The Economics of Inflation

Summary

Higher levels of unemployment are not necessary to manage inflation. Targeting purchasing power is less harmful. The income tax code can be used to fight inflation.

In the 1970s, when the U. S. suffered its worst case of inflation, there was no agreed upon course of action to systematically address the issue. Many options were considered, but there was no consensus. Inflation lingered until the Federal Reserve, under the direction of Paul Volker, continued to raise interest rates until it became clear to all that the rapid expansion of the previous two decades was over. It was here, and with the ascendancy of a neoliberal political regime, that the concept of the permanently underperforming economy was ushered in. Austerity and a balanced budget were to be the go-to strategy for those in charge of economic policy. With reduced leverage, labor was to suffer the brunt of this new strategy as higher levels of unemployment became the inflation fighting tool.

     Forty years of subpar economic performance has left its mark. Visions of a Great Society have long ago vanished. We are no longer the shining city upon a hill in which others gain strength. We neglect poverty, systemic racism, and environmental issues as we watch wealth inequality flourish. All because we accept a flawed narrative. We fail to address the issue of inflation properly.

     A system of musical chairs has been designed for the economy. No matter how well labor is positioned to compete for a ‘chair’, there will never be enough to go around for all participants. Upgrading one’s skills may help the individual to compete more effectively, but this does not create more jobs for when the music stops. The number of jobs will always bump up against the targeted rate of inflation as an economy heats up and interest rates are raised.

     Attempting to control inflation by excluding a portion of the workforce from participation lacks imagination. It is a resignation to the unpleasant aspects of a political system that only obeys the power of money. It is the expedient way to control the possibility of accelerating inflation but far from the best. We can do better. It is our duty to understand the dynamics of inflation and put in motion proper tools for combating price instability. Only then will we be able to address larger issues that need attention.

The Prescription

The Federal Reserve (the Fed) is currently charged with a dual mandate: fight inflation and create full employment. Given the tools available, this dual mandate is an overreach. They have been handed an impossible task. The Fed can either lower interest rates, speed up investments, allow business to expand, and create more jobs, or it can raise interest rates, slow business investments, restrict expansion, and fight inflation. It cannot do both. With tools that are available to them, the Fed cannot target accelerating inflation at its source.

     Prices are subject to inflationary pressures based upon the law of supply and demand. When demand is high for a given commodity and supply is low, prices tend to rise. When business is unable to increase supply to meet this increased demand, a new price level is established for that commodity. Where this happens generally, economy-wide, inflation is the result. A permanently underperforming economy is designed to interrupt the prospect of high demand. Higher interest rates and lower levels of investment creates higher levels of unemployment. With greater unemployment, some consumers are removed from active participation, and demand for goods and services falls. Limiting the possibility of high demand by way of unemployment, however, is unnecessary, inefficient, and self-defeating.

     Raising interest rates to slow business expansion is just the opposite of what is needed. If inflation is evident in the data, business must be encouraged to continue producing. Instead of raising interest rates to slow economic growth, we must allow business to strive to meet higher demand. Business should continue to enjoy attractive interest rates which helps to promote growth and, depending on the severity of the economic indicators, be granted lower tax rates.

     When the data suggests accelerating inflation, reducing federal spending is necessary but only a first step. The issue of consumer spending must be addressed. We must dial back consumer spending in the face of inflationary pressures until business can keep up with demand. This reduction in spending can be accomplished by way of higher levels of taxation for the individual taxpayer. Reducing disposable income in times of accelerating inflation will affect demand and bring spending more in-line with production. This process can be referred to as the Fiscal Policy Reaction Function.

     Limiting the purchasing power of the consumer will help to maintain current price levels. While not attractive to most, limiting demand for goods and services in this manner has the benefit of maintaining employment levels. Once business is again able to produce at levels commensurate with demand, the  inflation premium can and must be rescinded. This will allow consumer spending to return to previous levels and allow business to continue to innovate and expand.

