inflation

How is the economy doing this well?

PNRJ critique of neoclassical economics, current events, macroeconomics, politics , , , , , , , , , , , , , ,

Apr 14 JDN 2460416

We are living in a very weird time, economically. The COVID pandemic created huge disruptions throughout our economy, from retail shops closing to shortages in shipping containers. The result was a severe recession with the worst unemployment since the Great Depression.

Now, a few years later, we have fully recovered.

Here’s a graph from FRED showing our unemployment and inflation rates since 1990 [technical note: I’m using the urban CPI; there are a few other inflation measures you could use instead, but they look much the same]:

Inflation fluctuates pretty quickly, while unemployment moves much slower.

There are a lot of things we can learn from this graph:

  1. Before COVID, we had pretty low inflation; from 1990 to 2019, inflation averaged about 2.4%, just over the Fed’s 2% target.
  2. Before COVID, we had moderate to high unemployment; it rarely went below 5% and and for several years after the 2008 crash it was over 7%—which is why we called it the Great Recession.
  3. The only times we actually had negative inflation—deflation—were during recessions, and coincided with high unemployment; so, no, we really don’t want prices to come down.
  4. During COVID, we had a massive spike in unemployment up to almost 15%, but then it came back down much more rapidly than it had in the Great Recession.
  5. After COVID, there was a surge in inflation, peaking at almost 10%.
  6. That inflation surge was short-lived; by the end of 2022 inflation was back down to 4%.
  7. Unemployment now stands at 3.8% while inflation is at 2.7%.

What I really want to emphasize right now is point 7, so let me repeat it:

Unemployment now stands at 3.8% while inflation is at 2.7%.

Yes, technically, 2.7% is above our inflation target. But honestly, I’m not sure it should be. I don’t see any particular reason to think that 2% is optimal, and based on what we’ve learned from the Great Recession, I actually think 3% or even 4% would be perfectly reasonable inflation targets. No, we don’t want to be going into double-digits (and we certainly don’t want true hyperinflation); but 4% inflation really isn’t a disaster, and we should stop treating it like it is.

2.7% inflation is actually pretty close to the 2.4% inflation we’d been averaging from 1990 to 2019. So I think it’s fair to say that inflation is back to normal.

But the really wild thing is that unemployment isn’t back to normal: It’s much better than that.

To get some more perspective on this, let’s extend our graph backward all the way to 1950:

Inflation has been much higher than it is now. In the late 1970s, it was consistently as high as it got during the post-COVID surge. But it has never been substantially lower than it is now; a little above the 2% target really seems to be what stable, normal inflation looks like in the United States.

On the other hand, unemployment is almost never this low. It was for a few years in the early 1950s and the late 1960s; but otherwise, it has always been higher—and sometimes much higher. It did not dip below 5% for the entire period from 1971 to 1994.

They hammer into us in our intro macroeconomics courses the Phillips Curve, which supposedly says that unemployment is inversely related to inflation, so that it’s impossible to have both low inflation and low unemployment.

But we’re looking at it, right now. It’s here, right in front of us. What wasn’t supposed to be possible has now been achieved. E pur si muove.

There was supposed to be this terrible trade-off between inflation and unemployment, leaving our government with the stark dilemma of either letting prices surge or letting millions remain out of work. I had always been on the “inflation” side: I thought that rising prices were far less of a problem than poeple out of work.

But we just learned that the entire premise was wrong.

You can have both. You don’t have to choose.

Right here, right now, we have both. All we need to do is keep doing whatever we’re doing.

One response might be: what if we can’t? What if this is unsustainable? (Then again, conservatives never seemed terribly concerned about sustainability before….)

It’s worth considering. One thing that doesn’t look so great now is the federal deficit. It got extremely high during COVID, and it’s still pretty high now. But as a proportion of GDP, it isn’t anywhere near as high as it was during WW2, and we certainly made it through that all right:

So, yeah, we should probably see if we can bring the budget back to balanced—probably by raising taxes. But this isn’t an urgent problem. We have time to sort it out. 15% unemployment was an urgent problem—and we fixed it.

In fact in some ways the economy is even doing better now than it looks. Unemployment for Black people has never been this low, since we’ve been keeping track of it:

Black people had basically learned to live with 8% or 9% unemployment as if it were normal; but now, for the first time ever—ever—their unemployment rate is down to only 5%.

