Sunday, March 1, 2015

Inflation Cannot Be Micromanaged, or "Greenback Whirlybird Down!"

Contrary to conventional wisdom, central bankers don't have have the tools required to maintain price stability. Neither do governments. This is not to say that their actions don't affect inflation. When we combine the tools the central bank has (mainly the target rate) with the tools government has (mainly its control over the budget deficit/surplus), we are able to create inflation or deflation, depending on which one we want.

The ability to create inflation doesn't translate to ability to maintain price stability. The problem is that even though we can create inflation at will, we have no idea how much of it we will get -- and even more importantly, what will be the rate of change in inflation (for geeks: this is the second derivative of the hypothetical, general price level) at any point in time. Two years after the start of a government intervention, inflation could be three percent or it could be 10 percent, and it could be accelerating or decelerating. The most technically-minded among us might try to convince you otherwise, but they ignore the importance of inflation expectations and the role psychology plays in forming these.

The appearance -- or even a threat thereof -- of large fiscal deficits would affect inflation expectations among the public (investors included) in a very unpredictable way. As a consequence, inflation itself would be unpredictable (to be clear, time-lags, too, would make inflation management very difficult). This is because inflation expectations -- which depend heavily on human psychology and the relative attractiveness of competing stories -- are what really drives current and future inflation. All this is related to reflexivity.*

The "natural" (this is, absent a large-scale government intervention) outcome of our current debt overhang would be debt deflation. As far as I know, this is what William White is alluding to when he says "They have created so much debt that they may have turned a good deflation into a bad deflation after all.".

As I suggest above, and as Milton Friedman among others has suggested before me, a deflationary spiral could be countered through very large fiscal deficits (~10-20 %, without pretence to accuracy). This deficit could be "sterilized" (I stretch this concept) through a) new issuance of government bonds (by Treasury), or b) sale of existing ones (by central bank), or it could be un-sterilized as in "helicopter money" (see, for instance, Simon Wren-Lewis here) or overt money financing (OMF). (Related to this, I'd like to hear from Wren-Lewis, or any other expert, what is the difference between financing the deficit, on one hand, through bond issuance, and via OMF on the other, in a world where 2-5-year bond yields are negative while cash yields zero?)

So, my mental framework (or, theory) suggests that through large fiscal deficits an impending, severe debt deflation can be turned into volatile and unpredictable inflation. This inflation, or expectations thereof, would initially bring us increased spending, increased output and employment. It would increase the real GDP. This is exactly what the most short-sighted of us are after when they call for substantial government spending financed by a large fiscal deficit (this is why the "austerity vs. stimulus" debate doesn't make much sense to me). But this boost to the economy would be, to a large extent, due to increased speculation. At the extreme, we would see a Black Friday-esque spending frenzy as perfectly rational agents rush to buy real assets with existing and newly-created IOUs (formerly known as "money"), as they expect the value of currency to greatly diminish in the future. All this should be clear to any attentive student of inflation. Almost as clear to me is that we have already seen this kind of speculation in 2009-2014, albeit on a very small scale relative to potential.

Eventually, after a period of accelerating inflation, we would need to do what Paul Volcker and the Fed did -- thanks to sufficient public, and thus political, backing -- in the early 1980s. We would need to bring inflation down through an instant, deep recession and mass unemployment. Of course, there's always another option: to let the inflation run its course. I think we widely agree that it's better to take the recession than go down this path. Still, we cannot fully count on this to remain the case if push comes to shove.

There's always a possibility that the fiscal deficit would not be large enough -- let's say, due to political resistance -- to get the inflation even at the target level. In my world, this deflation or "low-flation" would ultimately have its cause in authorities' inability to convince agents that they should spend before inflation arrives and starts eroding the purchasing power of the currency. Something like this has been going on in Japan for something like two decades. But as my critique is aimed mostly at the same people who insist that Japan has not yet tried hard enough, and that all would be better there had they just tried harder, I won't analyze this possibility in detail here. All I want to say is that if we try hard enough, at one point we will get the volatile inflation and the (new) problems that come with it.

I state my critique once more: Inflation is not micromanageable in the way Modern Monetary Theorists (MMTers) or the living advocates of The Chicago Plan (CPs) seem to suggest. And I'm willing to bet that many of our best investors agree with me. We should never underestimate the effect of speculation on economic outcomes. Neither should we underestimate the difficulties we face if we try to differentiate between speculative and non-speculative transactions.

