Thursday, April 24, 2014

Bob Murphy on 1970s Inflation

Bob Murphy discusses the inflation of the 1970s here.

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,
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 = kd PY,
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.)
So how realistic are these assumptions?

The answer is not very realistic at all:
(1) 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.

(2) money supply is largely endogenous;

(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:
credit demand → broad money supply increase → base money increase. (Moore 2003: 118).
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.

Philip Pilkington has a great post here on this very subject:
Philip Pilkington, “Animism and Monetarist Thinking: The Inflation in the US in the 1970s,” Fixing the Economists, August 6, 2013.
Further Links
“US Inflation Rates (1946–1987), Keynesianism and Stagflation,” March 24, 2013.

“Stagflation in the 1970s: A Post Keynesian Analysis,” June 24, 2011.

“Hans Albert on the Quantity Theory of Money,” March 2, 2014.

“Joan Robinson on the Quantity Theory of Money,” March 3, 2014.

“Endogenous Money: A Bibliography,” April 5, 2012.

“Endogenous Money 101,” April 20, 2013.

“Rochon and Rossi on the History of Endogenous Money,” May 4, 2013.

“Endogenous Money under the Gold Standard,” May 19, 2013.

“Some Empirical Evidence on Endogenous Money,” May 27, 2013.

“Empirical Evidence on Endogenous Money,” August 10, 2013.

“The Quantity Theory of Money is Wrong,” August 7, 2013.

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.


  1. What do you see as the role of the Central Bank in all this ?

    1. The central banks mainly just accommodate the demand for high-powered money from banks. To that extent, they are passive, with respect to the quantity of money a capitalist economy creates. They do not directly control the quantity of money.

      Of course they set interest rates and influence economic activity that way, but as Post Keynesians point out, monetary policy is a blunt instrument, not always always reliable, and classical loanable funds theory is just not true.

      The aggregate level of investment is not some straightforward function of interest rates nor clearing of a mythical loanable funds market.

    2. Do you believe that a CB can successfully target a given rate of inflation by adjusting interest rates in response to inflation data (assuming positive interest rates?

    3. Assume that interest rates are 5% and the CB is targeting 2% inflation. The endogenous demand for loans starts to trend up. The CB sees the inflation rate has risen to 3% as a result of the increased lending so it raises rates to 6% and conducts OMO to adjust the money supply to hit this new target.

      Why would you not predict that the inflation rate would come down ?

    4. Rob Rawlings,

      Whatever influences the CB has on inflation are indirect, uneven, and ultimately unreliable.

      Raising interest rates to induce recession is no doubt normally disinflationary, but it is delusional to think the CB can reliably "target" inflation rates with the degree of accuracy you seem to be positing.

    5. In your view could a govt/CB successfully hit an inflation target using fiscal policy (should it choose to)?

  2. Very good. Less precise (but more data-driven) overview here:

    1. Have added an update above linking to that great post.

  3. Replies
    1. Contingent on the circumstance.

      Weimar Germany was caused by the debt repayments levied by the Allies exacerbated by the occupation of the Ruhr Valley.

      Zimbabwe was a result of the land reclamations.

      See resources collected here:

    2. Well, Ken B, I would look at as many hyperinflationary episodes as possible and see if you can make generalisations.

      Generally, it would appear to me that it takes a lot to induce hyperinflation, these episodes usually arise after an economy is badly shocked, with crises, wars, civil wars and loss of productive capacity, loss of confidence in the currency, and excessive government spending.

      Of course, a government monetising a budget deficit and engaging in spending above and beyond the ability of the capacity of the economy to supply goods could be and often is an important factor too, and run away demand side can play a role. (It was in Weimar Germany, for example).

      Phil Pilkington has an interesting take here:

    3. Bill Mitchell has an analysis of the Zimbabwe hyperinflation here:

    4. in Zimbabwe the real government fiscal deficit was equal to around 75% of GDP:

      'Central Bank Quasi-fiscal Losses and High Inflation in Zimbabwe: A Note'

      Sònia Muñoz (IMF)

    5. " loss of confidence in the currency,"
      As far as I can tell, hyperinflation is always caused by loss of confidence in the currency.

      If we have a huge internal devaluation of the currency (as France did sometime during the 1950s) without any loss of confidence in the currency, even though it is very high inflation, we don't call it hyperinflation for some reason.

      I tend to think that loss of confidence in the currency seems to require loss of confidence in the currency issuer in general -- not merely due to financial behavior, but a government being perceived as generally incompetent, lawless, unstable, and prone to being overthrown. I can't prove this but I'm strongly suspicious. The example of private bank-issued currencies reinforces this analysis. It seems to be possible sometimes to retain confidence in the currency *despite* all of this, and a better question might be why.

