21 April 2009

Smelling something fishy

Yesterday Tim O'Reilly, the very smart tech book publisher, tweeted Andy Kessler's Weekly Standard article Putting the Toothpaste Back Into the Tube.

It starts out with a clear, simple description of what economists mean when they're talking about the “money supply,” but then suddenly says something very surprising.

As we have all been taught, too much money chasing too few goods creates inflation, the price level goes up above and beyond what it should. That's bad, because you get less stuff for the same unit of work.

Uh, no. That's just not true. Inflation does not necessarily mean you get less stuff for the same unit of work. Consider this thought experiment: A capricious djinni suddenly doubles the money supply uniformly everywhere. Instead of $10 in your pocket, you have $20. Instead of $1000 in your bank account you have $2000. And likewise for everyone holding dollars everywhere. The djinni also telepathically informs everyone that this has happened. So what happens?

It's not hard to figure out. Five minutes later, there's a cardboard sign at the grocery store saying that all prices will be doubled. By the next day, all the stores have re-labeled everything to change their prices. But does that mean you're going to have trouble buying cheese and paying your suddenly doubled rent? No, because you've also gone to your boss and demanded double your salary, and she's given it to you; she can afford it because the widgets your company makes are selling for twice the price they used to.

Real inflation is of course messier than this simple thought experiment. F'rinstance, it rewards debtors and punishes savers: if I owe you $100 at 10% interest but that year there's 15% inflation that increases my income then I've come out ahead, while if I've kept $100 in the bank at that same interest rate I've fallen behind. But at its most fundamental level, currency inflation has nothing directly to do with rising or falling real wages.

I believe that Kessler understands this, because he immediately follows with an aside about deflation and why it isn't the party you'd imagine it would be, making my exact point.

On the flip side, with too little money chasing too many goods you get deflation, the price level goes down below what it normally would. Hey, you actually get more for your dollar. Woohoo! Except eventually someone is either going to cut your salary or you'll lose your job ...

So why is he BSing about inflation? Because he's criticizing the Federal Reserve's policy and making the argument that it is inflationary, and therefore bad. Now inflation is a problem, and I even share Mr Kessler's concern that Fed policy is indeed inflationary. See, for instance, Infamous J. Brad Hicks' analysis of the situation. (Update: It turns out Hicks badly underestimated excess capacity, which continues to soak up any inflationary tendency years later.) But Mr Kessler is going out of his way to exaggerate the problems from inflation, including raising the spectre of hyperinflation in the subtitle of his essay, which is an entirely different kettle of fish from the ordinary high inflation we may be facing with the dollar. So sorry Mr Kessler, you've already lost my trust.

This makes me think of Julian Sanchez' terrific recent blog post Climate Change and Argumentative Fallacies, talking about the ways folks with an agenda can fool you when debating complex subjects.

Come to think of it, there’s a certain class of rhetoric I’m going to call the “one way hash” argument. Most modern cryptographic systems in wide use are based on a certain mathematical asymmetry: You can multiply a couple of large prime numbers much (much, much, much, much) more quickly than you can factor the product back into primes. A one-way hash is a kind of “fingerprint” for messages based on the same mathematical idea: It’s really easy to run the algorithm in one direction, but much harder and more time consuming to undo. Certain bad arguments work the same way—skim online debates between biologists and earnest ID afficionados armed with talking points if you want a few examples: The talking point on one side is just complex enough that it’s both intelligible—even somewhat intuitive—to the layman and sounds as though it might qualify as some kind of insight. (If it seems too obvious, perhaps paradoxically, we’ll tend to assume everyone on the other side thought of it themselves and had some good reason to reject it.) The rebuttal, by contrast, may require explaining a whole series of preliminary concepts before it’s really possible to explain why the talking point is wrong. So the setup is “snappy, intuitively appealing argument without obvious problems” vs. “rebuttal I probably don’t have time to read, let alone analyze closely.”

If we don’t sometimes defer to the expert consensus, we’ll systematically tend to go wrong in the face of one-way-hash arguments, at least outside our own necessarily limited domains of knowledge. Indeed, in such cases, trying to evaluate the arguments on their merits will tend to lead to an erroneous conclusion more often than simply trying to gauge the credibility of the various disputants. The problem, of course, is gauging your own competence level well enough to know when to assess arguments and when to assess arguers. Thanks to the perverse phenomenon psychologists have dubbed the Dunning-Kruger effect, those who are least competent tend to have the most wildly inflated estimates of their own knowledge and competence. They don’t know enough to know that they don’t know, as it were.

Apropos of Sanchez, then, I have to admit that I cannot claim a lot of qualifications to talk about this. I don't have any proper economics education, I'm just a pretty smart guy with enough of an interest in economics to read economist Brad DeLong's blog and to have have thought that reading William Greider's 800-page tome The Secrets of the Temple: How the Federal Reserve Runs the Country was fun.

But who's Andy Kessler? Does he have an agenda? The article identifies him as “a former hedge fund manager turned author who writes on technology and markets.” I don't know about you, but “former hedge fund manager” certainly reads as a sign that the guy just might have an agenda that isn't in line with the concerns of an ordinary bloke like me. Then, checking his blog, I see that he's done a number of pieces for the Wall Street Journal opinion page. Whoa. The news section of the Journal is arguably the best newspaper in the US, but the opinion page is a notorious propaganda organ of right-wing plutocracy.

