Review 77: 838–855.
Bhaskar, V., Machin, Stephen and Gavin C. Reid. 1993. “Price and Quantity Adjustment over the Business Cycle: Evidence from Survey Data,” Oxford Economic Papers n.s. 45.2: 257–268.
This paper reports data from a questionnaire posed to managers of 73 small UK firms in 1985. It shows quantity adjustments “are overwhelmingly more important than price adjustments over the business cycle” (Bhaskar 1993: 257) and “[m]ost firms do not increase prices in booms or reduce them in recessions, and when they do, managers suggest that these are relatively unimportant” (Bhaskar 1993: 266).
Kashyap, Anil K. 1995. “Sticky Prices: New Evidence from Retail Catalogs,” Quarterly Journal of Economics 110: 245–274.
Blinder, A. S. et al. (eds.). 1998. Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage Foundation, New York.
This book reports a well-sampled survey of 200 US businesses. It was found that a typical good in the US is repriced roughly once a year, and prices are most sticky in the service sector, but the least sticky in wholesale and retail trade (Blinder et al. 1998: 105). Over 50% of firms said that they would not increase their prices when demand increased (Downward and Lee 2001: 476).
Downward, Paul. 1999. Pricing Theory in Post-Keynesian Economics: A Realist Approach. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.
This book reports a survey conducted by P. Downward involving 283 UK manufacturing enterprises (Downward 1999: 150–151). When asked whether the firm set its prices for its products by means of a mark-up on average costs, 63.7% of firms said either “very often” (29.9%) or “often” (33.8%). When asked whether the firm sets prices to create price stability on the market, 65.5% of firms said “very often” (17.3%) or “often” (48.2%) (Downward 1999: 160).
Hall, S., Walsh, M. and A. Yates. 2000. “Are UK Companies’ Prices Sticky?,” Oxford Economic Papers 52.3: 425–446.
This paper reports the results of a survey of 654 UK companies in 1995. When asked what happens when there is strong demand and this cannot be met from inventories or stocks, only 12% of firms said they would increase the price of their goods (Hall, Walsh, and Yates 2000: 442).
Bils, Mark and Peter J. Klenow. 2004. “Some Evidence on the Importance of Sticky Prices,” Journal of Political Economy 112.5: 947–985.
This paper shows a higher degree of price flexibility but only by including mere temporary price cuts (as in retail sales). Their method is disputed by Nakamura and Steinsson (2008) who point out temporary sales not affecting long-run prices of a good are abnormal and make prices appear more flexible than they really are.
Amirault, D., Kwan, C. and G. Wilkinson. 2004. “A Survey of the Price-Setting Behaviour of Canadian Companies,” Bank of Canada Review 2004/2005: 29–40.
http://www.bankofcanada.ca/2006/09/publications/research/working-paper-2006-35/
This paper examines price setting in a survey of 170 private, unregulated, non-primary sector Canadian firms. An impressive 67.1% of firms surveyed attributed price inflexibility to “cost-based pricing,” that is, to mark-up pricing (Amirault, Kwan, and Wilkinson 2004: 21).
Fabiani, Silvia, Gattulli, Angela, and Roberto Sabbatini. 2004. “The Pricing Behaviour of Italian Firms: New Survey Evidence on Price Stickiness,” ECB Working Paper Series No. 333
http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp333.pdf
This paper reports a survey in 2003 of 333 industrial and service firms in Italy (Fabiani et al. 2004: 8). It was found that about 60% of firms review prices once a year, and around 50% only actually change prices once a year too (Fabiani et al. 2004: 21).
Kwapil, Claudia, Baumgartner, Josef and Johann Scharler. 2005. “Price-Setting Behavior of Austrian Firms,” ECB Working Paper Series no. 464
http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp464.pdf
This paper reports a 2004 survey of 873 Austrian firms mainly in the manufacturing sectors. The firms were asked how often they changed prices on average in a given year: No change: 22.1%; Once a year: 54.2%; 2 to 3 times a year: 13.9% (Kwapil, Baumgartner and Scharler 2005: 18). Moreover, 63% of firms said they would leave their prices unchanged in response to a large positive demand shock, and 52% would leave prices unchanged in response to a large negative demand shock (Kwapil, Baumgartner and Scharler 2005: 33). In the face of small demand shocks (either positive or negative), 82% of firms simply leave prices unchanged (Kwapil, Baumgartner and Scharler 2005: 33).
Parker, Miles. 2017. “Price-Setting Behaviour in New Zealand,” New Zealand Economic Papers 51.3: 217–236.
An earlier version is online here:
Parker, Miles. 2014. “Price-Setting Behaviour in New Zealand”
https://cama.crawford.anu.edu.au/amw2013/doc/Parker,Miles.pdf
This paper reports a survey of 5,300 firms selected as a representative sample of all sectors of the New Zealand economy (Parker 2017: 217). It was found that the average firm reviews prices twice a year but changes its prices only once a year (Parker 2017: 229). When asked whether temporary price reductions were important, 44% of firms said “not at all,” and 17% said “a little important” (Parker 2014: 17).
Apel, Mikael, Friberg, Richard and Kerstin Hallsten. 2005. “Microfoundations of Macroeconomic Price Adjustment: Survey Evidence from Swedish Firms,” Journal of Money, Credit and Banking 37.2: 313–338.
This paper reports results from a survey of about 600 private-sector firms in Sweden. When asked to report how often prices were changed, the weighted results were that 40.3% of firms change prices once per year, and 27.1% adjust their prices less than once a year (Apel et al. 2005: 318).
Aucremanne, Luc and Martine Druant. 2005. “Price-Setting Behaviour in Belgium. What can be learned from an ad hoc Survey?,” ECB Working Paper Series No. 448.
This paper report the results of a survey of 1,979 firms in the industrial, construction, trade and services sectors, in a sample that should represent about 60% of Belgian GDP. It was found that 55% of firms changed prices once a year, 18% less often, and 27% more than once a year (Aucremanne and Druant 2005: 31).