This isn’t because people are dropping out of the labor force. Broad unemployment, which includes people marginally attached to the labor force, people employed part-time not by choice, and people who gave up looking for work, is also at historic lows, despite surging to almost 23% during COVID:

In fact, overall employment among people 25-54 years old (considered “prime age”—old enough to not be students, young enough to not be retired) is nearly the highest it has ever been, and radically higher than it was before the 1980s (because women entered the workforce):

So this is not an illusion: More Americans really are working now. And employment has become more inclusive of women and minorities.

I really don’t understand why President Biden isn’t more popular. Biden inherited the worst unemployment since the Great Depression, and turned it around into an economic situation so good that most economists thought it was impossible. A 39% approval rating does not seem consistent with that kind of staggering economic improvement.

And yes, there are a lot of other factors involved aside from the President; but for once I think he really does deserve a lot of the credit here. Programs he enacted to respond to COVID brought us back to work quicker than many thought possible. Then, the Inflation Reduction Act made historic progress at fighting climate change—and also, lo and behold, reduced inflation.

He’s not a particularly charismatic figure. He is getting pretty old for this job (or any job, really). But Biden’s economic policy has been amazing, and deserves more credit for that.

The unsung success of Bidenomics

PNRJ core principles, current events, macroeconomics, politics, public policy , , , , , , , , , ,

Aug 13 JDN 2460170

I’m glad to see that the Biden administration is finally talking about “Bidenomics”. We tend to give too much credit or blame for economic performance to the President—particularly relative to Congress—but there are many important ways in which a Presidential administration can shift the priorities of public policy in particular directions, and Biden has clearly done that.

The economic benefits for people of color seem to have been particularly large. The unemployment gap between White and Black workers in the US is now only 2.7 percentage points, while just a few years ago it was over 4pp and at the worst of the Great Recession it surpassed 7pp. During lockdown, unemployment for Black people hit nearly 17%; it is now less than 6%.

The (misnamed, but we’re stuck with it) Inflation Reduction Act in particular has been an utter triumph.

In the past year, real private investment in manufacturing structures (essentially, new factories) has risen from $56 billion to $87 billion—an over 50% increase, which puts it the highest it has been since the turn of the century. The Inflation Reduction Act appears to be largely responsible for this change.

Not many people seem to know this, but the US has also been on the right track with regard to carbon emissions: Per-capita carbon emissions in the US have been trending downward since about 2000, and are now lower than they were in the 1950s. The Inflation Reduction act now looks poised to double down on that progress, as it has been forecasted to reduce our emissions all the way down to 40% below their early-2000s peak.

Somehow, this success doesn’t seem to be getting across. The majority of Americans incorrectly believe that we are in a downturn. Biden’s approval rating is still only 40%, barely higher than Trump’s was. When it comes to political beliefs, most American voters appear to be utterly impervious to facts.

Most Americans do correctly believe that inflation is still a bit high (though many seem to think it’s higher than it is); this is weird, seeing as inflation is normally high when the economy is growing rapidly, and gets too low when we are in a recession. This seems to be Halo Effect, rather than any genuine understanding of macroeconomics: downturns are bad and inflation is bad, so they must go together—when in fact, quite the opposite is the case.

People generally feel better about their own prospects than they do about the economy as a whole:

Sixty-four percent of Americans say the economy is worse off compared to 2020, while seventy-three percent of Americans say the economy is worse off compared to five years ago. About two in five of Americans say they feel worse off from five years ago generally (38%) and a similar number say they feel worse off compared to 2020 (37%).

(Did you really have to write out ‘seventy-three percent’? I hate that convention. 73% is so much clearer and quicker to read.)

I don’t know what the Biden administration should do about this. Trying to sell themselves harder might backfire. (And I’m pretty much the last person in the world you should ask for advice about selling yourself.) But they’ve been doing really great work for the US economy… and people haven’t noticed. Thousands of factories are being built, millions of people are getting jobs, and the collective response has been… “meh”.

Statisticacy

PNRJ core principles, education, financial advice, science and academia, statistics , , , , , , , , , , , , , , , , , ,

Jun 11 JDN 2460107

I wasn’t able to find a dictionary that includes the word “statisticacy”, but it doesn’t trigger my spell-check, and it does seem to have the same form as “numeracy”: numeric, numerical, numeracy, numerate; statistic, statistical, statisticacy, statisticate. It definitely still sounds very odd to my ears. Perhaps repetition will eventually make it familiar.

