“Inflation, as a phenomenon, is independent of central banks and money. It can easily occur in a barter system, for example,” I wrote, on September 2 of last year.
I don’t know why I bother mentioning the date. Or in referring readers to the article from which that quote is excerpted. I’ve written some version of the same thing on so many occasions since inflation took off across the developed world that I long ago stopped trying to catalogue related discussions.
The idea that inflation is an independent phenomenon is self-evident, and it’s not new. Indeed, the whole point is that inflation has existed for as long as humans exchanged goods and services. But it’s not even new as an academic concept. There’s extant literature.
Somehow, though, it’s a controversial idea to other people, including most economists. That’s hardly an unusual juxtaposition. A lot of what seems self-evident to me is anything but to everyone else, and I’m often wrong. On this point, though, I’m right. Unequivocally.
And while I didn’t need anyone to “prove” it (because, again, it’s self-evident), a pair of economists with more impressive CVs than mine, agree. In a new paper, Guido Lorenzoni and Ivan Werning came right out and said it: Inflation can, and surely has, arisen “despite the complete absence of money, credit, interest rates, production and employment.”
Some readers might’ve already read the paper, which was released earlier this month. If that’s you, I suppose you don’t need to read the excerpts highlighted below. If you haven’t read the paper, they’re well worth a skim. The full paper is chock-full of obligatory mathematizing which, while crucial for academics who need to prove something to peers, isn’t especially pertinent for wider audiences.
In addition to excerpts from the paper itself, I’ve included a bit of color commentary from Rabobank’s Michael Every, who weighed in on the paper earlier this week.
From “Inflation Is Conflict,” by Guido Lorenzoni and Ivan Werning:
Inflation arises despite the complete absence of money, credit, interest rates, production and employment. Inflation is due to conflict, it cannot be explained by monetary policy or departures from a natural rate of output or employment. Our main results provide a decomposition of inflation into “adjustment” and “conflict” inflation, highlighting the essential nature of the latter. Conflict should be viewed as the proximate cause of inflation, fed by other root causes.
Many economists confidently agree that extreme and persistent inflation episodes are understood as largely driven by the growth in money supply, often prompted by a need for seignorage. But how exactly does money transmit to inflation? The simplest idea is “too much money chasing too few goods.” Formalizing this involves the quantity equation or more general forms of money demand. On closer inspection, one may still wonder what “money chasing goods” means and how the prices in good markets adjusts to clear the money market. The story feels incomplete.
For moderate and transitory inflations, things are less clear-cut and there is much less agreement. After all, money may chase goods and increase output instead of prices. Indeed, one important notion is that the transmission mechanism works from economic activity to inflation. Higher production and employment drive up costs and the real wage, leading firms to raise prices. According to these theories, inflation must be avoided by keeping the economy at the right “natural level” of output or employment, to avoid “too much spending chasing too few goods.” Monetary policy, managed through interest rates shapes economic activity and inflation. Money supply is not central to this story, economic activity and its management through interest rates is.
Both traditional inflationary stories contain elements of truth and are not necessarily at odds with each other. In our view, these existing theories of inflation are either incomplete about the mechanism, or overly specific to cover the broad issues surrounding inflation. As such, they may describe the root causes of inflation in some situations, but fall short of isolating the more general and proximate cause of inflation.
This paper argues that the most proximate and general cause of inflation is conflict or disagreement. In this view, inflation results from incompatible goals over relative prices, with conflicting economic agents each having only partial or intermittent control. Due to nominal rigidities, agents occasionally change a subset of prices that are under their control. Whenever they do, they adjust them to influence relative prices in their own desired direction. When coupled with staggered prices this conflict manifests itself in a finite level of inflation: The conflict over relative prices are largely frustrated. Despite a stalemate in relative prices, the changes in prices motivated by this conflict gives rise to general and sustained inflation in all prices.