Martins, Fernando. 2007. “How Portuguese Firms set their Prices,” in S. Fabiani, C. Suzanne Loupias, F. M. Monteiro Martins and Roberto Sabbatini (eds.), Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York. 152–164.
This chapter reports a 2004 survey by the Banco de Portugal of 1,370 Portuguese firms, mainly from manufacturing. The survey found that 75% of firms generally changed their prices but once a year (Martins 2005: 24).
Nakamura, Emi and Jón Steinsson. 2008. “Five Facts about Prices: A Reevaluation of Menu Cost Models,” The Quarterly Journal of Economics 123.4: 1415–1464.
This paper shows that without mere temporary price cuts (as in retail sales where prices revert to the normal, higher level after a sale) average prices change infrequently: only about every 7–11 months.
Langbraaten, Nina, Nordbø, Einar W. and Fredrik Wulfsberg. 2008. “Price-setting Behaviour of Norwegian Firms – Results of a Survey,” Norges Bank Economic Bulletin 79.2: 13–34.
This reports a well-sampled survey of 725 firms throughout many sectors of the Norwegian economy: nearly 50% of firms said that they only changed their product price once a year, and about 23% of firms said that they changed the price twice a year (Langbraaten et al. 2008: 18).
Levy, Daniel. 2007. “Price Rigidity and Flexibility: New Empirical Evidence,” Managerial and Decision Economics 28.7: 639–647.
This review article summarises 14 empirical studies of price rigidity in a special issue of Managerial and Decision Economics.
Keeney, Mary, Lawless, Martina, and Alan Murphy. 2010. “How Do Firms Set Prices? Survey Evidence from Ireland,” Central Bank of Ireland, Research Technical Papers, no 7/RT/10.
This paper reports a survey of 1000 Irish firms. When firms were asked how likely it was that they would adjust prices downwards in response to a negative demand shock, 66.5% of firms said that negative demand shocks were of little or no relevance to pricing decisions.
Klenow, Peter J. and Benjamin A. Malin. 2011. “Microeconomic Evidence on Price-Setting,” in Benjamin M. Friedman and Michael Woodford (eds.), Handbook of Monetary Economics Volume 3A. North Holland, Amsterdam and London. 231–284.
This chapter provides a table on p. 239 (Table 4) that lists surveys and studies from 19 nations on price rigidity. The data mostly comes from service and industrial sectors (and sometimes in addition also other sectors). For most nations, prices change “on average” at least once a year (Klenow and Malin 2011: 242). If merely short-lived prices (such as mere temporary price discounts) are excluded, prices change closer to once a year (Klenow and Malin 2011: 232).
Nakamura, Emi and Jón Steinsson. 2013. “Price Rigidity: Microeconomic Evidence and Macroeconomic Implications,” Annual Review of Economics 5: 133–163.
Kehoe, Patrick and Virgiliu Midrigan. 2015. “Prices are Sticky after All,” Journal of Monetary Economics 75: 35–53.
The reality of relative price rigidity is why even Monetarists and other more realistic Neoclassicals are forced to take account of short-run price and money wage stickiness in their models, and why many advocate activist monetary policies in a recession or depression.
Yet another crucial piece of evidence of relative price rigidity is that during most recessions since 1945 general price inflation continues even in the contraction of demand and we hardly ever see price deflation in a recession. The general price level in recessions still rises, and generally recessions are just disinflationary (lower rates of infation). In the United States since 1945, for example, virtually every recession has been inflationary: the only exceptions are 1949–1950, 1954–1955, and 2009.
Secondly, Academic Agent’s claim that Austrian theory is only looking at the prices of a good across a whole economy is a bizarre and blatant falsehood.
While Austrian price theory and the Austrian Theory of the Firm are of course not predicting what all firms do, they nevertheless must predict what the majority of firms do, or the average firm does, because otherwise they would be empirically false.
Murray Rothbard says the following about price determination:
“Private business prices its goods and services to ‘clear the market,’ so that supply equals demand, and there are neither shortages nor goods going unsold.” (Rothbard 2006a: 259).
If Rothbard isn’t talking about the average real-world firm here, or the majority of real-world individual firms, then what the hell is he even talking about?
During this pandemic crisis, some good prices have risen where production is inelastic (such as in fresh fruit and vegetables) or where supply-side issues have happened, but, as I stated, in many cases large supermarkets and retailers have maintained the prices of goods like toilet paper, tissues and hand sanitiser, even when shelves are empty.
More flexible prices on eBay or marginal small shops are obviously not representative of all prices, since only small quantities of the products in question are sold at the margins at these places.
The large supermarkets and retailers are where the vast majority of sales happen, and it was not “evil” government that is forcing them to maintain prices: the producers and retailers are largely choosing themselves to maintain prices, since this is their normal behaviour anyway with respect to many goods and services when demand changes: if demand increases, often production is simply ramped up and prices remain unchanged.
(4) Cantillon Effects
Academic Agent fails to understand my critique of the Cantillon Effect. My position is not Cantillon effects never happen at all.
My original position is that in the face of widespread relative price rigidity, Cantillon effects are likely to be minor and marginal, and, on their own, cannot possibly be a serious objection to government spending based on increasing the money supply, because all private sector activity that also increases spending by increasing the money supply would also cause the same type of minor or marginal Cantillon effects.
At this point in the discussion, “Radical Liberation” falsely claims I asserted that prices need to change instantly to changes in demand. Again, this is wrong. For major Cantillon effects to happen, most prices must be highly flexible in response to demand, and change relatively quickly and rapidly.
Also, Academic Agent totally misses my point about the gross contradiction in his reasoning in relation to the orthodox Quantity Theory of Money and the existence of Cantillon effects at the same time, since Austrian economics requires the rejection of short and long-run money neutrality, but money neutrality is a fundamental assumption of the Quantity Theory of Money.
