Before examining the claim in the Bloomberg headline, two foundational premises about money need to be reasserted and re-acknowledged (if you read TCA regularly, you’ve seen this before): First, money never buys anything, only goods and services buys things. Second, inflation is everywhere and always a monetary phenomenon.
Now, given the premises, is it even possible that a Federal Reserve chairman, who has only monetary policy at his disposal, could ever lead an economy anywhere? As might be expected, the answer is resoundingly, emphatically, “No”. Yet the illusion persists, in no small measure because the economics fraternity, like a band of medieval priests explaining the vicissitudes of nature to an enthralled and credulous laity, has instilled the belief in a gullible public that a) monetary policy determines real economic outcomes (outside of its short-term inflationary or deflationary impacts) and b) that money buys things. Given that the premises upon which Mr. Bernanke is said to have led the economy are false, it really doesn’t matter whether his critics are right or wrong. He hasn’t led the economy anywhere.
But has the Fed caused inflation, which is what the article asserts its critics are wrong about? According to Mark Gertler, an economics professor at New York University who has published research with Bernanke and was cited in the article, “The criticism about the Fed being inflationary is not fact based.”
But is it? The article cites the record of the consumer price index since Paul Volker’s tenure on the Fed to bolster the argument that Bernanke has not created inflation:
During Bernanke’s tenure, the U.S. consumer price index has risen an average of 2.4 percent, lower than the 3.1 percent average for Alan Greenspan and 6.3 percent for Paul Volcker. Greenspan was chairman from 1987 to 2006; Volcker was Fed chief from 1979 to 1987.
Does an increase in the CPI necessarily mean there is inflation? Would a decrease necessarily mean there is deflation? No and No. Again, inflation/deflation are monetary phenomena. If prices wish to climb but don’t, or don’t climb as robustly as demand conditions warrant, because the value of money has increased relative to the goods and services it represents (i.e., there is less of it) then there is deflation, even if prices rise anyway. The obverse is true for inflation. If prices wish to decline because of declining demand, but don’t because the value of money has declined relative to the goods and services it is intended to represent (i.e., there is more money), then even though prices may decline or stagnate, there still is inflation. Prices that didn’t fall though demand has fallen are like Sherlock Holmes’ dog that didn’t bark, a sure clue to an inflationary monetary policy.
To further explain, using a radically simplified economic system as an example, if an economy had only two products, say beans and corn, but nonetheless used money to as a medium of exchanging them, and if the quantity of beans and corn remained the same over time, but the quantity of money (or its velocity, which I’ll further explain in a moment) increases, then prices would increase, as a monetary phenomenon. Because there is more money relative to the quantity of goods it is intended to represent, the price of the goods increase in monetary terms. If before the increased quantity of money, it took two bushels of corn to buy one bushel of beans, the price of beans and corn will eventually, after a lag to allow the market to adjust to the new monetary signals, resolve to the same level as before, assuming all other things stay the same (ceteris paribus). This is inflation, a purely monetary phenomenon. If instead, for example, consumers begin to favor corn over beans, there will be price changes that reflect the new underlying economic fundamentals; corn’s price will fall relative to beans. These price changes that are neither inflation or deflation.
Thus, aside from rising prices not necessarily constituting a reliable inflationary signal, or even a reliable lack of deflation, there can also be changes in the taste or utility of one item relative to another that might increase or decrease the price of an item relative to another. Price changes caused by changes in utility, or by cost reductions due to increased productivity, or any number of other factors not bearing on the price and quantity of money relative to the goods and services it is intended to represent, are neither inflation nor deflation. They are simply price movements in accord with changes to underlying economic fundamentals.
Teasing out whether price changes are monetary phenomenon, or are driven by economic fundamentals is often difficult. For example, just before the oil embargo of 1973, the US had, in 1971, abandoned the gold standard, which caused the price of gold to increase in dollar terms, i.e., the economy already had an inflationary bias before the embargo. In fact, the very reason for abandoning the gold standard was the devaluing dollar relative to gold due to increasing fiscal and current account deficits. The relative impact the embargo had on price increases caused by inflation (devalued currency) and price increases caused by the supply shock is somewhat revealed in the following graph:
Gold prices increased a bit after Nixon abandoned the gold standard, but they really skyrocketed with the two embargoes (1973 & 1979). If we understand that money doesn’t buy things, but that only goods and services buys things, then if a situation obtains where there are less things to buy, the amount of money should decrease as well. The oil embargoes reduced the supply of goods and services available for purchase throughout the economy. For prices to remain stable, the quantity of money should also have declined. That it didn’t, and in fact was expanded in order to increase employment (the idea that monetary policy can create jobs is another illusion that persists in the face of mountains of evidence to the contrary), explains the massive inflationary episodes of each era, culminating in the dollar crisis of 1979, and Paul Volcker’s severely restrictive monetary policy to combat it.
The best method to determine whether prices have changed because of the money, or because of the underlying economic fundamentals is to compare prices of commodities with very stable demand that are traded internationally. To determine whether money is losing or gaining value because of an oversupply/undersupply situation, see how the currency has fared against a basket of internationally-traded agricultural commodities, which generally have stable (gradually rising with the population) quantities demanded and supplied.
The Food and Agriculture Organization of the United Nations has been charting world food prices (a composite index of individual indices for meats, dairy, cereals, oils and fats, and sugar,) since 1990. I wish I could figure out how to import it, but can’t. I’ll have to simply explain it, and encourage you to see the graph for yourself (here). The index starts in 1990 at about 100 (not necessarily dollars or any other unit of measurement). By 1996, it reaches a peak of over 130, after which it begins declining. It bottoms out mid-2002 at under 90, then steadily begins climbing, reaching 130 again by 2007. Between 2007 and 2008, it skyrockets to 220, after which it plummets back to just above 130 by 2009. Since 2009, it has more or less steadily and steeply increased, reaching an all-time high of about 225 in mid-2010, then backing down a bit, to about 210 now (all figures are nominal–there is an adjusted “real” amount, but it’s not clear exactly how the adjustment is made).