So no, I don't trust anything this article has to say. Indeed, per Mr Sanchez' argument, the more sensible Mr Kessler sounds, the more I discount what he says as potentially fishy. And I'll be very suspicious from now on of anyone who echoes Mr Kessler's proposal that the Fed needs to promise to raise interest rates in the near future; I have no idea what's wrong with that proposal, but I smell a rat.


Kate said...

Your nose is not deceiving you. The rat you smell is real! (Excellent discourse, by the way.)

Anonymous said...

So who are you on Twitter? I'm clarissethorn.

Anonymous said...

While most of the article is spot on and is a very interesting analysis of how you detect an author's bias, there is one point I'd like to make.

In your thought-experiment world, you're able to offset the rise in the price of goods by demanding a higher wage; however, the decision to increase your wage is not necessarily just on whether the company is flush with cash. In fact, it behooves your boss to not simply double your wage in response to a general doubling of prices. They're making twice the money selling widgets, so if they give you only 1.5x your wage, they now receive a greater profit from your labor. The decision to give you a raise in pay commensurate with inflation is going to be based on a number of things, most of which come down to whether or not there are other jobs you can easily transfer to that will pay you that full wage...or whether or not you can be replaced with cheaper labor.

From a macroeconomic level, wages will only perfectly track inflation if labor is fungible. This creates the necessary condition for laborers to choose their wages based only who is paying the market equilibrium price. Labor isn't fungible, though, which is why there's a fair dose of imperfection in wages tracking inflation over time.

This is also an asymmetric thing. During inflationary periods, your boss has a vested interest in not paying you a full inflation adjustment if possible, as it's an easy way to hold extra profit. In deflationary times, however, cutting your pay or firing you is nearly always the preferable choice. Deflation always brings a drop in aggregate demand for everything, including labor.

I believe this is why real wages 1964-2004 have been negative despite positive inflation for the entire period.

I should also note that in the thought-experiment world you're talking about a one-time jump in currency deposits, and generally conversations about inflation are concerned more with long-term and endemic inflationary processes. In competitive goods and labor markets where all players have perfect information, changes in current deposits will cause overnight changes in prices and wages, and this simplified money supply becomes irrelevant.

But the asymmetry of access to information and to seek changes in wages is what complicates it. If your demon gave you $5T in cash and nobody knew, you could spend with alacrity at current price levels until someone did. The lag in information flows, as well as what must be done to get a rise in revenues, is what makes inflation a sticky matter.

Or at least so says another semi-trained amateur.

Jonathan Korman said...

I certainly agree that inflation has been part of the machinery of the slipping of American real wages since the mid-'60s. But I'd submit that the American oligarchy has encouraged a narrative in which declining wages can be misattributed to “inflation” rather than the downward pressure they put on wages through stuff like the Fed constricting the money supply when unemployment dips “too low.”

In my admittedly artificial thought experiment, I grant that an employer would like to use this opportunity to renegotiate my pay downward—and of course will try—but having given both sides perfect information there's nothing in the situation that has really changed since the original salary negotiation I had with my employer. I suppose that realistically this becomes a referendum on my pay—if I'm a valued employee I can justify a raise in the guise of cost-of-living, if I'm weak I'll end up losing ground in the renegotiation—but in the aggregate, this is a wash.

Your observation that inflation enables employers to cut real pay in spite of wages being sticky downward, though, makes it occur to me that this is yet another reason why modestly inflationary policy is a good thing during recessions: it makes it possible for employers to take on more employees at less pay rather than less employees at more pay, during times when we want to prevent both the human consequences of high unemployment and the economic consequences of an idle workforce.

Anonymous said...

I actually agree with inflationary policy during recessions. Despite classic Keynesian thinking failing to explain stagflation, I do think that Keynes Was Right about government and central bank policy effectively acting as a flywheel on the economy-- engaging in inflationary pressure in slowdowns and engaging in disinflationary pressure when the economy is roaring.

But that's also why I saw the article in question as mostly stating the obvious to me, because you're supposed to open the flood gates in a recession and then tighten the money supply as things improve. Saying it's hard to do is likewise true. If monetary policy were easy, we wouldn't need experts doing it.

If you're granting employer and employee perfect information, then I agree. I certainly already allowed the existence of genies, so I'm in for a penny already, so might as well be in for a pound. I do reiterate, though, that it's not so much changes in money supply, but delays in information signaling through prices and disparities in information between parties, that creates "damage" in inflation. If you have the power to act before prices go up, you benefit; if you don't, you tend to break even at best.

And I actually agree that more people at a lower price is preferable. Actually, as long as reductions in wages don't result in wages going below cost of living, I tend to believe an employer is wiser to reduce wages in lieu of firing otherwise productive employees. It avoids future fixed costs, keeps people employed, and can let a company look for "recession products" while others simply go idle.

Jonathan Korman said...

Yes, yes, and yes. Especially to the point about the real problem with inflation: if folks don't know what the inflation rate is going to be in times to come—and no one does—then their economic planning is harder to do, creating economic problems at large.