(5) The Quantity Theory of Money
Here it appears that Academic Agent refuses to defend the orthodox Quantity Theory of Money.
At least this is in line with the most important Austrian economists, who did not defend the orthodox Quantity Theory of Money either, but had serious criticisms.
However, changes in the general price level are a highly complex result of many factors, and not some simple function of money supply. Real factors also are an important factor in driving inflation.
If we dig deeper into the Austrian view of inflation, we can find some surprisingly sensible analysis.
Curiously, the Austrian economist Frank Shostak has a surprisingly sensible view on inflation:
“the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services .... While increases in money supply (i.e., inflation) are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant – i.e., inflation is high – prices might display low increases.” Frank Shostak, “Defining Inflation,” Mises Daily, March 6, 2002.
The statement that prices “are determined by real and monetary factors” is, essentially, empirically correct (although, from the Post Keynesian perspective, still needs qualification), but requires we reject the Monetarist superstition that “inflation is always everywhere a monetary phenomenon,” which Academic Agent appears to defend.
As I said, while a long-run, sustained price inflation does need a growing money supply to sustain it, the money supply is often not the causal factor in such price inflations, but the intermediary factor. Monetarists mistake the intermediary medium (money supply) for the only and fundamental driver of price inflation, when real factors underlie movements in prices.
To put this another way, in serious depressions, the falling money supply (when so much of the money supply is understood to be credit money) was not so much the cause of the collapse of economic activity, but the consequence of the collapse in economic activity as credit demand collapsed (though, of course, when banks failed and depositors lost their money savings, this affected economic activity too).
In fact, this is the whole point of the Post Keynesian insight into capitalism: the ability to increase production in an historically unprecedented way is achieved in modern capitalism not simply by superior technology and production methods, but also by an endogenous money supply: a banking and monetary system where capital investment can be financed by new credit money, not backed by prior “saved” money.
As Nicholas Kaldor said in “The Irrelevance of Equilibrium Economics” (Economic Journal 82 [1972]: 1237–1252):
“This is the real significance of the invention of paper money and of credit creation through the banking system. It provided the pre-condition of self-sustained growth. With a purely metallic currency, where the supply of money is given irrespective of the demand for credit, the ability of the system to expand in response to profit opportunities is far more narrowly confined.” (Kaldor 1972: 1250).
Money supply growth, then, is a necessary condition of not only long-run, sustained price inflation, but also a dynamic, highly-productive capitalist economy, because most money is credit money created by banks and, in earlier pre-1930s capitalist eras, by private sector agents who created bills of exchange, promissory notes, negotiable cheques, fractional reserve credit money (book money) and private bank notes.
In this sense, at a fundamental level, in a modern advanced capitalist economy, economic activity and demand for credit drives money supply growth, although in commodity money systems, exogenous growth in the money supply did happen via new gold discoveries, which could then cause demand-side inflation.
The more a modern capitalist economy has an endogenous money system, the more that the Quantity Theory fails to apply.
(6) Full Employment and William H. Hutt
Here Academic Agent appears to largely concede my critique is valid.
However, when Academic Agent (at 2.14.11) states that “the economy does not have the goal of full employment,” he appears to have forgotten the whole point of flexible money wages in Neoclassical and Austrian theory: a flexible money wage (and absence of other alleged harmful interventions) is supposed to cause a strong tendency towards the clearing of the labour market, which is just another way of saying that free markets are supposed to have a strong tendency towards elimination of involuntary unemployment and high levels of employment.
Moreover, Academic Agent makes the insane charge (from 2.17.29) that Post Keynesians wish to create something like Mises’ “Evenly Rotating Economy” (a fictitious general equilibrium state) when nothing is further from the truth: Post Keynesians totally reject general equilibrium analysis or the idea that a dynamic capitalist economy that faces uncertainty and constant change could ever have a tendency to general equilibrium, or could ever reach that state.
BIBLIOGRAPHY
Kaldor, N. 1972. “The Irrelevance of Equilibrium Economics,” Economic Journal 82: 1237–1252.
Rothbard, Murray N. 2006a. For a New Liberty: The Libertarian Manifesto (2nd edn.). Ludwig von Mises Institute, Auburn, Ala.
The quantity theory of money states that when the money supply expands or contracts, this is the cause – when other variables are constant – of proportional or equal changes in the price level.
In the quantity theory, the direction of causation therefore runs from the money supply to the price level, the money supply is assumed to be exogenous, and the money supply function independent in the sense described by Colin Rogers (1989: 244–245).
The standard form of the Cambridge Cash Balance Equation as used today is usually given as follows:
M = kPY or M = kdPY
where M = the quantity of money; k or kd = the amount of money held as cash or money balances; P = the general price level; Y = real value of the volume of all transactions entering into the value of national income (that is, goods and services).
In the Cambridge approach, the variable k was held to be superior to Irving Fisher’s “velocity of circulation” concept V, because, unlike V, k is supposed to be empirically measurable.
Therefore M and P are causally related, if kd and Y are constant (Thirlwall 1999).
I will use the Cambridge Cash Balance Equation in what follows.
Post Keynesians say that the quantity theory is not true for modern advanced capitalist economies, where money is largely endogenous.
Perhaps it might be true for an economy with pure commodity money and an exogenous supply, as Colin Rogers (1989: 175, 244) argues, but even here the idea that the relationship between money supply and price level, even if kd and Y are constant, must necessarily and always be proportional in a real world economy, as compared with an analytic mathematical equation true merely by definition, seems questionable.
Of course, advocates of the quantity theory will appeal to the econometric evidence. Doesn’t this prove their case? Not really. A review of the econometric evidence, as, for example, in a good study like Grauwe and Polan (2005) shows that it is a mixed bag, at best. Some studies show a proportional relationship (e.g., Vogel 1974), but others do not, but merely demonstrate a strong positive correlation (Grauwe and Polan 2005; McCandless and Weber 1995; Dwyer and Hafer 1988). Supporters of the quantity theory respond by saying that, if the data does not show a proportional relationship, then by definition kd and Y must have changed. The trouble is that this starts to render the quantity theory a tautology – the sort of mathematical or analytic a priori statement immune from empirical verification or falsification, because it is not in fact an empirical statement at all.
