February 16, 2004
Donald R. Byrne, Ph.D.
Edward T. Derbin, MA, MBA
Note: To print a hard copy of this newsletter, click on the following link for a PDF download…
Early in 2003, the President of the Federal Reserve Bank of Cleveland, Jerry Jordan, retired after over a decade in that position. Over a quarter of a century before that he became a well-known monetarist and wrote profusely on the topic as a senior research economist at the Federal Reserve Bank of St. Louis. Even better known as the high priest of Monetarism, is Milton Friedman (and Anna Schwartz Federal Reserve Bank of Minneapolis-The Region-Anna Schwartz on Milton Friedman (September 1998)), a long time Economics professor at the University of Chicago. While Monetarism comes in many variants, it argues that at least the excessive growth in money is a necessary condition for inflation but to many of this persuasion, it is a necessary and sufficient condition in causing inflation.
The roots of monetarism go back to the early quantity theory. As it evolved it took on more sophisticated forms, but the excessive growth of money was at the core of inflation. Essays on Inflation, written by Thomas M. Humphrey, was one of the best treatments of this evolution. The Federal Reserve Bank of Richmond published it in many editions in 1980s and is available through their website at http://www.rich.frb.org/pubs/index.cfm/0.
Monetarism is a line of reasoning emanating from the Quantity Theory. In a very early version (reference to David Hume http://www.econlib.org/library/enc/bios/hume.html), often called the crude quantity theory, prices on the average grew proportionally to the growth rate of money: Money times it Velocity equals Total Spending. Real output times it prices is the current dollar value of total output, today referred to as GDP. Since there are more than one definition of money and these definitions have changed over the years, a rough approximation of what money meant in this context would be what is called M-2 or thereabouts. The link between spending and money is referred to as the velocity of money. For example, if nominal or current dollar GDP for a year is 100 and the average quantity of money during that period is 50; the velocity of money is 2.
Note: money is a stock (measured at any given point in time) and GDP a flow (measured over a period of time) so that we use the average stock of money for the year in which GDP is measured.
For this to be so, the velocity of money must be stable. Real output must be at capacity or full employment levels. When money increases, total spending increases, and if output is constant at full employment capacity, prices will have to rise. In some form or another, the stability of velocity of money is critical to the relevance of the quantity theory of price levels. As a policy guide, the very least is that if the velocity is not stable, its path can be predictable. At its height of popularity in the 1970s and early eighties, even if the secular trend in velocity was rising, as long as it was predictably rising it could be compensated for with a lower rate of increase in money. In the late 1980s and 1990s, the velocity of money such as M-1 and M-2 lost this quality. Part of the g rowing instability of M-1, M-2 and the other monetary aggregates was due to the rapid innovations in practices such as swept balances and part was due to the rapid growth of new and more widespread financial claims often called near money, such as overnight and term repos and Eurodollars.
Inflation is the process in which the average of prices is rising. Firms raise prices in order to raise revenue to increase profits (revenues – costs = profits or losses). If price increases no longer increase revenue because the quantity sold decreases so much, price increases no longer give relief to the firm from falling profits due to rising costs, e.g. in the auto industry.
The editors of this Newsletter would argue that the increasingly competitive structure of the American economy was gradually eliminating price power of firms and labor. The downward price rigidity was giving way to downward flexibility of prices as increasing competition eliminated the price power of firms in many industries. The bias toward inflation was gradually disappearing. In increasingly competitive markets (technically, price elasticity of demand at each price was increasing), the ability of price increases to increase a firm’s revenues was diminishing. The rational for price increase was disappearing. Control of costs began to replace attempts at price increases. Restructuring was on the rise.
It is the (gradual) emergence of this New Paradigm that has been gradually eliminating the inflationary bias, and the link between money and price level changes. Thus came the declining relevance of monetarism including its declining influence in the determination and conduct of monetary policy.
While never stressed, the acceptance and continued relevance of the so-called Keynesian Revolution that became dominant by the late 1940s, depended upon the cartelism of markets, both product and resources markets like labor. The gradual demise of competition in the late 1800s and Pre-W.W.II period resulted in a large part of the American economy being subject to price power by firms and labor resources. When this occurs, prices become rigid downward. The first reaction by firms with market power when demand weakens is to cut output and not prices. This imparts to the economy an increasing inflationary bias as well as a recessionary bias. Though a powerful figure in Neo-Classical economics, Keynes began to understand this growing problem in market adjustment to falling demand. His mentor, Alfred Marshall pointed this out in Book Five of his very popular PRINCIPLES.