The biggest reason why we ended up with this massive, global debt problem is our inability to understand how all "money" is just a promise to pay (an IOU), and, as it logically follows, that it is not possible to pay for anything with this "money" (see my post from yesterday). Once we accept this, we must accept that the Quantity Theory of Money (QTM) should be dismissed in its entirety. But this we haven't done. Even people who understand quite well how "money" is just an IOU (for instance, MMTers and CPs) still view inflation more like a technical issue, something that is micromanageable -- wait for it -- through well-calibrated injections and withdrawals of "money" by the government. Are they all monetarists now?

I'm puzzled. Sometimes I wonder if nearly all our economists are suffering from doublethink.

* I'm greatly indebted to George Soros who, with his book "The Alchemy of Finance" (1987), has shed much light on reflexivity both in financial markets and the economy in general. Robert Shiller has helped me better understand the role stories have in affecting outcomes (see, for instance, his article at Project Syndicate). I present Soros as the prime evidence for my claim that to understand the economy one needs to be a philosopher, while Shiller's work speaks for the importance of understanding psychology. The society consists of individuals who contemplate and participate (i.e. act); they both compete and co-operate. That's probably all there is to an economy.

Mumblings post scriptum

There are many ways out of our current mess. Some are much better than others. None of them is an easy one. We have only bad options left. On the normative side, once we get there, I have a lot of suggestions on how to ease the pain, how to take care of the society and build a better future for all of us. (I'm dismal only as a scientist, not as a human being.) But first, we need to agree on what is ailing us -- only then we can try to apply the right treatment.

What got us here is our mistaken belief in the existence, both on a microeconomic and a macroeconomic level, of "money". The truth is that our financial system consists only of debts and credits -- all kinds of liabilities and a mountain of IOUs. The current amount of these liabilities and the corresponding IOUs is just too big. This is what is ailing us. We need to get it back to a substantially lower level, and it seems to me that it will take a global recession ("It" will happen again) to achieve this. This is my diagnosis (it's based on a considerable amount of work I've done since 2008). As we analyze the treatment options and weigh them against each other, we should keep in mind the following goal: to get the world through this turmoil with the least possible damage.

This is only my 11th blog post. It won't take long to read all of them, in case you would like to get a better understanding of where I come from. If someone is interested, I could add a short bibliography. I find myself unable to add any specific references in my text, as I usually have no clue about the person who planted a certain thought in my head. My list of suspects is very long. A random sample ("name-dropping"): Adam Smith, Léon Walras, Charles Mackay, Silvio Gesell, Walter Bagehot, Knut Wicksell, Alexander del Mar, Eugen Böhm-Bawerk, Ludwig Mises, Alfred Mitchell-Innes, Joseph Schumpeter, Friedrich Hayek, John Maynard Keynes, Irving Fisher, Henry Simons, Karl PolanyiJames Tobin, Adam Fergusson, Charles Kindleberger, Milton Friedman, John Kenneth Galbraith, Hyman Minsky, Paul Volcker, William White, Adair Turner, Claudio Borio, Philip Coggan, Nassim Taleb, George Soros, Robert Shiller, Daniel Kahneman, Amos Tversky, Bill Gross, Howard Marks, Stanley Druckenmiller, Warren Buffett, Charlie Munger, George Cooper, Michael Lewis, Matt Taibbi, David Graeber, Steve Keen, Izabella Kaminska, Steve Roth, Noah Smith, Martin Wolf, Matt Stone, Trey Parker, Paul Krugman and "Tyler Durden".


  1. Some random comments from me:

    1. a recently started series on FT alphaville shows how consistently and by how large a margin did the Fed underestimate the US inflation in post-2008 years: That's a data point to further your claim of inability to manage inflation. (Incidentally, in the same series you can find evidence that the Fed considered QE to be a weak monetary tool at best and they saw fiscal stimuli as effective, contrary to the "crowding out" and "quantity of money" crowds again).

    2. I believe the "quantity theory of money" is considered discredited at this point in time. As in, not used by the central bankers themselves. Since they are the only ones who could apply it in practice, it's effectively dead.

    3. I have not read all your posts yet but I don't quite follow all of your logic in this one. Specifically, I don't understand your feelings of upset at the inability to pay for anything with money-cum-IOU: it works quite mechanically and quite well, various accounts are marked up or down. Of course, if you unravel all of the hypothecation chains you will reduce a given set of transactions to their "primal" barter origins. The problem with barter however (if we assume it to be the only "true way to pay for anything") is that it only works contemporaneously: you swap your fish you caught today for berries someone gathered today. As soon as you need to spread things over time (and you always do), you need some tokens of trust to facilitate exchange. Entries in some ledger book (IOUs) can work quite well for recording who owes what to whom. I am yet to be convinced that an "overhang of book entries" is a real problem if all actors in the economy are *rational*.