In reality, there are deeper empirical criticisms of the quantity theory than the mixed evidence on proportionality, because the quantity theory requires certain prior assumptions for the theory to work.
But, before we get to these criticisms, what can be salvaged from the quantity theory?
It is true that the quantity theory captures some basic truths. These are as follows:
(1) a long-run, sustained price inflation does need a growing money supply to sustain it;
(2) so in view of (1), it is not at all surprising that the econometric literature often finds a strong or very strong positive correlation between the money supply changes and price level changes (Grauwe and Polan 2005; McCandless and Weber 1995; Dwyer and Hafer 1988).
(3) it is also true that deflations are often correlated with a falling money supply or decelerations in money supply growth.
To be clear, the issue is not whether an expanding money supply is necessary for a sustained, long-run price inflation. An expanding money supply is indeed a necessary, but not sufficient, condition for price inflation.
But when quantity theorists say that “inflation is always and everywhere a monetary phenomenon” (Friedman 1968: 98) they mean something more than just the basic ideas expressed above.
The crucial issues as raised by the quantity theory as part of its assumptions are:
(1) is the money supply exogenously determined, and is there an independent money supply function?
(2) is the assumption of long-run money neutrality as required for the quantity theory to work a realistic one? (It is true that some naïve versions of the quantity theory would assume even a short-run neutrality, but most modern neoclassical economists are realistic enough to recognise the strong degree of nominal price and wage rigidity that exists in modern economies, which, they admit, causes short-run money non-neutrality.)
(3) is the direction of causation as assumed in the quantity theory equation from left to right (that is, from the money supply to the price level)? That is to say, it is really an exogenously-determined money supply that is the fundamental cause, or driver, of price level changes?
A crucial issue is (1) above: is there an exogenous, independent money supply? Is it the primary, causal origin of changes in the price level?
Quantity theorists are asserting that a truly independent and exogenous money supply is the causal driver of inflation and deflation.
So why do Post Keynesians reject the quantity theory?
What this means is that normally broad money creation is credit-driven. That is, most money is created by private banks and its quantity is determined by the private demand for it. This is the essence of endogenous money. In an endogenous money system, even the “monetary base” is normally endogenous too, given that the central bank must accommodate the banks’ demand for high-powered money to avoid financial crises and banking panics.
So what of question (1) above?
Post Keynesians contend that a truly independent money supply function does not actually exist in an endogenous money world, because credit money comes into existence because it has been demanded (Rogers 1989: 244–245). So the broad money supply is not independent of money demand, but can be demand-led (Ingham 2004: 53).
Next, what of question (2)?
There is considerable evidence that money can never be neutral, not even in the long run. The concept of neutral money holds that changes in the money supply will only affect nominal values (e.g., money prices, nominal money wages, etc.), not real variables (such as production, employment, and investment). Nevertheless, neoclassical economists accept the evidence that price and wage rigidity is a strong characteristic of the real world. They must then assume that prices and wages are sufficiently flexible in the long run, and that they really do adjust in the long period. The trouble is that there is little evidence for this. Most prices are mark-up prices and relatively inflexible with respect to demand changes in both the short and long run. Most capitalist economies are far from full use of resources, and even in booms businesses make use of stocks and capacity utilisation to manage demand changes, rather than changes in prices.
The mysterious long-run flexibility does not seem to be visible in the data, and the long run is just a sequence of short-run periods anyway.
A further complication is that nominal variables can also be found in contracts, such as debts, production orders, or forward contracts, but these are precisely the things that will not necessarily change when the money supply changes.
And, even if you assume an exogenous money supply, a direction of causation from left to right, and reasonably flexible prices, there will still be Cantillon effects, the phenomenon that price level changes caused by increases in the quantity of money depend on the way new money is injected into the economy, and actually where it affects prices first. That is to say, although prices rise as the exogenous quantity of money increases, contrary to the quantity theory of money, we should not expect prices to rise proportionally, but in a complex manner that depends on who received the money and how they spent it (this idea, as it happens, is used by Austrians as the basis of their own criticism of the quantity theory.)
Finally, what of question (3), concerning the direction of causation?
Under an endogenous money system, the direction of causation is generally from credit demand (via business loans to finance labour and other factor inputs) to money supply increases (Robinson 1970; Davidson and Weintraub 1973).
Therefore the direction of causation generally runs:
(1) business demand for credit (to pay for goods and labour factor inputs, whose prices may have risen against previous production periods) + demand for demand deposits
→ (2) increases in broad money
→ (3) banks’ demand for more reserves (high-powered money) when they need to clear obligations.
→ (4) the central bank creates the needed reserves.
Changes in the general price level are a highly complex result of many factors, and not some simple function of money supply.
This crucial point about the direction of causation in the relationship between money supply and output/prices is discussed by Joan Robinson:
“The correlations to be explained [sc. in the relationship between money supply and real output] could be set out in quantity theory terms if the equation were read right-handed. Thus we might suggest that a marked rise in the level of activity is likely to be preceded by an increase in the supply of money (if M is widely defined) or in the velocity of circulation (if M is narrowly defined) because a rise in the wage bill and in borrowing for working capital is likely to precede an increase in the value of output appearing in the statistics. Or that a fall in activity sharp enough to cause losses deprives the banks of credit-worthy borrowers and brings a contraction in their position. But the tradition of Chicago consists in reading the equation from left to right. Then the observed relations are interpreted without any hypothesis at all except post hoc ergo propter hoc.” (Robinson 1970: 510–511).
So what we can say is that – in contrast to the quantity theory – money supply changes are often the effect of changes in credit demand, production and economic activity, and not the cause of the latter phenomena.
