How To Have a Respectful Opinion About Inflation
A lot of us talk about inflation wrong, so I wrote this very long article about how to do it better.
From my time on earth, I have found that there are some people you simply cannot satisfy. Among those people are die-hard leftists, who seem to compete with each other’s dissatisfaction with everything until they don’t have a dog in any important fight, and die-hard libertarians, who cannot be pleased by anything unless both the government and the Federal Reserve is dismantled and we go back to the gold standard.
I consistently observe that both factions discount any incremental progress towards their goals because it does not solve everything they think is wrong with the world. Or what I will now call, in the spirit of Alan Greenspan, irrational fastidiousness.
During the 2020 election and now the Biden administration, leftists have shown their fair share of irrational fastidiousness. But recently, it has been the libertarians’ time to shine.
Although this time around their fastidiousness may not be so irrational.
Ignore This Section if Your Economics Understanding > a C-Student in a High School Economics Course
Inflation has been a trending issue as of late. An introductory economics textbook will define inflation as too much money chasing too few goods, causing prices to rise. A wide array of possibilities could produce the aforementioned phenomenon. Decreased production because of anything that makes goods more costly to make (cost-push inflation), or anything that makes it easier for people to buy stuff (demand-pull inflation).
Supply shortages or increases in production costs having to do with land, labor, and capital are events that can cause inflation by decreasing production too much. Low-interest rates or increasing the money in circulation, are all events that can cause inflation by increasing demand by too much. Inflation is measured by the percentage by which prices of goods increase, otherwise known as the Consumer Price Index (CPI).
Interest rates are a major way that central banks such as the Federal Reserve tame inflation. By managing interest rates, central banks can keep inflation under control by increasing or decreasing the cost of borrowing money. The Federal Reserve currently targets an inflation rate of 2%, which for some people is outright abhorrent. Most are fine with it.
Ideology-Tinted Glasses or Extraordinary Foresight?
Libertarians have been ringing the alarms about inflation forever but are only taken seriously once every decade or so, commonly for the political benefit of the Republican party. First, it was government deficit spending that was adding too much money to the money supply (because the banks lending to the government are essentially creating a lot of new money). Then it was the quantitative easing (QE) programs during the Great Recession and COVID-19 — which was adding too much money to the money supply. (QE is when the Federal Reserve creates new money to buy treasury bonds and securities from banks to inject money into the economy and combat low economic activity.)
Now, there are complaints about incoming inflation because of the size of Biden’s recovery plan, coupled with the gas crisis, lumber crisis, and diapers crisis. Times have changed in more than one way in that prominent economists such as Larry Summers, the personification of arrogance, have joined the choir of complaining.
Gas, lumber, and diapers are a few of the many goods facing global supply shortages because producers are unable to meet skyrocketing demand from consumers in the US due to COVID-19 restrictions being gradually lifted. A phenomenon I’ll coolly name living by globalization and dying by globalization and probably never mention again.
We see prices of all of these goods increasing, hence providing legitimate evidence for inflation occurring. Consumer prices rose by 4.2% in April, the highest in 13 years. It seems as if there is both decreased production and increased demand because of Biden’s large spending package — which sounds like a recipe for ‘too much money chasing too few goods’. Is another economic disaster ahead? Are libertarians right? Most importantly, can I no longer call libertarians irrationally fastidious??
Everybody Is Right, but in a Much More Real Sense No One Is Right
Inflation is bad. The last time widespread inflation occurred was in the 1970s. Just as they do with future economic predictions, economists debate on and on about what causes past economic events — and inflation in the 70s is no different. There is no disputing, however, how horrible it was for everyone, reflected in people’s fondness for figures such as Ronald Reagan who, in relative terms, resurrected the American economy.
As a response to extreme double-digit inflation, Federal Reserve Chairman Paul Volcker raised interest rates to as high as 20% (they are currently near zero), making it difficult for people to buy homes, cars, and other purchases that might require borrowing from a bank. Volcker’s logic was that if there is too much money in the economy, make it harder to get more money. Naturally, unemployment surpassed 10% and car dealers began sending the Federal Reserve coffins filled with keys of unsold cars.
I certainly hope there is no inflation. But I am not one to say whether it will happen or not.
The macroeconomy is the culmination of hundreds of billions of economic decisions made each day by people. When one decides to save instead of spend for leisure, they make an economic decision. Sticking with car dealer-related testimonies, an owner of a car dealership who raises car prices because he heard interest rates will be lowered soon is another economic decision.
What macroeconomists, the people studying the economy, do is attempt to summarize what effects cause millions of people to make the decisions they are making. They model these effects sometimes to predict future behavior and most times to demonstrate a relationship between effects and an outcome. All the data in the world is readily accessible to them and they have the rigorous mathematical and statistical training to see patterns, trends, correlations, and causal relationships within these datasets. Despite this, they quarrel about everything and rarely come to a consensus.