Inflation was not a problem in the 1930s, when Keynes wrote his GENERAL THEORY; nonetheless, his model had an implied theory of inflation as well as recession. If at full employment, total spending as represented by the Aggregate demand line was above the 45-degree line, an inflationary gap existed.
In the Keynesian argument, an economy could be at equilibrium in a ‘great depression’ or with accelerating inflation. The market would not heal itself as was implied in the neoclassical vision of Say’s Law. It was incumbent upon the government through policy intervention such as expansive fiscal policy, to eliminate the recessionary gap. In the late thirties, it was believed that monetary policy was of little value since lowering interest rates, even to negative values, would little help to stimulate investment spending, since there was so much excess capacity. Besides he suggested, the interest rate could not be driven below a minimum level called the Liquidity trap since people would hold money rather than risk investing it. This bias against the efficacy of monetary policy has pretty much disappeared in recent years. From the attention paid to it in FOMC meetings, this seems to be the case.
This necessity of government intervention did not set well with those on the right, nor does it set well today. Fortunately, the need for government intervention is diminishing as increasing competition in markets is eliminating both the recessionary and inflation biases that have so longed plagued the U.S. economy.
The microeconomic assumptions behind the Keynesian Model involve downward price rigidity due to lack of competition in markets – in our current economy; this no longer holds sway.
Keynes – Post World War I – World II:
When price rigidity reigned supreme…
Figure 8.6 (from The New Paradigm in Economics: Economic Understanding for the 21st
Century Donald R. Byrne, Ph.D.)
Figure 8.6 (from The New Paradigm in Economics: Economic Understanding for the 21st Century
Donald R. Byrne, Ph.D.)
…into the 21st Century:
so much for sticky prices!
As we will see in futures issues, the same increasing competitive forces cause a less unequal income distribution by elimination of surplus rewards whether it be profits or labor compensation. These are characteristics of the evolving New Economic Paradigm in the American economy.
In a very real sense, this is a rambling set of arguments that have been generated over one and one-half centuries. It more or less began with the battle between Bohm-Bawerk and others over Karl Marx’s argument that capital was unproductive. Marx asserted that only labor was productive. This is a variation of what has occurred throughout the history of economics. The Physiocrats argued only agriculture produced a surplus. Some argued that services did not produce surpluses, only the goods sectors did that.
…But the Austrian School stands for much more to it supporters. Probably one of its more important tenets is the Austrian Theory of the Trade Cycle. It is really a first cousin to Knut Wicksell's theory of inflation. In the Wicksell version, banks create money and credit and cause the market rate of interest to fall below the natural rate of interest. The natural rate of interest was that interest rate that equated saving and investment and assured that the natural rate of employment was achieved, that is the labor market was cleared. By driving down the market rate of interest below the natural rate of interest, Investment exceeded saving, resulting is excess demand and causing inflation.
The Austrian version stresses that once the market rates of interest were driven below the natural rate, the excess investment was called malinvestment. When interest rates rose to their natural levels, the excess investment had to be worked off thus resulting in the contraction part of the trade or business cycle. In a Congressional hearing around 2-years ago, the Fed Chairman used the term ‘malinvestment’ to describe the economic malaise the United States had entered. Terms like irrational exuberance, while not necessarily Austrian, were also frequently used.
Both the Wicksellian and Austrian arguments rest on the old classical theory of interest rates, where saving and investment determined the natural interest rates. As that theory was amended including contributions of Wicksell, it has evolved into the Loanable Funds Theory of Interest Rates. Economic historians such as John Gurley and Edward Shaw recognized that other sources of credit (such as increases in the velocity of money) as contributing to more rapid economic growth by driving down interest rates and accelerating the rate of capital accumulation.
Modern financial theory does not deny that mistakes occur by firms in undertaking some expansion requiring capital, but is more due to errors in forecasting future cash flows rather than artificially low interest rates. If one were to look at real interest rates rather than nominal or market rates…interest rates in the inflation-adjusted sense have changed far less than have nominal or market rates of interest not so adjusted.
Disappearing inflationary bias between nominal and real interest rates – in the face of Rational Expectations…
Did you know…?