In short, money is generally the effect, not the cause.
Finally, what drives an inflation can be complex, and there is no simple, monocausal explanation. Often inflations are a cost-push phenomenon, in which
(1) workers or unions demand higher wages and businesses agree to these increases and/or
(2) prices of other factor inputs rise, and then businesses will need to obtain higher levels of credit from banks.
So inflation might be driven by demand for higher wages or supply-side factors. Hence broad money supply growth rates rise in an endogenous money world which generally accommodates the demand for credit, but this rise precedes further price increases because businesses will generally raise mark-up prices to maintain profit margins at a later time, given that most firms engage in time-dependent reviews and changes of their prices at regular intervals. In extreme situations, a wage–price spiral might break out: this involves the same process as above but in a vicious circle.
It is a perfect example of how Austrians are still mired in the false and misleading quantity theory of money, and all its mistaken assumptions.
He uses the following graph (which can be opened in a separate window) showing M2 money supply growth rates with the CPI inflation rates.
The key to understanding and interpreting this graph are the theories of
(1) endogenous money and (2) mark-up pricing.
Furthermore, the supply shocks and wage-price spirals of the 1970s – the historically specific factors – cannot be ignored either.
First, let us dispose of the quantity theory of money and explain endogenous money theory.
There are two main versions of quantity theory, as follows:
(1) The Equation of Exchange: MV = PT,
where M = quantity of money; V = velocity of circulation; P = general price level, and T = total number of transactions.
(2) the Cambridge Cash Balance equation: M = kdPY,
where M = supply of money; kd = demand to hold money per unit of money income; P = general price level, and Y = volume of all transactions in the value of national income.
A number of assumptions have to be made for the quantity theory to explain changes in the price level, as follows:
(1) prices are flexible and respond to demand changes in either (1) both the short and long run, or (2) at least in the long run. Related to this is a tacit assumption that the economy is near equilibrium in the sense of full use of resources and high employment, where stocks and capacity utilization are not fundamental methods that firms use to deal with changes in the demand for their products.
(2) money supply is exogenous;
(3) under the equation of exchange, for an increase in M to lead to a proportional increase in P, both V and T must be assumed to be stable.
Under the Cambridge Cash Balance equation, M and P are causally related, if kd and Y are constant (Thirlwall 1999).
(4) the direction of causation. The quantity theory assumes the direction of causation runs from money supply increase to price rises.
(5) in some extreme forms there is the assumption, following from (1), that money supply increases induce direct and proportional changes in the price level. (I will just note as an aside that Austrians already reject this, because they emphasise Cantillon effects, the idea that price level changes caused by increases in the quantity of money depend on the way new money is injected into the economy, and actually where it affects prices first.)
(3) The velocity of money and demand for money are unstable, subject to shocks and move pro-cyclically (Leo 2005; Levy-Orlik 2012: 170);
(4) the direction of causation. Under an endogenous system the direction of causation is generally from credit demand (via business loans to finance labour and other factor inputs) to money supply increases (Robinson 1970; Davidson and Weintraub 1973).
Therefore the direction of causation generally runs:
This is true, as noted above, since the money supply is endogenous: most of the money supply is “broad money” or bank money, and that is increased by credit expansion in the form of bank loans.
(5) that money supply growth necessarily or generally induces direct and proportional changes in the price level is empirically false (De Grauwe and Polan 2005).
We can see here why broad money supply growth precedes inflation or real output changes.
The reason is that (1) money is largely endogenous and (2) growth in the broad money supply is generally caused by credit growth. Many businesses finance their wage and other factor input bills with credit from banks, so that before real output grows money supply will grow.
Cost-push inflation happens in the same way: when (1) workers or unions demand higher wages and businesses agree to these increases and/or (2) prices of other factor inputs rise, then businesses will need to obtain higher levels of credit from banks. Hence broad money supply growth rates rise, but this rise precedes price increases because businesses will generally raise mark-up prices to maintain profit margins at a later time, given that most firms engage in time-dependent reviews and changes of their prices at regular intervals.
The process of a wage–price spiral involves actually this type of phenomenon, but in a vicious circle.
This crucial point about the direction of causation in the relationship between money supply and output/prices is discussed by Joan Robinson:
“The correlations to be explained [sc. in the relationship between money supply and real output] could be set out in quantity theory terms if the equation were read right-handed. Thus we might suggest that a marked rise in the level of activity is likely to be preceded by an increase in the supply of money (if M is widely defined) or in the velocity of circulation (if M is narrowly defined) because a rise in the wage bill and in borrowing for working capital is likely to precede an increase in the value of output appearing in the statistics. Or that a fall in activity sharp enough to cause losses deprives the banks of credit-worthy borrowers and brings a contraction in their position. But the tradition of Chicago consists in reading the equation from left to right. Then the observed relations are interpreted without any hypothesis at all except post hoc ergo propter hoc.” (Robinson 1970: 510–511).
Secondly, we need to understand mark-up pricing.
Many businesses – and probably a majority in any given developed capitalist economy – set their prices mainly as a profit mark-up on total average unit costs (that is, fixed plus variable costs).
Prices tend to change when total average unit costs change or when the firm wants to change its profit mark-up, and therefore supply costs are the important factor causing price changes (the overwhelming empirical evidence proving that mark-up pricing is prevalent throughout the developed world is here).
Although demand-side inflation is a real and important phenomenon, it is not the only major cause of inflation. In fact, often demand-side inflation is a grossly overestimated cause of inflation and the really important cause is increases in mark-up prices by cost-push inflation: for mark-up prices are, generally speaking, not responsive to changes in demand (Kaldor 1976: 217).
In the post-WWII world when unions were much stronger, collective bargaining in wages prevalent, and cost of living clauses standard in wage contracts, a sufficiently large rise in wages or spike in energy or raw materials costs could set off wage–price spirals, as businesses maintained their profit margin by simply raising their mark-up prices.