What we non-economists do is listen to these macroeconomists, often indirectly through the media, and simplify what is already a colossally simplified assertion about the decisions of millions of people. We then proceed to regurgitate our incomplete recollection of this information onto unsuspecting innocent people — usually in a patronizing manner.
The Insufferable Inseparability of Math and Economics
Most mathematical models that economists build involve aggregating every major effect that could affect the variable they are trying to measure. These models are not methods to calculate numbers. Rather they are methods to observe certain variables and their effects on the output variable. Take the ‘New Keynesian’ model studying inflation that was developed in the 90s:
The left side of the equation represents inflation, while the right side comprises what causes inflation. To avoid reminding everyone of math, each of the symbols on the right side of the equation represents an effect, such as cost-push inflation or inflation expectations, that drives inflation.
There are disagreements about the models themselves and how to use them, as well as the weight that each effect might have on inflation. Of the two out of three major models I can decently understand, the model described above is the only model to factor inflation expectations — an effect that is hotly contested by economists. The effect of inflation expectations acknowledges that it is the people in firms who ultimately make the economic decision to raise prices. An economic decision that can be triggered not only by inflation already taking place but by expecting inflation to take place, creating a self-fulfilling prophecy.
If a store owner is alarmed by how low-interest rates are getting, then it is he who increases the prices of his goods, thereby helping start inflation even if it has not strictly happened yet. Whether economists at the Fed believe this self-fulfilling prophecy is a significant phenomenon or not determines whether their approach to combating inflation is based on forecasting inflation or waiting until they see inflation happening.
The inclusion of other effects in inflation models such as ‘velocity of money’ or ‘current economic output’ is among other subjects of debate between economists. If the inclusion itself is not being debated, then the weight of each effect surely is.
Within all of these effects, there are even more ‘partial effects’ that are hard to intuitively gauge the strength of, until the inflation that the effect is affecting has already taken place.
Cost-push inflation, for example, may be present today because of shortages in gas, shipping containers, which assist the transportation of goods, and semiconductors, which are essential parts of consumer electronics. All of these shortages could be increasing prices of enough goods to indicate widespread inflation. Production costs may also be increasing because of labor shortages, a debate that is subject to the same kind of limitations that inflation is subject to.
Labor shortages may be caused by generous unemployment insurance, the unattractiveness of low-wage work, high costs of child care keeping parents at home, or a continued fear of COVID-19. One of these effects, however, cannot explain the decision-making of the millions of unemployed. In all likelihood, there is a labor shortage because of all of these effects but it is determining the weight of each effect that proves cumbersome.
Tunnel Vision
The most prominent vice that everyone, especially us non-economists, possesses is our tendency to disproportionately focus on one effect or ‘partial effect’ to summarize the decision-making for hundreds of millions of individuals.
Take the following chart that circulated on Twitter a week or so ago.
The chart is very susceptible to improper conclusions being made about the effects that drive the differences in prices of these goods. Cable news pundits might focus on the difference in presidents. Libertarians may cite that Biden’s administration spent a lot irresponsibly and kept interest rates low. Conservatives might emphasize that the extension of generous unemployment insurance has disincentivized work and caused a labor shortage, subsequently causing prices to increase.
Liberals, on the other hand, might retort back that the increase in prices is a temporary reaction to transitioning back to a normally functioning economy. They will recall how May 2020 was a deflationary environment and how there was substantially lower demand for the goods compared in the chart above.
All of these observations could be accurate but it would be wrong to think that any of the described effects act alone. Debates that take place should not be about the prominence of one effect instead of the other. Rather, the weights of the effects should be discussed, compared, and thought about deeply.
Much of economic analysis paints a picture that involves identifying and examining relationships between every ‘effect’ related to the phenomena being studied and investigating the weight of the effects in comparison with each other. Unfortunately, such analysis is lost upon most people whose economics come from TV talking heads and high school textbooks.
I diss economists a lot, but the best ones should be given credit for comprehensively considering all ‘effects’ in their studies regardless of their ideological leanings. Chief economists of corporations seen on CNBC and Bloomberg, meanwhile, will pass off statements that are made in their corporation’s own economic interests as legitimate analysis. So will economists appearing on CNN or Fox, who make statements invested in their network’s interests.
However, ‘TV economists’ are not necessarily lying. Instead, they provide a part of the picture that the best economists are attempting to illustrate in its entirety. The part that fits their narrative well. Viewers latch on to what they hear and the conversations they have about economics become an exchange of undercooked talking points that lack the nuance they should be having.
While adding nuance and considering the entire ‘picture’ is not the path to finding definitive answers, it is the path to having a productive discussion. And most important to this article, it is the path to having a respectful opinion about inflation.
Great piece! You slightly touched on this idea, but there is also the "base effect," where inflation rises throughout March, April, May of 2021 because the base months used in computations are March, April, May of 2020 - hence then % increase seems very large because there was a massive dip in spring 2020. I also love your insistence on nuance and productive discussions!