  4. Phil
    As I understand it, by the end of the hyperinflation it took more Marks to buy a house than existed in all of Germany before it began. Did the reparations payments, which I assume to heve been an outflow from Germany, create the new numbers of Marks needed to buy houses, cars or bread? I am skeptical.
    I do believe that they printed Marks, in amounts unheard of before, and I can see how that might play a causal role. Do you disagree?

    1. Yes and no. The issuance of the Marks didn't cause the inflation. It was their use to buy foreign currencies that crashed the value.

      Then when the French occupied the Ruhr Valley (due to missed reparation payments) the supply-side of the economy collapsed just as it did in Zimbabwe.

    2. I do believe that they printed Marks, in amounts unheard of before, and I can see how that might play a causal role.

      Ken B, yes, that is absolutely right, the Weimar budget deficit was running at about 50% if GDP, and the Reichsbank was monetising a lot of that deficit.

      But I do not think Philip disputes that.

      I certainly don't. And yes, that was a big reason where hyperinflation happened.

    3. Philip,

      Just for the sake of clarity, surely you don't deny the huge budget deficits in Weimar Germany and the way the Reichsbank was monetising a lot of that deficit?

      I know the collapse of the exchange rate must have been a significant driver of hyperinflation as well, but obviously both are involved.

    4. The hyperinflation started first due to the foreign currency purchases. The rise in prices messed up the spending and taxation regime and that is what led to budget deficit, so far as I recall.

    5. OK, so you're endorsing the balance of payments theory of the hyperinflation as the fundamental cause, right?

      Joan Robinson (in her Review of The Economics of Inflation by C. Bresciani-Turroni,” The Economic Journal 48.191 [ 1938]: 507–513) takes a form of this view, but puts the emphasis on how the soaring wage levels were a missing link in how the inflation exploded into hyperinflation.

    6. In that particular instance it was the most important cause. I think that the Argentine hyperinflation was similar (the military junta bought dollars to buy weapons). But the Chilean hyperinflation under Allende was primarily due to redistribution and outlandish social spending.

      Robinson is right, of course, in that money wages rose in response to the rise in import prices. But the true cause of this rise in money wages was the inflation and hence the depreciation. So, the depreciation is the root cause. The budget deficit was almost wholly an effect of wage and exchange rate dynamics.

    7. "monetising the debt" has nothing to do with hyperinflation. CB could not stop hyperinflation in Weimar or Zimbabwe by "not monetising the debt". Or then again, It could have collapsed the payment system by "not monetising the debt". If you consider that an option to prevent hyperinflation under those circumstances(massive government deficits).

  5. I will try to find time tomorrow to continue with Phil. But right now I just want to direct you to Murphy's astonishingly disingenuous post on Cliven Bundy's racist remarks. Philippe nails him, but look at the reactions. Especially Bob's: he cannot imagine that Philippe is serious but assumes he's just "being provocative."

    1. That thread has a weird and disturbing quality.

    2. Well, given that the owner of the blog thinks that the 'They' are building walls to lock you in and poison you with chemtrails I guess old school slavery might not look so bad.

    3. LK, I hope it wasn't my comments you found weird and disturbing..?

    4. Goodness, no, you're a voice of sanity there in the wasteland of intellectual desolation that is the comments section of that blog, Philippe.

  6. Philip wrote:
    "Yes and no. The issuance of the Marks didn't cause the inflation. It was their use to buy foreign currencies that crashed the value."

    I don't want to seem overly picky but this cannot as stated be right. If the French had taken those newly minted Marks and papered their walls with them, would there have been hyperinflation? Clearly not. Nor would there have been had the French agreed to a ton of blank paper in payment, or cancelled the debt. It was the recirculation of the bills that can only be the culprit in your sequence. And so we are back to rapid exogenous expansion of the money supply as a strong causal factor.

    1. I have the same reservations.

      The problem here is that theorists are not 'running' these ideas on actual currency exchanges to see how they work.

      You can't work from the accounts - which has a tendency to 'convert' currency artificially due to the manner of their drafting.

      You have to go to cash. You have to understand exactly where the exchanges took place, who was the other side of the exchange and what they did with the actual denomination they had.

      To what extent is convertibility suspended at this time in history for example. Are there any hidden backdoors.

      In modern times money is used to buy foreign currency (the modern name is 'liquidity swaps'), and that money is buried by the now foreign owners to avoid exchange rate fluctuations. That's how the Chinese manage their economy for example.

      So there is a danger with too much high level analysis, without getting down and dirty with the actual underlying transactions. You can end up inferring liquidity where there is none, or conversions where none happened.