Now we have sketched the two theories we need to understand inflation, in addition to demand-led inflation, we can turn to an actual explanation of the 1970s inflation from its origin in the late 1960s until 1975.
We can break down the inflation trends as follows:
(1) Phase 1: 1967–1971
The US saw a spike in inflation from October 1967 to February 1970. Then inflation turned around and, although high, inflation rates gradually fell right down to June 1972.
This was preceded by a spike in M2 growth rates from January 1967 to January 1968.
In the United States, unemployment had fallen to 3.8% in 1966 and 3.6% in 1968, historically low levels. Low unemployment led to some bidding up of wages in this period in the non-unionised sector. Unionised workers in turn also demanded higher wages. The inflation in the US, then, was driven by unusually higher wage demands (Kaldor 1976: 224), just as it was throughout other Western countries. As Nicholas Kaldor noted, around 1968–1969, similar types of wage rises occurred in Japan, France, Belgium and the Netherlands, and from 1969–1970 in Germany, Italy, Switzerland and the UK, which Kaldor attributed largely to trade union action (Kaldor 1976: 224).
But then the US recession from December 1969 to November 1970 struck, and there was a marked decrease in inflation and M2 growth rates.
From April 1970, acceleration in M2 growth rates began again and (as we would expect) preceded the recovery in real output that ended this recession.
But M2 growth rates soared to a high level from April 1970 to July 1971, as the expansion in the business cycle occurred and higher wage demands continued.
The momentous event that would set the stage for the inflation in the next phase was the end of the Bretton Woods system on August 15, 1971, when Nixon closed the gold window.
The end of Bretton Woods was momentous: inflationary expectations and instability on financial and commodity markets resulted, as well as a rise in commodity speculation as a hedge against inflation. This contributed to the cost-push inflation that was being felt in many countries after 1971.
Nevertheless, the end of Bretton Woods in August, 1971 did not suddenly unleash run-away inflation. As we see in the chart, US inflation rates continued to fall until June 1972.
(2) Phase 2: 1971–1974
The spike in US inflation began again in June 1972 and continued until December 1974.
What caused this? Three major factors did:
(1) an explosion in commodity prices from 1972;
(2) wage–price spirals, and
(3) the first oil shock.
Let us start with factor (1).
In the late 1960s, the US began dismantling its commodity buffer stock policies that had previously ensured price stability in the golden age of capitalism.
The prelude to stagflation was marked by a significant explosion in commodity prices that occurred in the second half of 1972. Part of the problem was the failure of the harvest in the old Soviet Union in 1972–1973 and the unexpectedly large purchases on world markets by the Soviet state (Kaldor 1976: 228). This could have been averted had the United States not dismantled its commodity buffer stock policies in the 1960s. As we have seen above, the end of Bretton Woods also induced commodity speculation and rises in commodity prices and raw materials costs.
This feed into further price rises, which in turn exacerbated wage–price spirals.
The final factor that explains the surge in inflation down to December 1974 was the first oil shock from October 1973, when various Middle Eastern producers of oil instituted an embargo that lasted until March 1974 (Kaldor 1976: 226). In most countries, the double digit inflation of the 1970s was caused by the oil shocks (both the first and second).
This explains why M2 growth rates, while high, actually fell gradually from January 1973 to June 1974 as a recession struck the US from November 1973 to March 1975. This inflation was a supply-side phenomenon.
The accelerating inflation rates from 1973 to 1974 occurred when the US economy was in recession and this anomaly puzzled many economists at that time.
The new portmanteau word “stagflation” (stagnation + inflation) was increasingly used to describe the phenomenon, which meant the simultaneous occurrence of stagnation or recession (with high unemployment) and accelerating inflation.
I have not bothered to continue this analysis down to 1980, but it could be easily done.
The very same factors as described above also explain the second bout of stagflation and the major cause was the Second oil shock.
Update
Philip Pilkington has a great post here on this very subject:
BIBLIOGRAPHY
Davidson, Paul and Sidney Weintraub. 1973. “Money as Cause and Effect,” The Economic Journal 83.332: 1117–1132.
De Grauwe, P. and M. Polan. 2005. “Is Inflation Always and Everywhere a Monetary Phenomenon?,” Scandinavian Journal of Economics 107: 239–259.
Kaldor, N. 1976. “Inflation and Recession in the World Economy,” Economic Journal 86 (December): 703–714.
Leo, P. 2005. “Why does the Velocity of Money move Pro-cyclically?,” International Review of Applied Economics 19.1: 119–135.
Levy-Orlik, N. 2012. “Keynes’s Views in Financing Economic Growth: The Role of Capital Markets in the Process of Funding,” in Jesper Jespersen and Mogens Ove Madsen (eds.), Keynes’s General Theory for Today: Contemporary Perspectives. Edward Elgar, Cheltenham. 167–185.
Moore, B. 2003. “Endogenous Money,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics. Edward Elgar, Cheltenham. 117–121.
Robinson, Joan. 1970. “Quantity Theories Old and New: Comment,” Journal of Money, Credit and Banking 2.4: 504–512.
Thirlwall, A. P. 1999. “Monetarism,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z. Routledge, London and New York. 750–753.
Joan Robinson (1970) is a short but perceptive paper on the quantity theory of money and its problems.
First, consider the equation of exchange:
The Equation of Exchange: MV = PT,
where M = quantity of money; V = velocity of circulation; P = general price level, and T = total number of transactions.
Is T to include (1) all transactions in, say, a year or (2) only those that are connected with real GDP? (Robinson 1970: 504). The Cambridge Cash Balance equation remedies the confusion, and P is an index of prices suitably constructed as appropriate to the type of transactions in T (Robinson 1970: 504). But is not new money also spent, for example, on purchases of assets on secondary financial asset markets? How does this affect the equation? (one modern economist who defends the quantity theory tries to address the problem in this talk, with a Post Keynesian critique following).