Codifying into Law

To make the above plan of action workable will, unfortunately, require an act of Congress . . . literally. It will be necessary to codify this strategy into law. When accelerating inflation appears in the data, time will be of the essence. There will be no time for deliberation. We must agree to a solution in advance. This process, as it unfolds in real time, must be removed from the political sphere. As signs of accelerating inflation appear, tax rates must be adjusted automatically and across the board.

     Early signs of inflation are readily available. These signs include tracking wage increases, observing service sector and commodity prices, examining the Baltic Dry Index where international trade is quantified, recognizing financial bubbles, and the list goes on. This process, for the most part, has been worked out by the Fed. This is the same data that is currently used to adjust the Federal Funds interest rate, when political considerations are not in play. Indicators are available that will show unwarranted demand pressures on goods and services and the need to act.

     Once the proper indices are agreed upon, the formula, perhaps in the form of an algorithm or a type of machine intelligence where the power of historical data is used to its fullest extent, must be codified into law. The result of this process would then trigger an automatic response when the conditions warrant. Individual income tax rates would be raised or lowered based upon the outcome of this analysis. Deliberations on a proper course of action must be decided in advance as the lessons of the 1970s has revealed. Timely action is the key to managing inflation.

     Compelling action among rabid partisans will be the challenge. It must be recognized, however, that this approach to fighting inflation is a potential win-win. The business community continues to expand with this strategy, and labor enjoys higher rates of employment. Consensus may be possible given that forestalling inflation and higher levels of employment are in everyone’s interest.

Conclusion

The current prescription of limiting overall economic growth to combat inflation is not efficient and is counterproductive. We do not need to engineer a permanently underperforming economy to address the prospect of accelerating inflation. A more targeted approach can allow for higher levels of employment and a more robust economy. We can look to the data for answers and use the tax code to help regulate demand. A more institutionalized approach to managing inflation is possible. The health of the economy and social cohesion depends on our ability to make this happen.

The Profession of Economics and Its Enemies >>>>> (Part 3 of 3) — The Political Sphere

Abstract

     The art of politics marginalizes economic policy. The economist is beholden to the  

     political. The economic sphere must seek autonomy from the political.

The following is the third of a three-part series considering why the profession of economics has not been able to shed the label of ‘the dismal science’. Part One advanced that this label results from a failure on the part of the discipline to properly conceptualize the nature of an economy. Part Two suggested teaching economics from the business college further mischaracterizes the profession. This Part Three advances the admittedly fanciful notion of removing the economic sphere from the political sphere, where many good ideas go to die.


                                                       The Stage

The U. S. economy experienced its best performance in the decades following World War II. The large war debt was paid down, unemployment was low, and inflation was under control. It’s generally recognized that pent-up demand for goods and services led the way to this good fortune. The 10 or so millions of men and women who came back from the war were ready to resume their lives and take on personal debt, if necessary.  While it wasn’t recognized at the time and is still not fully acknowledged, this phenomenon of increased spending validated the Keynesian principle of effective demand. While pent-up demand may not have been the spark Keynes sought regarding economic performance, it nonetheless spurred the economy for a generation.

The existence of an effective demand, however, was not enough to sustain this newfound prosperity. Inflation surfaced in the late 1960s and early 1970s, and a failsafe mechanism to deal with its potential to do harm was unavailable. While it was recognized that the economy was overheated due to the cost of the Vietnam War and ongoing social issues,  the prospect of inflation went unanswered. Neither President Johnson nor President Nixon was ready to pull back on the reins of a booming economy. Good economic policy was beholden to the political.

As the economy continued to deteriorate, this lack of action provided the perfect opportunity for neoliberals of various stripes to claim that Keynesian economics does not work and that there was no alternative but to return to the self-serving, neoclassical doctrine of austerity. Cuts to social programs and high interest rates slowed the economy and eventually reduced inflation but left labor wanting. Fast forward through 40 years of low and vastly unequal growth, and we now have no alternative but to change course.

                                                      The Proposal

As was shown, the problem with the U. S. economy in the late 1960s and early 1970s was not with an inability to provide for the needs of society. An effective demand and the tenacity of the business community  accomplished that brilliantly. The problem was the systemic inability to protect against accelerating inflation in the face of political pressures.