Here’s what US producer prices have done during the same period:
Looking from 1990 onward, the trajectory of prices for food and feedstuff as revealed in the US PPICFF has almost perfectly mirrored that of the FAO Food Index, which is of course, not surprising.
We know that the supply and demand for food steadily grows with the population. All the market participants intimately understand this, and price their futures contracts accordingly. But is there any way to predict the value of the money in which contracts are priced? If the money supply is also stable and steadily growing, relative prices should also be stable. But what has happened to the money supply?
The “monetary base” consists of currency and paper money, both in circulation and in bank vaults, and the reserve balances of depository institutions held by the fed. It is considered “high power” money because the fractional reserve nature of banking in the financial system means that one dollar of base money translates to many multiples more of money in the economic system.
Wow. Since the start of the recession, base money has more than tripled, after only gradually and steadily rising for most of the previous half century. This expansion in the money stocks almost fully explains the increases in food prices since the recession began.
Money velocity explains the rest:
Increased velocity during the latter 90’s explains the bump in the FAO index then, and the decreasing velocity since the recession explains why the massive increase in money stocks have not also yielded massive inflation now. Money velocity is the number of times money changes hands each year. In our simplistic economic system used as an example, if the money changed hands four times over the course of the year, the system would need only one-fourth as much money; if instead it changed hands less than once a year, prices would decline. The Fed has been furiously printing money to offset money’s decreased velocity, hoping beyond hope to forestall price decreases that would otherwise obtain. As the prices of agricultural commodities indicate, it has mostly been successful. This failure of prices to fall; this increase in the prices of agricultural commodities after massive increases in the money supply–these are monetary phenomena. These are inflation.
Just because the Consumer Price Index has seen only muted increases in overall prices, after an initial decline at the beginning of the recession, does not mean the Fed has not engineered inflation. It has. Otherwise, prices would have likely continued falling, partly due to the deflationary force of declining monetary velocity, and partly due simply to declining demand. If monetary velocity continues its downward slide, it will hit a point beyond which all the money printing in the world won’t force prices higher, which is roughly where Japan stands about now. Whether the Fed will similarly reach a point where it can no longer engineer even nominal price increases is not clear, but it seems that the more furiously is money created, if prices wish to decline in the face of declining demand, the more rapidly will velocity decline.
It could be argued that Bernanke’s inflationary policies have yielded increased employment. It is true that wages are extremely sticky on the downside, so any decline in the value of labor’s input will mainly cause unemployment, rather than decreased wages. There is also mandated minimum wage levels that put a floor under wage price declines no matter how reduced the value of labor becomes. Bernanke’s inflationary strategy, forestalling overall price declines that would otherwise have obtained, and even engineering nominal price increases in some realms, may have reduced the value of labor relative to the goods and services it is capable of buying, such that labor, particularly at lower-tier levels, could again be profitably employed. In other words, Bernanke’s inflation, which affected everything except wages, may have brought relative wage levels down to an acceptable level such that overall employment could increase. For whatever reason, people are loath to accept a pay cut, and are especially loathe to lose a job because of economic changes, much preferring instead to pay more for their gasoline and food even as their paycheck stays the same. The result is no different than a pay cut, but the trip to lowered wages seems to go more smoothly with inflation than with actual wage cuts. If there has been any value to Bernanke’s inflation strategy, it is in this reduction in friction that has allowed real wage rates to slip to a market-clearing level.
A few more graphs might more clearly show what is meant by Bernanke’s inflation strategy having greased the economic gears enough to allow an expansion in employment, the first is of the wage cost of the nonfarm business sector, used as a proxy for wages generally:
As is clear by examining the index since the last recession began, wages are roughly at the level now that they were before the recession began. But what of overall consumer prices, which are the prices of things wages are used to buy?
After an almost unheard of dip during the last recession, consumer prices have resumed their relentless climb attendant to an inflation-biased Fed, and now stand significantly higher than they were before the recession. What has the combination of these factors done to the labor markets?
After a steep decline at the beginning of the recession, total employment levels have reversed some of their decline, but still lag by about 5 million jobs their previous peak, and are increasing now at an increasing rate.
Did Bernanke’s inflation help to reverse the employment trend? Probably, but it would have happened eventually anyway, after even sticky wages had declined enough to make employing labor profitable again.
As every economist will tell you, there is no such thing as a free lunch. If indeed Bernanke’s inflation helped matters along on the employment front by forcing wage rates down through inflation, what costs were incurred in doing so? The same costs inflation always imposes, which is to say, a decline in the value of money as a medium of exchange and store of value, the misallocation of capital into markets that seem to be growing (domestic energy?) but mainly owe their growth to monetary mischief, and ultimately, the next big deflation, when the next big overblown bubble bursts (again, domestic energy?), or just when overall demand gets oversupplied due to the impaired signaling value of prices in an inflationary regime, such as explains much of the carnage of the last recession. At which point, Mr. Bernanke will undoubtedly again shower the world with dollars, which will undoubtedly cause more inflation, but maybe not enough to keep prices from falling anyway. All of Bernanke’s money couldn’t prevent house price declines this time.
If When this massive inflation he has now engineered succeeds in so misallocating capital that another bust obtains, Mr. Bernanke might just run out of paper and ink before the markets return to what he believes is a rational, persistent rise in prices.