Tyler (and Scott S.) vs. me on inflation

Tyler Cowen writes,

To see why the huge increase in bank reserves did not result in inflation, consider that there has been a considerable decrease in U.S. excess bank reserves over the last five years. No one claims that this has been accompanied by a massive deflation, whether in securities markets or elsewhere. Once that point is conceded, it’s possible to see why higher levels of reserves are not necessarily inflationary.

Let me stress that his views are fairly mainstream. It is my views that you should especially doubt. I hold outlier views in two ways. Rather than argue against Tyler, I will argue against what I think Scott Sumner would say. I hope this deals with Tyler en passant.

1. Fiscal dominance vs. monetary dominance. The government tries to control the level of nominal income using fiscal and monetary policy. If you are a worker, your nominal income is your salary. If you are a self-employed yogurt maker, your nominal income is the revenue from your yogurt sales, less the cost of inputs.

If the government wants to use fiscal policy to raise nominal income, it can run a larger deficit. Congress votes to send Paul a stimulus check for $1000 by borrowing the money from Peter, giving Peter a Treasury bill. Paul feels $1000 richer, and Peter does not feel poorer, because he expects to be paid back. (As academic economists will tell you, there is actually a longstanding dispute on this point. Just Google “Barro are government bonds net wealth” or “Ricardian equivalence.”)

If the government wants to use monetary policy to raise nominal income, the Fed obtains Peter’s Treasury bill, paying for it using a digital asset, called bank reserves, or Fedcoin, if you will. The more Fedcoin that banks have, the more freely they will lend, and the more freely the public will spend.

Scott’s argument for monetary dominance is that the Fed, which sets monetary policy, is way more agile than Congress, which sets fiscal policy. It’s like a game of rock, paper, scissors in which if Congress shows rock, the Fed shows paper. Or if Congress shows scissors, the Fed shows rock. The Fed can always win.

Consider the $1.9 trillion stimulus Congress is debating. Even though it would be an adverse supply shock, as quantified by Casey B. Mulligan and Stephen Moore, it would tend to raise nominal income. If it passes, the Fed can decide to be less expansionary in order to keep nominal income on target. If it fails, the Fed can be more expansionary and still hit the target. Note that no Fed chairperson would ever say this out loud; instead, the Fed chairperson is obligated to tell Congress that whatever it plans to do is exactly what the economy needs and thank heaven for Congress, because the Fed could never do the job all by itself.

I believe in fiscal dominance. That is because I do not think that Peter cares all that much whether he hangs on to his T-bill or exchanges it for money. Scott thinks that Peter will spend more in the latter case. I am skeptical.

In this regard, my views coincide with the Modern Monetary Theory of Stephanie Kelton. (Rest assured that her views and mine differ in many other respects). She would say that Fedcoin is merely non-interest-bearing government debt (although since the financial crisis of 2008 the Fed has paid interest on Fedcoin). I might prefer to say that T-bills are interest-bearing money.

2. Inflation as an autocatalytic process

Scott, like almost all mainstream economists, sees inflation as having a continuous dose-response pattern. Give the economy a higher dose of money and it will respond with higher inflation. Other economists measure the “dose” as the employment rate.

I think of inflation as an autocatalytic process. Inflation is naturally low and stable. But it can be jarred loose from that regime and become high and variable. Then it takes a lot of force to bring it back to the low and stable regime.

Another example of an autocatalytic process is a social media platform. If you want to try to build the next Facebook, it is really hard to get started. But once enough people join, then their friends will want to join, so growth becomes automatic.

When inflation picks up to an annual rate of 8-10 percent, it changes your behavior. I know, because I remember the 1970s. When you run a business and you see your suppliers and workers demanding 10 percent more than they did a year ago, you cannot ignore that when you set your price. When you are a worker and see the cost of the stuff you buy going up 10 percent per year, you need to demand a raise just to keep up.

The real take-off point for inflation in the 1970s was the New Economic Policy of President Richard Nixon, announced in August of 1971. He let the dollar “float,” meaning that it depreciated in world markets. In a misguided attempt to stifle inflation, he imposed wage and price controls. In order to work properly, a capitalist economy must have freely moving prices. The controls were a self-inflicted adverse supply shock. Adverse supply shocks raise prices (and recall that the latest “stimulus” is an adverse supply shock on steroids). Although for a little while the price controls repressed inflation, the more enduring effect–the supply shock–went in the other direction. Note, too, that inflation itself is a supply shock, because a lot of the steps that households and businesses take to protect against inflation are steps that detract from productive activity.

Once inflation gets going, the only way to stop it is to slam on the economic brakes. Usually, this means drastically cutting government spending. But in the U.S. in the early 1980s, we slowed the economy without cutting government spending. Instead, the foreign exchange market put on the brakes by raising the value of the dollar, stimulating imports and making our exports non-competitive. And the bond market put on the brakes by raising interest rates, so that nobody could afford the monthly payment on an amortizing mortgage. After a few years of high unemployment, inflation receded.

Most economists attribute these developments to Fed policy under the sainted Paul Volcker. Scott could say that this was exhibit A for monetary dominance. The economic consensus may be right, but I would raise the possibility that the financial markets were the main drivers.

What about more recent experience? As I see it, since the 2008 crisis Congress has been undertaking ever-more-reckless deficit spending, throwing match after match on the firewood, without starting an inflation fire. Maybe that pattern will persist. But if an inflation fire does get going, I will be less surprised than the markets.