Some may associate a conflict perspective with certain specific inflation episodes, but not others — such as during times of powerful labor unions and strained labor relations. Likewise, some may associate it with an advocacy for income or price control policies, or as a critique of conventional interest rate policies. While these possibilities fit our general framework, none of them follow without adopting further specific modeling assumptions, which we do not undertake here. The perspective we offer in this paper is broader. Our goal is to provide a framework to think about conflict as the proximate cause of inflation.
In our view, traditional ideas and models of inflation have been very useful, but are either incomplete about the mechanism or unnecessarily special. The broad phenomena of inflation deserves a wider and more adaptable framework, much in the same way as growth accounting is useful and transcends particular models of growth. The conflict view offers exactly this, a framework and concept that sits on top of most models.
From Rabobank’s Every, editorializing around the paper:
If you are of an economic bent, read [Lorenzoni and Werning] in full. Of course, you still won’t change your mind on what drives inflation, but it will kill an hour or two. If you aren’t of an economic bent, the simple introduction to the paper can be best summarized here via their analogy to two parties selling apples and bananas.
Simply, if the two take turns to set the relative price of their goods (i.e., the apples to bananas ratio), then they can say: “1”, “1”, “1”, “1”, and we have zero inflation. Or, the pattern can be “1”, “1.1”, “Ah, so 1.1 back at you!”, “Ah ha, so 1.2 to you!”, “Really? How do you like 1.3?!” and an escalatory cycle. Note this is absent money, interest rates, supply-side shocks, profits or nominal or real wage growth, some of which the paper slots in later — and all of which are extremely pertinent at the moment. How are these conflicts going to be resolved?
This simple apples and bananas model ironically again makes the point that most people calling CPI professionally are not comparing apples to apples.
This is self evident. But would it not be true that there is also a monetary form of inflation as well? Is it possible that there are at least two separate “forms” of inflation?
I am not an expert in inflation, although I had a colleague who was. His dissertation studied price inflation in Italy over time starting in the middle ages (economists, got to love ’em). The thing is, inflation is not a “thing,” any more than “illness” is a thing. Illness is simply the opposite of wellness. Illness can’t be cured or mitigated without knowing what specific illness is involved. Inflation is a general descriptor that describes a situation involving changes in price of individual items. To fix this one has to change the conditions that created the change in a specific price. During every inflationary cycle some prices will fall and more will rise, each at different rates of change. Commodity prices are interesting in this regard. We just had a shortage of eggs, for example. This is easily cured by the egg farmers. Not enough eggs = rising prices … The response will be swift. Farmers will use some of their eggs to get more chickens and in only a few short months, more chickens = more eggs => falling prices. Beef prices will not respond so quickly. It takes roughly two years for a baby cow to become a pile of strip steaks and hamburgers so prices of beef fall more slowly. Crops used to respond more slowly because of growing cycles, but crops grow all over the globe so rising prices will always attract increased supply somewhere. Same with cows, of course. This is not about money or the Fed or some machine. It’s about people and markets. People demand goods and services to meet their needs. If more people want stuff the market can’t supply, the market has to respond. Prices may rise for a while but that will attract more participants and more supply and prices will fall. Everyone, even our dangerous Chinese enemies, exchange goods in markets and everyone everywhere has been doing this daily for many millennia. The market, the bazaar, whatever it’s called has been the most important social function in society as long as we’ve been in existence. Inflation, deflation, disinflation and all descriptors not things in and of themselves. They are words to generalize an aspect of the human condition. IMO, the biggest difficulty in economics is how to reconcile the actual economic activity of individual humans with attempts to aggregate this behavior and manage an invented general term, like inflation, for example, which does not capture the human at all. Markets and those participating in them are still the motor.
Thanks to our Dear Leader for posting the abbreviated analysis and to Dr. Lucky’s further illumination on the topic.
(Though I’d suggest that eggs are a bad example because most of the run-up was due to the mandatory culling of flocks to stymie the spread of some diseases. It’s usually the only option when diseases start to hop from flock to flock.)
