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Interest rates, rising inflation and economic imbalances

By Václav Klaus, Czech ex-president

Many things are not discussed enough in our relatively small economic community, and even fewer are discussed to the point where there is even a rudimentary consensus on them. Before we make strong statements about the possible effect of our central bank's recent intervention in interest rates, we should seek to answer the question "what is causing our current inflation?". But this is impossible without each discussant subscribing to one of the well-known hypotheses for the causes of inflation and to one of the competing macroeconomic theories. Unfortunately, this is not happening.

One group of our economists concentrates on the easily visible particulars, on examples of the rise in specific prices (energy, housing, some foodstuffs) and on the various supply-side bottlenecks (caused by virus-related restrictions), while the other, along with Milton Friedman, is convinced that inflation is always a monetary, i.e. money-related, phenomenon, and that it is there – in the evolution of the money supply – that its cause must be sought. This was nicely described in a recent article by my good friend, the well-known Canadian economist Herbert Grubel (What's Causing Inflation? Bottlenecks or Too Much Money?, Financial Post, November 10, 2021).

The ČNB's anti-inflationary monetary measure, which was implemented two weeks ago and which provoked such a strong reaction from the outgoing Prime Minister Babiš, is essentially based on the adoption of a variant of the Keynesian doctrine, in other words, it involves not subscribing to the monetarist doctrine. The ČNB's intervention was based on the fact that both the demand for money and the demand for investment and consumption, as well as decisions on government spending, are a function of the interest rate. Therefore, if demand is to be curbed, interest rates must rise. I don't know exactly how the ČNB knows the elasticity of each component of aggregate demand to interest rates, but it probably considers it to be statistically significantly higher than one. That is an example of a topic that we should have a serious discussion about.

The ČNB's action was probably based on the view that the current inflation in and around our country is the result – cumulative in recent years – of an imbalance between aggregate demand and supply. This imbalance was created by a long-standing lax monetary policy that was not afraid of inflation but fought deflation. Aggregate demand has recently been moving away from aggregate supply, both because of demand growth itself and because of lockdowns and bottlenecks of all kinds on the supply side. I do not dispute this interpretation of the cause of our inflation, assuming that this argument was exploited by the ČNB.

Off-topic, climate: globally, by the UAH AMSU satellite dataset, November 2021 was just 0.08 °C warmer than the average November in 1991-2020. The anomaly collapsed from 0.37 °C in the previous month. If you wish, 3/4 of the global warming in the recent 15 years was undone, mostly by the newly starting second La Niňa in a row. Negative anomalies (and maybe deeper than the recent ones) are totally possible in coming months.
The reasons for the abnormally rapid growth in aggregate demand must be sought back to the 2008-2009 crisis. At that time, there was a paradigm shift, an almost panicky fear of a repeat of the 1920s, i.e. of a lack of aggregate demand, and therefore unconventional monetary policy methods were adopted. These were given the entirely new, difficult-to-interpret name of quantitative easing.

In this "easing", the central banks' stimulation of the economy was not through interest rates but through the purchase of private and public sector bonds. The central banks printed money at a rate unknown in history and did not take inflation into account. They feared deflation and scared us with deflation. The statistically reported growth rates of the money supply were unprecedented. They didn't cause inflation for a long time, which is why this policy continued for many years. All was seemingly well.

However, I was not so sure even then. The logical consequence of the rapid growth of the money supply was the strange behavior of the velocity of money circulation (\(V\)), or the demand for money. The velocity of money was decreasing, which an economist must interpret as an increase in the demand for money. Interest rates were not rising (on the contrary, they were falling, often to negative values), which was an illogical motivation for the increasing holdings of money. Money was lying idle, with nowhere to invest it.

However, this was not a textbook special Keynesian case; it is not conceivable with such rapid growth in money supply, which did not remain "in the air". For it to occur, stagnation would have had to persist for an extended period of time, which was not a dominant characteristic of the world economy in the past decade. Economic growth was under way until the viral adventures.