Neoclassical economists solved the problem of inflation in the 1980s by creating a permanently underperforming economy where the prospect of high demand never surfaces. Once a hint of inflation becomes evident in the data, the Federal Reserve raised interest rates, and business expansion is dialed back. Unfortunately for many, the cure is as bad as the disease.

Inducing unemployment lacks understanding. Accelerating inflation results from too much demand chasing too few goods. Limiting the capacity of business to produce goods and services when it already is underproducing is counterproductive. Instead of raising interest rates to slow economic growth, interest rates must be maintained or lowered to allow business to meet higher demand by way of expanding operations. When the prospect of inflation appears in the data, business should continue to enjoy attractive interest rates and, depending on the severity of the economic indicators, be granted lower rates of taxation.

Consumer spending must be targeted to fight inflation and not interest rates. Reducing consumer spending will allow supply and demand to become closer in alignment. When aggregate supply and aggregate demand are in close alignment, inflationary pressures are minimized.

This reduction in spending must be accomplished by way of higher levels of taxation for the individual. When the prospect of inflation appears in the data, an across the board tax increase is necessary for individual taxpayers. Once business is again able to produce at levels commensurate with demand, the increase to individual tax rates can and must be rescinded to previous levels. This will help to spur business into further action. While the consumer is asked to shoulder most of the burden in this fight against inflation, this strategy is preferred because unemployment levels will remain low as business continues in its attempt to expand.

                                                          The Challenge

Timely adjustments to income tax rates will be critical in this future fight against accelerating inflation. There will be no time for deliberation. Data that is currently used by the Federal Reserve to project inflationary trends must be used to trigger a rise in the tax rates of individual taxpayers when conditions warrant. These adjustments must be codified into law such that human intervention is not necessary. Fashioning automatic triggers will be challenging given the dynamics of partisan politics. Without these automatic triggers, however, the prospects of gridlock are great. We must guard against this.

Developing automatic triggers to raise or lower income taxes is not a far-flung idea. No one benefits from inflation. In the not-too-distant future we are destined to trust our very lives to self-driving cars. Given the availability of current and historical data, we should be able to codify into law an autonomous economic policy to combat inflation and remove the prospects of accelerating inflation from the political.

                                                     Conclusion

We do not need to engineer a permanently underperforming economy to address inflation. With the proper tools, high levels of employment can be maintained within a growing economy. We must codify into law procedures necessary to combat inflation prior to its arrival.

It is beholden on us all to not only correctly define the nature of an economy and to properly train future generations of economists. We must allow the economy to work for all. If good economic policy can be removed from the political sphere, a significant shortcoming of the discipline of economics will cease to exist and, in the process, perhaps, put an end to the label of ‘the dismal science.’

                                                           References

     Polanyi, K., 1944, The Great Transformation: The Political and Economic Origins of Our 
     Time, Beacon Press, Boston

     Saez, A. & Zucman G., 2019, The Triumph of Inequality, W. W. Norton & Company, 
     New York

     Schleifer, T., 2019, “Silicon Valley billionaires keep getting richer no matter how much 
     money they give away”, Vox, https://www.vox.com/

The Profession of Economics and Its Enemies >>>>> (Part 2 of 3) — The College of Business

Abstract

     The forces of supply and demand reside outside of the economic profession. 

     Introducing the law of supply and demand to the new student of economics is harmful. 

     The discipline of economics must establish itself as a social science.

As was stated in Part One of this series, the profession of economics has long carried the label of ‘the dismal science’, perhaps due to a failure on the part of the discipline to properly conceptualize the nature of an economy. Part Two argues that the standard economic curriculum is intractably flawed perpetuating this unfortunate label. It is argued here that attempts to understand how an economy works by way of market forces misdirects the new student.

Teaching Economics

A perusal of leading macroeconomic textbooks reveals the principles of supply and demand as critical to understanding how economies work. These textbooks place markets at the center of the economic universe and support the invisible hand theory of social benefits.