A few statistical tidbits that might be of interest
There are seventeen definitions of poverty published by the U.S. Census Bureau.
(see U.S. Census Bureau Poverty 2002)
You may be surprised that poverty levels are considerably lower, or higher, than you may have thought. Bear in mind that the measures are relative (within the scope of the Census Bureau’s definitions as well as beyond…this is solely within the context of the United States).
We will be discussing income distribution in upcoming newsletters. Again, you may be surprised to learn how little difference there actually is between the various levels of income.
Another topic near and dear to most readers is taxes – how much, or how little we pay…
The first thing that jumps out at the reader (or should) is the fact that the overwhelming burden of (Federal Personal Income) taxes are borne by only half of the taxpayers…96% in 1999.
The following graphs depict a number of issues in relation to the GDP. We opted to go as far back as the data was available to show how we stack up today…
How much have federal taxes really gone down?
The tax (as a percent of GDP) reached their recent high watermark in 2000.
There is an ongoing debate over the two methodologies employed in measuring the levels of unemployment (employment)…Namely, the Household Survey and the Payroll Survey (Establishment).
There are critics of both, but please read the following to at least have a reasonable understanding of both (their limitations and purposes).
Statement of Kathleen P. Utgoff Commissioner Bureau of Labor Statistics Friday, February 6, 2004:
“Turning now to our survey of households, the unemployment rate was little changed in January at 5.6 percent. Civilian employment rose by 496,000 (after accounting for an adjustment to the population estimates), and the employment-population ratio edged up to 62.4 percent.”
“Nonfarm payroll employment increased by 112,000 in January and has risen by 366,000 since August 2003. In January, there were job gains in construction and several service-providing industries. While manufacturing employment continued to trend down, the rate of job loss has slowed considerably in recent months. The unemployment rate, at 5.6 percent, was little changed over the month but is down from its recent peak of 6.3 percent in June 2003.”
…more from Bureau of Labor Statistics 10/8/2001
Coverage, definitions, and differences between surveys
The sample is selected to reflect the entire civilian noninstitutional population. Based on responses to a series of questions on work and job search activities, each person 16 years and over in a sample household is classified as employed, unemployed, or not in the labor force.
People are classified as employed if they did any work at all as paid employees during the reference week; worked in their own business, profession, or on their own farm; or worked without pay at least 15 hours in a family business or farm. People are also counted as employed if they were temporarily absent from their jobs because of illness, bad weather, vacation, labor-management disputes, or personal reasons.
People are classified as unemployed if they meet all of the following criteria:
They had no employment during the reference week; they were available for work at that time; and they made specific efforts to find employment sometime during the 4-week period ending with the reference week. Persons laid-off from a job and expecting recall need not be looking for work to be counted as unemployed. The unemployment data derived from the household survey in no way depend upon the eligibility for or receipt of unemployment insurance benefits.
The civilian labor force is the sum of employed and unemployed persons. Those not classified as employed or unemployed are not in the labor force. The unemployment rate is the number unemployed as a percent of the labor force. The labor force participation rate is the labor force as a percent of the population, and the employment-population ratio is the employed as a percent of the population.
The sample establishments are drawn from private nonfarm businesses such as factories, offices, and stores, as well as Federal, State, and local government entities. Employees on nonfarm payrolls are those who received pay for any part of the reference pay period, including persons on paid leave. Persons are counted in each job they hold. Hours and earnings data are for private businesses and relate only to production workers in the goods-producing sector and nonsupervisory workers in the service-producing sector.
Differences in employment estimates. The numerous conceptual and methodological differences between the household and establishment surveys result in important distinctions in the employment estimates derived from the surveys. Among these are:
--The household survey includes agricultural workers, the self-employed, unpaid family workers, and private household workers among the employed.
These groups are excluded from the establishment survey.
--The household survey includes people on unpaid leave among the employed. The establishment survey does not.
--The household survey is limited to workers 16 years of age and older.
The establishment survey is not limited by age.
--The household survey has no duplication of individuals, because individuals are counted only once, even if they hold more than one job. In the establishment survey, employees working at more than one job and thus appearing on more than one payroll would be counted separately for each appearance.
Other differences between the two surveys are described in "Comparing Employment Estimates from Household and Payroll Surveys," which may be obtained from BLS upon request.
(Opinions expressed on this web page are those of a faculty member or employee and do not necessarily reflect the position of University of Detroit Mercy)