For the concept is clearly a very important one. Literacy and numeracy are no longer a serious problem in the First World; basically every adult at this point knows how to read and do addition. Even worldwide, 90% of men and 83% of women can read, at least at a basic level—which is an astonishing feat of our civilization by the way, well worthy of celebration.

But I have noticed a disturbing lack of, well, statisticacy. Even intelligent, educated people seem… pretty bad at understanding statistics.

I’m not talking about sophisticated econometrics here; of course most people don’t know that, and don’t need to. (Most economists don’t know that!) I mean quite basic statistical knowledge.

A few years ago I wrote a post called “Statistics you should have been taught in high school, but probably weren’t”; that’s the kind of stuff I’m talking about.

As part of being a good citizen in a modern society, every adult should understand the following:

1. The difference between a mean and a median, and why average income (mean) can increase even though most people are no richer (median).

2. The difference between increasing by X% and increasing by X percentage points: If inflation goes from 4% to 5%, that is an increase of 20% ((5/4-1)*100%), but only 1 percentage point (5%-4%).

3. The meaning of standard error, and how to interpret error bars on a graph—and why it’s a huge red flag if there aren’t any error bars on a graph.

4. Basic probabilistic reasoning: Given some scratch paper, a pen, and a calculator, everyone should be able to work out the odds of drawing a given blackjack hand, or rolling a particular number on a pair of dice. (If that’s too easy, make it a poker hand and four dice. But mostly that’s just more calculation effort, not fundamentally different.)

5. The meaning of exponential growth rates, and how they apply to economic growth and compound interest. (The difference between 3% interest and 6% interest over 30 years is more than double the total amount paid.)

I see people making errors about this sort of thing all the time.

Economic news that celebrates rising GDP but wonders why people aren’t happier (when real median income has been falling since 2019 and is only 7% higher than it was in 1999, an annual growth rate of 0.2%).

Reports on inflation, interest rates, or poll numbers that don’t clearly specify whether they are dealing with percentages or percentage points. (XKCD made fun of this.)

Speaking of poll numbers, any reporting on changes in polls that isn’t at least twice the margin of error of the polls in question. (There’s also a comic for this; this time it’s PhD Comics.)

People misunderstanding interest rates and gravely underestimating how much they’ll pay for their debt (then again, this is probably the result of strategic choices on the part of banks—so maybe the real failure is regulatory).

And, perhaps worst of all, the plague of science news articles about “New study says X”. Things causing and/or cancer, things correlated with personality types, tiny psychological nudges that supposedly have profound effects on behavior.

Some of these things will even turn out to be true; actually I think this one on fibromyalgia, this one on smoking, and this one on body image are probably accurate. But even if it’s a properly randomized experiment—and especially if it’s just a regression analysis—a single study ultimately tells us very little, and it’s irresponsible to report on them instead of telling people the extensive body of established scientific knowledge that most people still aren’t aware of.

Basically any time an article is published saying “New study says X”, a statisticate person should ignore it and treat it as random noise. This is especially true if the finding seems weird or shocking; such findings are far more likely to be random flukes than genuine discoveries. Yes, they could be true, but one study just doesn’t move the needle that much.

I don’t remember where it came from, but there is a saying about this: “What is in the textbooks is 90% true. What is in the published literature is 50% true. What is in the press releases is 90% false.” These figures are approximately correct.

If their goal is to advance public knowledge of science, science journalists would accomplish a lot more if they just opened to a random page in a mainstream science textbook and started reading it on air. Admittedly, I can see how that would be less interesting to watch; but then, their job should be to find a way to make it interesting, not to take individual studies out of context and hype them up far beyond what they deserve. (Bill Nye did this much better than most science journalists.)

I’m not sure how much to blame people for lacking this knowledge. On the one hand, they could easily look it up on Wikipedia, and apparently choose not to. On the other hand, they probably don’t even realize how important it is, and were never properly taught it in school even though they should have been. Many of these things may even be unknown unknowns; people simply don’t realize how poorly they understand. Maybe the most useful thing we could do right now is simply point out to people that these things are important, and if they don’t understand them, they should get on that Wikipedia binge as soon as possible.

And one last thing: Maybe this is asking too much, but I think that a truly statisticate person should be able to solve the Monty Hall Problem and not be confused by the result. (Hint: It’s very important that Monty Hall knows which door the car is behind, and would never open that one. If he’s guessing at random and simply happens to pick a goat, the correct answer is 1/2, not 2/3. Then again, it’s never a bad choice to switch.)