The invisible hand theory describes the unintended social benefits of an individual’s self-interest. This theory is short-sighted and assumes too much. It assumes a balance between competing interests, the interests of the entrepreneur and the interests of the wage earner. It assumes an equitable distribution of financial power. With rare exceptions, this is not the case. Given the power dynamics of this relationship, the entrepreneur has historically exercised a commanding influence, with predictable results.

The operational force at work in an economy must be viewed in terms of buying power. These operational forces recognize the very human need for goods and services which create the demand that drives an economy. An economy built upon the market principle of self-interest cannot itself guarantee an effective demand. Evidence of this is how the invisible hand disappears when consumers have no money. Markets feed an economy but are not its fulcrum. Markets are ancillary to the operation of an economy.

In its current interpretation, the discipline assumes that an economy has an overall price that is then used to affect overall quantities purchased. This abstraction is the initial sleight of hand on the path toward the discipline’s betrayal of the student. It has yet to be demonstrated that an economy has an overall price. The ability to generate one mathematically does not make it meaningful. Prices are a function of a market and not of an economy, as was offered in Part One of this essay. To suggest that the forces of supply and demand operate at the level of aggregates abuses this principle.

The Law of Supply and Demand

Introducing the concept of supply and demand to the student of economics in an introductory macroeconomic course is brilliant if the intent is to deceive. This well-known and intuitive law is readily accepted by the student as useful in the attempt to understand how economies work. With an easy-to-understand concept the subjugation is complete. This misrepresentation has the effect of imprinting the student with a direction not unlike a hatchling that identifies the first creature it sees as its mother. Perhaps this is what Paul Samuelson meant when he said, “I don't care who writes a nation's laws -- or crafts its advanced treaties -- if I can write its economics textbooks.”

Interlacing the principles of finance with those of economics sends the student off into a blind alley where the true nature of an economy is not to be found. Economies cannot be managed at the level of business. They cannot be managed in terms of markets. Economies must be administered by managing aggregate demand. Good economic policy is the result of adjustments to aggregate demand for goods and services in relation to aggregate output. Factors that go into a buying decision and the outcome of those decisions is beyond the scope of the economic profession.

A Social Science

Teaching economics from the business college with business instructors, as is the case at many universities, sends the wrong message. Imagining economics to be a function of business is destructive. Unlike business, economies operate on principles far removed from products and competition. Economies do not have a profit motive. At the national level, an economy do not compete. Properly administered, an economy works to ensure full employment and a healthy business environment.

The student must recognize that influencing economic policy is not possible from within the business community. Economic policy takes place outside of market activities. If the intent is to work for a privately held firm with the expectation of high wages, any passion for public policy will remain unfulfilled.

Where are the social scientists in this betrayal? How is it they allow business interests to override their home turf? Where are the real economists that look out for the needs of the broader community? Are they more concerned with their own careers than the needs of the students or the greater issue of social welfare? Are they comfortable with students of economics being taught to be good businessmen and businesswomen? What if the student understood in advance the goal of an economist is the public welfare and not increased profits for a privately held firm? Who is there to advise the student? Perhaps, most economists themselves are unaware of their true mission.

Conclusion

When passing knowledge from generation to generation, economists must prevent an intellectual fatality. Suggesting an economy can be understood in terms of the same forces that govern a market does a disservice to the profession. To avoid self-mutilation, the discipline must offer imagery that conforms closer to reality, that is, imagery that can be built upon when designing public policy. This imagery must start with a recognition of the difference between the mechanics of the true economic forces at play within an economy and the mechanics at play in a market. The student must understand that the problem he or she is attempting to solve is not a business problem. With that in mind, economists must ensure their profession acts to ensure that its mission is regenerated anew with each generation. Only then can they hope to put an end to the label of ‘the dismal science’.

References

     Saunders. P. and Walstad, W. (1990) “Foreword,” in The Principles of Economics 
     Course: A Handbook for Instructors, McGraw-Hill Publishing Company, New York

     Kalecki, M. (1944) Political Aspects of Full Employment, Political Quarterly, pp. 1-5.