But perhaps that was not the case for so much growth in \(V\). Maybe we are just miscalculating. The quantity \(V\) (one of the four variables in the equation of exchange) \[ P = \frac{M\cdot V}{Q} \] is not directly measurable, it is only calculated as a residual. [LM: This single equation that I added didn't cut 50% of the sales, as argued by Hawking; it doubled the value of the blog post instead.] Its magnitude depends on the other factor on the same side of the equation, the size of the product, or alternatively the volume of transactions. I have previously hypothesized that it is better to talk about transactions (\(T\)) rather than product (\(Q\)), which are much larger in magnitude than the product produced and statistically reported, and which have grown much faster than GDP in this decade.

The same applies, of course, to the correct or incorrect measurement of \(P\), the price level. If \(P\) is expressed as an index of consumer prices (still variously truncated, e.g. by energy and housing prices, not to mention price developments on the financial markets), then \(V\) looks awfully big. But money may not have been lying fallow throughout the last decade, it may have been servicing transactions outside GDP, i.e. outside output. Still, I'm inclined to hypothesize that there is too much money in the economy unnecessarily, and that it is the ultimate cause of today's inflation. Central banks have been too "accommodative", the money supply has grown too fast. The rapid rise in the savings rate is evidence of this.

The question is whether an increase in interest rates will lead to a reduction, or at least a slowdown, in the growth rate of aggregate demand, or rather, the question is which components of aggregate demand are interest elastic, or interest sensitive. Consumption probably not so much, except for mortgage demand. Investment, I don't know, and I'm not sure there's a large preponderance of demand in the capital goods market in particular. Certainly the \(G\) variable, or government demand, would need to be put on the brakes. It may be complicated by the rise in the cost of servicing government debt, but the evolution of government spending is very autonomous, and the sensitivity of politicians' decisions on government spending to interest rates is minimal. We will have to ask the Pirates and STAN, since we have not had time to ask [Venezuela-style socialist outgoing welfare minister Ms] Maláčová how strongly they will react to interest rates in their vote on the state budget deficit in parliament. I am not optimistic in this respect.

Moreover, we are not living in a vacuum. Given the great interconnectedness of the European energy market, we may well be experiencing imported inflation, the importation of higher prices, especially of energy raw materials and energy (which we do not import yet). This could be one variant of cost-push inflation, but even in this case the assumption (and therefore the ultimate culprit) would be persistent lax monetary policy. There can be no cost-push inflation without it, as economists and bankers know, or should know.

This, of course, also applies to the other obvious cost pressure, which is caused by wage growth. The tensions in the labour market are a reflection of the state of our economy as a whole, with demand for labour outstripping supply (as evidenced by our exceptionally low unemployment rate, the lowest in the EU), but there are also autonomous wage pressures at work that are not directly related to the state of the labour market.

This is both the Maláčová-style continuous increase in the minimum wage (almost doubling during the era of the Sobotka-Babiš governments), the coveted gifts to various professions and groups on the labour market (supposedly for their "overwork" during the pandemic), and the success of unions in important sectors – à la the car industry – without any connection to product and productivity growth. But let's not forget, without an overly "accommodative" monetary policy, fighting deflation for most of the decade, even this would not have been possible.

It would be tragic to try to suppress inflation (to create a state of so-called repressed inflation [regulations to truncate the growth of prices and/or wages which produce a big real inflation as soon as the regulations are removed, unless they are accompanied by some further complex regulations to actually reduce the demand]). The only method of getting rid of inflation is to let it run its course and prevent it from turning into a self-powering vicious circle in the future. This requires very prudent monetary as well as fiscal (budgetary) policy. But that is beyond the debate on the initial effects of central bank interest rate hikes.

Václav Klaus, Weekly "Echo", 2 December 2021

Translated with (free version)

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