There is a lot of hysterical talk these days about the threat of inflation and some talk, more thoughtful in my view about the current risks of deflation. It is insightful to go back to the writing of Keynes in the 1920s and early 1930s on these issues.
A number of these writings are collected in his very accessible work Essays in Persuasion. In 1919 and 1923 he had what would be considered today the fairly conventional monetarist view of these questions. His famous line on Lenin having said ''that the best way to destroy the Capitalist system was to debauch the currency comes from a short essay in 1919 in the aftermath of the first world war and the social chaos that affected defeated Germany. By 1923 as first inflation and then deflation struck in Europe Keynes began to discuss the two processes and the injuries that they caused. He wrote that inflation was injurious because of the arbitrary effect it had on altering the distribution of wealth between different social classes. But that deflation was ''more injurious" in retarding the production of wealth. Most of the nineteenth century had seen a relative stability over the century in the value of money as expressed in its price adjusted purchasing power, although there was a long period of falling prices at the end of the century.
Prices did fluctuate but according to Keynes never more than 30 % in either direction. But the first world war changed all that and since the end of the war there had been a large inflation that eroded the value of wealth and the savings of the middle class by huge amounts in most of Western Europe with the greatest erosion occurring in Germany, Austria-Hungary and Russia.This massive erosion of values according to Keynes affected the social psychology of the investing class and indeed of all those from the middle and upper classes who in the past had saved in order to invest. Keynes concluded that it ''was not safe or fair to combine the social organization developed during the nineteenth century...with a laissez-faire policy toward the value of money". In business inflation led to windfall profits to those who had borrowed money to undertake their entrepreneurial investments. Booms which might not be sustainable in the long run got underway and these booms often led to sudden slumps and depressions.
Then the problem dramatically shifted from that of inflation to that of falling prices, unemployment and deflation.
Because deflation and falling prices increased the burden of indebtedness since the debts were contracted for in inflated currency entrepreneurs and business were forced to carry a large speculative position in order to operate. As deflation proceeded uncertainty about the future would grow and many business people would be reluctant to undertake production under the circumstances. '' the general fear of falling prices" might inhibit '' the production process altogether."
Keynes therefore counseled that the monetary authorities needed to undertake countervailing actions in order to reverse pessimistic expectations and falling prices. In a boom they needed to act against inflation. In a bust they needed to act against falling prices and slumping production. He concluded
that inflation and deflation were both problems that needed an appropriate policy response that was timely. Between the two ''perhaps deflation is , if we rule out exaggerated inflation such as that of (hyperinflation in) Germany, the worse;because it is worse in an impoverished world to provoke unemployment than to disappoint the rentier.''
Later in his essay on the Liberal economic platform of 1930 and in his the Treatise on Money(1930) he developed a more sophisticated theory of profit push, wage push, bottleneck and disproportionality between savings decisions and investment decisions, theory of inflation which he then partly included in the General Theory(1936) wherein he shows that inflation can occur well before the point of full employment due to these structural factors at work.(See ch. 21 The Theory of Prices, GT)
Those who complain and shrilly warn of inflation in the current circumstances of severely depressed aggregate demand and excessive liquidity preference ought to go back and read Keynes before the General Theory to understand that he was also a monetary economist who well understood the risks of both inflation and deflation but also understood how to diagnose which problem was the priority according to the circumstances of the day.
Have you seen this, and can you comment on it?
ReplyDeletehttp://www.youtube.com/watch?v=PTUY16CkS-k&feature=player_embedded#!
Yes I have looked at this. Its cute but largely badly informed crude monetarist dogma despite the animation and clever scenario. Accommodating monetary policy which is promoted through the Fed purchasing somewhat more government debt than it might have done in the absence of the previous slump is a wise policy in the current circumstances. if one looks at the data one cans see that the addition of high powered money is relatively small in comparison to existing M2, inflation is currently close to zero and the reduction of unemployment still sluggish . The stimulus through fiscal policy is still rather small considering the size of the problem so the additional Q.E. is warranted.The object of the exercise is to keep interest rates as low as possible and affect the bond market. It is not to create inflation nor to reward those who deal in treasuries Cartoons can be fun but not so much fun when they mislead the viewer.
ReplyDeleteYes. No matter which side of the economic spectrum you espouse, it's dangerous to get into such complicated concepts in mere minutes. But there's still something I don't understand - why is the Fed buying bonds from Goldman Sachs rather than the Treasury?
ReplyDeleteThe Fed buys and sells debt instruments in the bond market. That has been its historic role in the exercise of monetary policy. The Treasury rarely borrows directly from the Federal Reserve. In fact, for a period of time this was prohibited. However, during World War 2 the Fed was authorized to purchase securities directly from the Treasury up to a certain limit. This also creates high powered money and a number of monetary theorists would argue that this will lead automatically directly to a rise in prices. But it depends on the circumstances . If the economy is far from full employment most of the vector forces will act first upon output rather than prices. The problem occurs when there is sufficient uncertainty in the markets that people will prefer to hold idle cash instead of either bonds or stocks or undertake job producing investments. Hence the need for an active fiscal policy of spending directly on infrastructure and job creation. Goldman Sachs may or may not sell the debt instruments it holds according to its own assessment of risk and the direction of interest rates just as any other actor including other banks and funds in the financial markets.
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