    4. I think you misrepresent MMT. They don't really want to micromanage inflation, they want money to be spent on "productive" things without needless political bickering about "how are we're going to pay for this via taxes/other budget cuts". Decades/centuries of budget balancing orthodoxy make a lot of people scared of MMT approach, so MMT has to respond with some politically acceptable compromises, that's all. Inflation management is not a core MMT proposition, I don't think.

    5. Your reading list is impressive. I find myself in a somewhat similar situation but am not familiar with a good ~40% of the names in your list. However, I've started pruning some authors from my "credible list": for example, "Tyler Durden" (a pseudonym for a group of people, I don't know how they are related otherwise) has published articles that were either factually incorrect (I was lucky to be directly involved in some events they reported on and I so I knew) or misrepresent how our monetary system works. ZH is certainly popular but the signal-to-noise ratio is very low, IMHO. They are good at linking back to their own posts which proved to predict correctly but conveniently forget to do the same for those who turned out to be wrong.

  2. Thanks for a very relevant comment, Sardonic!

    I just finished a new post, so I should have time to get back to you tomorrow on this one. I can see you touch many of my key points, so I'm looking forward to discuss this further!

  3. 1. Thanks for the link! These are always fun to read. But I still hold Volcker as my main witness for the impossibility of inflation micromanagement.

    2. Yes, I agree QTM is mostly discredited. But what bothers me is that I see it lurking behind these ideas of "helicopter money" being OK as long as it doesn't create too much inflation. If it does, then we stop "creating more money". Do you see my point? It's a subtle one, I admit, and perhaps this has more to do with a general view of inflation being fairly easy to manage.

    3. Are you stating that one can pay with an IOU? If yes, you don't agree with me if I say that an IOU is synonymous with "a promise to pay (later)"? My point is exactly that we "need to spread things over time", and these things are payments. Since the 1980s, a growing number of our book entries are related to payments that will take place 10-40 years from now. This "intertemporality" is where my theory steps in and explains how it affects economic agents and, thus, our economy.

    4. I think you misinterpret me. I'm not saying inflation management is a core MMT proposition. I'm saying that they cannot propose increased government deficit spending without taking into account how this will affect agents' inflation expectations. Many MMTers are implying that we can increase the government deficit as long as inflation doesn't run away. I'm saying that this is very risky business, as inflation cannot be micromanaged, and thus we might end up with runaway inflation without realizing it before it is already too late to bring it under control with any light measures. This is my core *critique* towards MMT.

    5. Well, most of those names have been added on the list during the last 12 months :-) You're absolutely right about ZH. It has its place, but I view it more like drug which should be administered carefully and should not be used by people whose ability to apply source criticism is not well-developed (in other words, I agree with your "signal-to-noise ratio" comment). On a more general note, I'd argue that ZH is doing very well because there are many intelligent and experienced people who need to hear from someone that they haven't lost their minds when they think this is not going to end well. John Hussman quoted SocGen's Albert Edwards in his latest report:

    "“We are at that stage in the cycle where I begin to doubt my own sanity. I’ve been here before though and know full well how this story ends and it doesn’t involve me being detained in a mental health establishment (usually)."

    Hussman is a very thoughtful guy, an independent thinker. Here's another report related to these psychological effects of our current market environment ("a Speculative Bubble"):

  4. I don't want to start too many conversations at once (we need to focus on our "money definition" until we're satisfied) so I'll be brief here:

    #4>"I'm saying that they cannot propose increased government deficit spending without taking into account how this will affect agents' inflation expectations."

    This may be true, but I don’t know how to solve this problem of “agents’ expectations” in many other contexts either except for education and very gradual changes. After all, a rational view of, for example, QE is that it is not strongly inflational or maybe slightly deflational, but there were many who screamed it will cause “hyperinflation”.

    Another example is classic: bank runs. There were some recent ones in a China province. How do you convince people that the gov is never going to run out of money? In that Chinese case they literally had to truck a lot of paper money into the bank and stack it up high in the windows so the piles of money were visible from the outside… People are irrational and learn slowly (or not at all).

    #5 I know about Hussman and have read several of his reports. He is in a bit of a trouble: he seems to be doing the right things but his fund’s returns are low now because he chose to sit QE out. I hope we get that crash that he is waiting for before all his customers abandon him…

    If you haven’t seen it, the set of videos from Wine Country Conference has some interesting ones (Hussman himself, Stephanie Pomboy, Steen Jakobsen, etc):