Furthermore, the quantity theory has been interpreted to mean that changes in the quantity of money produce a proportionate change in the price level (Robinson 1970: 505), something which is mostly untrue.
And then there is the fundamental problem: the direction of causation in the relationship between money supply and real output:
“The correlations to be explained [sc. in the relationship between money supply and real output] could be set out in quantity theory terms if the equation were read right-handed. Thus we might suggest that a marked rise in the level of activity is likely to be preceded by an increase in the supply of money (if M is widely defined) or in the velocity of circulation (if M is narrowly defined) because a rise in the wage bill and in borrowing for working capital is likely to precede an increase in the value of output appearing in the statistics. Or that a fall in activity sharp enough to cause losses deprives the banks of credit-worthy borrowers and brings a contraction in their position. But the tradition of Chicago consists in reading the equation from left to right. Then the observed relations are interpreted without any hypothesis at all except post hoc ergo propter hoc.
There is an unearthly, mystical element in Friedman’s thought. The mere existence of a stock of money somehow promotes expenditure. …. The general implication of Friedman’s doctrines is that money is very important, not as a symptom but as a cause of instability. …
… the essence of the quantity theory is that there is a definable and recognizable quantity, M, the movements of which have a powerful influence upon the movements of PT. In short, the whole argument of both [sc. of the two main monetarist] schools [sc. of Friedman and Henry C. Simons] consists in reading the quantity equation from left to right instead of from right to left.” (Robinson 1970: 510–511).
This has always been the severe problem with the quantity theory.
That is, in contrast to monetarist and conventional neoclassical interpretations, the fundamental causal relationship is actually running from
(1) business demand for credit (to pay for goods and labour factor inputs, whose prices may have risen against previous production periods) + demand for demand deposits
→ (2) increases in broad money
→ (3) banks’ demand for more reserves (high-powered money) when they need to clear obligations.
→ (4) the central bank creates the needed reserves.
Changes in the general price level are a highly complex result of many factors, and not some simple function of money supply.
I continue with a topic from Albert et al. (2012): the quantity theory of money.
Albert et al. (2012: 304) notes that the classical quantity theory of money holds that changes in the stock of money cause changes in the price level, and in extreme forms that the changes are proportional.
When this empirically testable version of the theory proved questionable, less stringent forms of the quantity theory were developed:
“Unfortunately, this [sc. Classical] theory has not proven to be successful, consequently it has been necessary to resort to a less demanding form of it. In the course of the development of economic thought, this form, too, has been abandoned in favor of what is known as the quantity or exchange equation, which maintains that the product of the amount of money and speed of money flow is identical to the product of the trade volume and the price level. However, as it is normally interpreted, this equation is analytic; thus the transition from the old quantity theory to the equation of exchange results in a tautology, and consequently a decrease in the informational content to zero, something which has by no means been noticed by all theoreticians.” (Albert et al. 2012: 304–305).
Thus the stipulation of the quantity theory that the velocity of circulation and trade volume need to be held constant is akin to the ceteris paribus assumption of the law of demand.
In fact, matters are far worse than even Albert believes.
As Albert notes, two main versions of quantity theory are used:
(1) The Equation of Exchange: MV = PT,
where M = quantity of money; V = velocity of circulation; P = general price level, and T = total number of transactions.
(2) the Cambridge Cash Balance equation: M = kdPY,
where M = quantity of money; kd = the amount of money held as cash or money balances; P = general price level, and Y = real value of the volume of all transactions entering into the value of national income (that is, goods and services)
A number of assumptions have to be made for the quantity theory to explain changes in the price level:
(1) prices are flexible and respond to demand changes in either (1) both the short and long run, or (2) at least in the long run. Related to this is a tacit assumption that the economy is near equilibrium in the sense of full use of resources and high employment, where stocks and capacity utilization are not fundamental methods to deal with demand.
(2) money supply is exogenous;
(3) under the equation of exchange, for an increase in M to lead to a proportional increase in P, both V and T must be assumed to be stable.
Under the Cambridge Cash Balance equation, M and P are causally related, if kd and Y are constant (Thirlwall 1999).
(4) the direction of causation. The quantity theory assumes the direction of causation runs from money supply increase to price rises.
(5) in some extreme forms there is the assumption, following from (1), that money stock increases induce direct and proportional changes in the price level.
(3) The velocity of money and demand for money are unstable, subject to shocks and move pro-cyclically (Leo 2005; Levy-Orlik 2012: 170);
(4) the direction of causation. Under an endogenous system the direction of causation is generally from credit demand and price increases to money supply increases (Robinson 1970; Davidson and Weintraub 1973).
Therefore the direction of causation generally runs:
This is true, as noted above, since the money supply is endogenous: most of the money stock is “broad money” or bank money, and the major driver of the expansion of this type of money is (1) credit expansion in the form of bank loans plus (2) the creation of ordinary demand deposits and saving accounts.
(5) that money stock increases necessarily or generally induce direct and proportional changes in the price level is empirically false (De Grauwe and Polan 2005).
It follows that the quantity theory in most of its theoretical forms can only be made true by simply transforming it into an analytic a priori statement about a hypothetical world of marginal or near zero relevance to the real world.
BIBLIOGRAPHY
Albert, Hans, Arnold, Darrell and Frank Maier-Rigaud. 2012. “Model Platonism: Neoclassical economic thought in critical light,” Journal of Institutional Economics 8.3: 295–323.
Davidson, Paul and Sidney Weintraub. 1973. “Money as Cause and Effect,” The Economic Journal 83.332: 1117–1132.
De Grauwe, P. and M. Polan. 2005. “Is Inflation Always and Everywhere a Monetary Phenomenon?,” Scandinavian Journal of Economics 107: 239–259.
Leo, P. 2005. “Why does the Velocity of Money move Pro-cyclically?,” International Review of Applied Economics 19.1: 119–135.