As our DL notes at the top, this real life way of looking at inflation doesn’t sit well with economists indoctrinated in Germanic economic theories in graduate school. Sadly that applies to many or most Fed Governors who actually call the shots.
There are many causes of inflation and I still think the traditional way of transmission is a large part of it. That traditional way being too much money chasing too few goods. I do think conflicts can cause inflation, I am thinking from the USA perspective WWII, the Vietnam conflict and the Iraq conflict did cause inflation because of the shear money spent. I don’t believe the money spent on Ukraine has approached that level in any meaningful way. I believe the inflation caused over the last two quarters is being caused by greedy corporations. In the beginning of the pandemic we had a drop off in demand caused by the layoffs in March at the very beginning of the pandemic. Then China shut down, I then understood the impact that China has on the world economy when I realized how much I buy on a weekly basis comes from China. When the flow of goods slowed down and the cost of shipping skyrocketed to me that was the initial cause of inflation. When a shipping container went from 3K to 30K companies had to raise prices to stay in business. China has opened up so the cost of those containers has come down to a more reasonable level but the prices haven’t come down to match. During this time the war in Ukraine started, initially we didn’t do anything, eventually we did start sending money but not large enough amounts to cause inflation. But what did cause the current round of inflation was Russia colluding with SA to raise the price of oil in the hope that we would give Russia Ukraine on a platter for the sake of the low price of oil. Well thank God we didn’t but we did empty the SPR to keep the price of gas from going to $6 or $7 a gallon.
All these things have a lag effect, when the cost of shipping containers went crazy corporations absorbed some of it and raised prices some. The cost of shipping containers has come down long enough that this shouldn’t be an issue. The cost of oil has come down with releases from the SPR. I think the current inflation is due to working through this. Also I do believe that the pandemic checks we received did cause some of the inflation. Because the response had to be so quick there was no easy way for the 50 different unemployment systems to adjust to raising unemployment payments so the government picked $600. Knowing that most states pay 30% – 40% of the wages based on last employer. If you were on the lower part of the wage scale you got a significant raise. This was clearly inflationary. It also effected wages because if I was making $14 an hour on unemployment no sane person would go back to a job making $8 an hour. This clearly was inflationary but this has been going on for over a year so I believe that layoffs are starting to happen and will continue. To get rid of these high wage earners.
The inflationary item left is the corporations. They have kept the cost of goods higher for longer to maximize profits, which is the goal of capitalism. In the old days when we had competition what would happen is someone would start lowering price to gain market share. My hope is this happens again, but because of the corporate concentration that currently exists in our system I’m not sure if this will happen this time around,
Inflation is about as specific for economics as illness is for medicine.
These kinds of alt-takes or at least more nuanced views are a primary reason why I subscribe to HR. But if we are abstracting, can’t we just say that humans are naturally inflationary as a principle of our existence? Whether we are hunting and gathering or bundling mortgages into credit tiers, don’t we all always want more for less? Businesses want higher prices and margins, workers want higher wages and salaries, banks (at least the big ones) want higher interest rates. We’re all in this shell game together, and while it’s not zero sum, often one segment’s gains comes at the expense of another’s, at least until the winds shift.
And staying abstract, the only counterweights to this overriding human tendency towards infation seems to be competition and productivity. That’s where the focus should be, not on money supply and velocity. How about fewer monopolies and oligopolies, and more/better education and training? Or we could just keep tinkering with IOER and capital requirements, at least until we discover the steering wheel isn’t connected to anything. (Like a lot of elevator “close door” buttons).
Droit de seigneur- The lord of the manor let’s you into the castle and pulls up the drawbridge when the barbarians attack. In return, the lord gets to sleep with your wife on your wedding night. (I always knew my medieval history background would come in handy someday…). I think unregulated capitalism and communism both lead us back to feudalism…. Feudalism- the nobility holds lands from the crown in exchange for military service, vassals are tenants of the nobles, obliged to live on their lord’s land, giving tribute, labor and a portion of their crops in return for military protection…Another word for peasants is villein-hence our word villain….