July 4, 2014


How inflation nonsense took over finance : Introducing the Finance Macro Canon (Noah Smith, 7/03/14, The Week)

Stop me if you've heard this one before:

1. Inflation is caused by increases in the money supply. If the Fed expands the monetary base ("prints money"), the new money may sit for a while in the bank, but will eventually make its way into the broader economy, at which point it will cause inflation. [...]

3. Alternatively, money-printing might itself be defined as inflation. [...]

6. Government borrowing requires the Fed to buy bonds to hold down interest rates and keep the government from defaulting; this will cause/is causing/is defined as inflation. [...]

I have heard this basic story from many employees in the financial industry. I have heard it from a large number of finance writers, including some people I like and respect (but also including some who are shameless hucksters). I have heard it from undergrads at Stony Brook and Michigan. I see it on Twitter and on the blogs and on TV, and I hear it in Wall Street bars. I call it the Finance Macro Canon -- the basic framework through which a big chunk of Wall Street sees the macroeconomy.

What I think about each of these belief items is not important (Just for the record, I think #4, 5, 6, and 7 very well might be true, #3 is goofy, #2 is utterly wrong, and #1 is one of the biggest mysteries of macroeconomics). The really interesting question is why the finance industry has become such a hive mind with regards to this worldview.

First of all, part of this canon defies the data -- Japan's eternal zero interest rate policy didn't end deflation, nor did a dramatic expansion of its monetary base in the 2000s. And America's "money-printing" and ZIRP haven't done much to budge inflation. Second of all, the canon goes against the bets of the finance industry itself -- inflation expectations, as measured by TIPS breakevens, are around 2 percent, even in the long term.

This, I think, is why the Shadowstats BS -- or its cousin, the "have you seen the price of a gallon of milk lately" BS -- is so crucial to the Finance Macro Canon (FMC). Humans have cognitive dissonance -- it's difficult for us to take actions that don't jive with our beliefs. So subscribers to the FMC have to tell themselves that CPI isn't actually real inflation -- that's the only way to reconcile their bet on low CPI with their belief in the theory that QE and ZIRP cause inflation. 

Whatever may have been the case in other historical situations, it has been the case since Margaret Thatcher, Paul Volcker and Ronald Reagan combined to break the inflation of the 70s and to destroy the trade labor movement that inflation is exclusively a functio of wage inflation, which has been quiescent for over 30 years and is oonly going to be driven down by the ongoing trends in trade, immigration and technology.

Posted by at July 4, 2014 8:02 AM

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