Levy-Orlik, N. 2012. “Keynes’s Views in Financing Economic Growth: The Role of Capital Markets in the Process of Funding,” in Jesper Jespersen and Mogens Ove Madsen (eds.), Keynes’s General Theory for Today: Contemporary Perspectives. Edward Elgar, Cheltenham. 167–185.
Moore, B. 2003. “Endogenous Money,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics. Edward Elgar, Cheltenham. 117–121.
Robinson, Joan. 1970. “Quantity Theories Old and New: Comment,” Journal of Money, Credit and Banking 2.4: 504–512.
Thirlwall, A. P. 1999. “Monetarism,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z. Routledge, London and New York. 750–753.
The quantity theory of money is still at the heart of mainstream analysis of price movements and inflation.
In essence, there are two versions of theory:
(1) The Equation of Exchange: MV = PT,
where
M = quantity of money;
V = velocity of circulation;
P = general price level, and
T = total number of transactions.
(2) the Cambridge Cash Balance equation: M = kPY,
where
M = quantity of money;
k = demand to hold money/the amount of money held on hand;
P = general price level, and
Y = volume of all transactions in the value of national income.
Irving Fisher’s equation of exchange is actually not the basis of neoclassical monetary theory. Rather, the Cambridge cash balance equation is the more influential version of the theory (Flynn 1984). The Cambridge cash balance equation also replaces the velocity of circulation concept with the idea of the demand to hold money.
The worth of these equations and the quantity theory as a general theory of inflation are doubtful. (Of course, “inflation” must be understood in what follows as a general and sustained increase in prices as measured by a price index).
First, the contention that money stock increases induce direct and proportional changes in the price level is empirically questionable (De Grauwe and Polan 2005).
Secondly, there is the direction of causation. The quantity theory assumes the direction of causation runs from money supply increase to price rises.
At most, the quantity theory captures a basic truth that a sustained general increase in prices requires a growing money stock.
But, while a money supply increase is a precondition for this, it is also an intermediate factor, and not generally the cause of price inflation.
The fundamental causes of a general price inflation are still supply side factors (rises in wages or prices of factor input costs) or demand side ones (high demand causing price increases in flexprice markets).
The direction of causation in an endogenous money world is not, generally, from money supply increases to price increases, but from credit demand and price increases to money supply increases (King 2002: 166; Robinson 1970; Davidson and Weintraub 1973). The latter does provide an intermediate step whereby a larger money supply allows further price increases and sustained price inflation without causing macroeconomic problems induced by shortage of money and credit.
A rising broad money stock means that banks require more reserves for their clearing of debts and transactions conducted in bank credit money. Central banks provide those reserves.
This should be quite clear because the money supply is endogenous: most of the money stock is “broad money” or bank money, and the major driver of the expansion of this type of money is credit expansion in the form of bank loans (the creation of ordinary demand deposits and saving accounts is also an important factor).
But what causes the demand for and changes in the level of bank loans?
For businesses, it is investment and often changes in factor input bills. Wage rises can be induced by wage bargaining and other institutional factors, and factor input prices generally rise because of administered pricing decisions or demand/supply dynamics in flexprice markets.
Conversely, when a severe price deflation occurs accompanied by a contraction in the money supply, the direction of causation between the two is highly complex. Falls in prices in both flexprice markets and even fixprice markets can be induced by severe demand collapses, administered price decisions, or falls in factor input prices. To the extent that credit growth is reduced by these factors, money supply growth from credit will also fall.
And an actual monetary contraction can also be the consequence of other factors such as a collapsing financial system, the contraction in broad money as credit money (or bank money) is destroyed as people scramble for the higher form of money (such as cash), and repayment of bank loans and debt further contracts broad money.
The issue is complicated by debates between Post Keynesian “horizontalists” and “structuralists” on the role of the interest rate and how credit supply is determined, but that need not concern me for the purposes of this post.
The idea that inflation is “always and everywhere a monetary phenomenon” is unacceptable because it assumes an exogenous money world and the wrong direction of causality.
This is why the solution to accelerating inflationary outbreaks in capitalist economies is:
(1) incomes policy, especially policies to stop excessive wage rises and wage–price spirals; (2) price stabilisation of fundamental factor input prices through buffer stocks, and (3) demand management.
Trying to control money supply growth rates, as in Friedmanite monetarism, is pointless, because (1) the direction of causation is backwards and (2) central banks do not have direct control over the rates of money supply growth anyway.
BIBLIOGRAPHY
Davidson, Paul and Sidney Weintraub. 1973. “Money as Cause and Effect,” The Economic Journal 83.332: 1117–1132.
De Grauwe, P. and M. Polan. 2005. “Is Inflation Always and Everywhere a Monetary Phenomenon?,” Scandinavian Journal of Economics 107: 239–259.
Flynn, D. O. 1984. “Use and Misuse of the Quantity Theory of Money in Early Modern Historiography”, in E. van Cauwenberghe and F. Irsigler (eds.), Münzprägung, Geldumlauf und Wechselkurse: Akten des 8th International Economic History Congress, Section C7, Budapest 1982. Verlag Trierer Historische Forschungen, Trier. 383–417.
Ingham, Geoffrey K. 2004. The Nature of Money. Polity, Cambridge, UK and Malden, MA.
King, J. E. 2002. A History of Post Keynesian Economics since 1936. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.
Moore, B. 2003. “Endogenous Money,” in J. E. King, The Elgar Companion to Post Keynesian Economics. Edward Elgar, Cheltenham. 117–121.
Robinson, Joan. 1970. “Quantity Theories Old and New: Comment,” Journal of Money, Credit and Banking 2.4: 504–512.
Rogers, C. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.
Thirlwall, A. P. 1999. “Monetarism,” in P. A. O’Hara (ed.), Encyclopedia of Political Economy: L–Z (vol. 2). Routledge, London. 750–753
Smithin, J. 2012. “Inflation”, in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 288–294.