  7. You should see the comments on Murphy's Lessons from Waco thread. WOW.

    1. Even before you get to the comments section, Bob's analysis in the actual post is utterly loopy.

      His implied claim that the Branch Davidians were not religious nutjobs is itself ludicrous.

      And, oh my lord, Ken B, did you see this comment by Bob Murphy:

      "Grane Peer wrote:

      >We would do well to not care about the
      >opinion of the average american.

      No, it is the opinion of the average American that is keeping Cliven Bundy alive, and you and me out of prison camps."
      Holy bejesus.

    2. Well put.

      So the BLM just want to kill Bundy, the same govt that can keep perfect secrecy for 50 years on killing a president, keep chemtrails a secret, cannot quietly off an old rancher

    3. Does Bob Murphy believe in chemtrails?

    4. Is it just me, or dies this post from Bob appear to suggest that Bob Murphy also believes in the NWO conspiracy theory?

      I've asked Bob to clarify if that is the case, as wasn't sure what to make of it:

      "Yes you need to choose your words carefully when you're fighting against an evil empire...

      ...if you believe (as many of Bundy’s supporters do) that there is a group of people coordinating governments around the globe to usher in a New World Order etc. etc., then yes you have to choose your strategy and tactics wisely. I wasn’t saying Cliven Bundy was racist, I was saying he was reckless."

    5. I genuinely used to enjoy Bob's blog when he wrote posts like this:

      Or, say, for his work on Sraffa versus Hayek and even his PhD, because all this work showed him to be an unconventional Austrian of some interest.

      But now the increasingly bizarre content of Free Advice posts is just turning me off even wanting to read the comments section, really.

    6. Also, off-topic but I miss also Isaac Marmolejo's Radical Subjectivist blog, which was actually the best Austrian blog I've ever seen. If only the Austrian school had more economists in the tradition of Ludwig Lachmann, it might be able to make some progress in its economic thought.

  8. Philippe,
    Murphy seems to believe in chemtrails. Criticism of the idea clearly angers him. He believes or semi believes almost every conspiracy that has the feds as the villain.
    Murphy seems to have a need to be the voice in the wilderness, the one guy who sees through the plot, the one thinker to reject the mundane, the one with the secret and dangerous insight. He seems like a very smart guy actually, but with poor judgment, and almost incapable of dispassion or any other bulwark against raging confirmation bias.

    1. i asked him whether he believes in the NWO conspiracy theory and got this response:

      "I have said repeatedly and explicitly that I think the government would kill Bundy if they could get away with it. So him offering his opinion on “the Negro” is an unforced error.

      Do I believe in a “NWO conspiracy”? Well, George Bush Sr. explicitly said there is a NWO, so that’s not a conspiracy theory in the pejorative sense. There are secret meetings of bankers etc. That’s not a conspiracy theory.

      But I don’t necessarily subscribe to all the stuff that comes out of that train of thought."

      But he does think the government is maybe building a wall along the border with Mexico to stop US citizens from escaping, and he also apparently thinks the government would like to stick everyone in prison camps...

    2. Did you ask him on the blog, or in email?
      As I said, he semi believes all this stuff. Worse he takes his belief that theory X is plausible as evidence for theory Y, even if X and Y are contradictory. I do not have a link but have seen the reasonimg laid out more than once.

    3. on the blog. The link to the comment is above. The other stuff about the border wall and prison camps comes from other comments.

  9. Maybe it's just because I'm sensible, but when I first read the Quantity Theory of Money I assumed Joan Robinson's interpretation, which made sense.

    Prices are sticky in the short run (and always sticky downward). Demand for money is often sticky in the short run, and always "sticky downward" (it can jump suddenly up, but not suddenly down).

    So the quantity of money equations, in either form, then tell us that if we suddenly reduce the quantity of money, we will see a sudden drop in the transaction volume -- in short, sudden drops in the money supply (such as the "demonetization" of something formerly considered money) can induce market "freezeups".

    So far so good.

    But apparently there were economists who were making ludicrous causality interpretations for the quantity of money equations? This shouldn't shock me, given how dumb most economists can be, but it does.
    "But the tradition of Chicago consists in reading the equation from left to right. "
    What unbelievable rot! Who introduced this misinterpretation? I'm not sure this Chicago interpretation even qualifies as the "Quantity Theory of Money" -- it's a perversion.

  10. Oh, Lord Keynes, how come the rapid changes in the PPI in 2008 had no effect whatsoever on the CPI less food and energy?

    I don't believe the idea that "supply shocks" are explanations for either inflation or unemployment in modern advanced capitalist economies.