Is the cure for inflation worse than the disease?

PNRJ current events, macroeconomics, politics, public policy , , , , , , , , , , ,

Nov 13 JDN 2459897

A lot of people seem really upset about inflation. I’ve previously discussed why this is a bit weird; inflation really just isn’t that bad. In fact, I am increasingly concerned that the usual methods for fixing inflation are considerably worse than inflation itself.

To be clear, I’m not talking about hyperinflation—if you are getting triple-digit inflation or more, you are clearly printing too much money and you need to stop. And there are places in the world where this happens.

But what about just regular, ordinary inflation, even when it’s fairly high? Prices rising at 8% or 9% or even 11% per year? What catastrophe befalls our society when this happens?

Okay, sure, if we could snap our fingers and make prices all stable without cost, that would be worth doing. But we can’t. All of our mechanisms for reducing inflation come with costs—and often very high costs.

The chief mechanism by which inflation is currently controlled is open-market operations by central banks such as the Federal Reserve, the Bank of England, and the European Central Bank. These central banks try to reduce inflation by selling bonds, which lowers the price of bonds and reduces capital available to banks, and thereby increases interest rates. This also effectively removes money from the economy, as banks are using that money to buy bonds instead of lending it out. (It is chiefly in this odd indirect sense that the central bank manages the “money supply”.)

But how does this actually reduce inflation? It’s remarkably indirect. It’s actually the higher interest rates which prevent people from buying houses and prevent companies from hiring workers which result in reduced economic growth—or even economic recession—which then is supposed to bring down prices. There’s actually a lot we still don’t know about how this works or how long it should be expected to take. What we do know is that the pain hits quickly and the benefits arise only months or even years later.

As Krugman has rightfully pointed out, the worst pain of the 1970s was not the double-digit inflation; it was the recessions that Paul Volcker’s economic policy triggered in response to that inflation. The inflation wasn’t exactly a good thing; but for most people, the cure was much worse than the disease.

Most laypeople seem to think that prices somehow go up without wages going up, but that simply isn’t how it works. Prices and wages rise at close to the same rate in most countries most of the time. In fact, inflation is often driven chiefly by rising wages rather than the other way around. There are often lags between when the inflation hits and when people see their wages rise; but these lags can actually be in either direction—inflation first or wages first—and for moderate amounts of inflation they are clearly less harmful than the high rates of unemployment that we would get if we fought inflation more aggressively with monetary policy.

Economists are also notoriously vague about exactly how they expect the central bank to reduce inflation. They use complex jargon or broad euphemisms. But when they do actually come out and say they want to reduce wages, it tends to outrage people. Well, that’s one of three main ways that interest rates actually reduce inflation: They reduce wages, they cause unemployment, or they stop people from buying houses. That’s pretty much all that central banks can do.

There may be other ways to reduce inflation, like windfall profits taxes, antitrust action, or even price controls. The first two are basically no-brainers; we should always be taxing windfall profits (if they really are due to a windfall outside a corporation’s control, there’s no incentive to distort), and we should absolutely be increasing antitrust action (why did we reduce it in the first place?). Price controls are riskier—they really do create shortages—but then again, is that really worse than lower wages or unemployment? Because the usual strategy involves lower wages and unemployment.

It’s a little ironic: The people who are usually all about laissez-faire are the ones who panic about inflation and want the government to take drastic action; meanwhile, I’m usually in favor of government intervention, but when it comes to moderate inflation, I think maybe we should just let it be.

Housing prices are out of control

PNRJ inequality, public policy , , , , ,

Oct 2 JDN 2459855

This is a topic I could have done for quite awhile now, and will surely address again in the future; it’s a slow-burn crisis that has covered most of the world for a generation.

In most of the world’s cities, housing prices are now the highest they have ever been, even adjusted for inflation. The pandemic made this worse, but it was already bad.

This is of course very important, because housing is usually the largest expenditure for most families.

Changes in housing prices are directly felt in people’s lifestyles, especially when they are renting. Homeownership rates vary a lot between countries, so the impact of this is quite different in different places.

There’s also an important redistributive effect: When housing prices go up, people who own homes get richer, while people who rent homes get poorer. Since people who own homes tend to be richer to begin with (and landlordsare typically richest of all), rising housing prices directly increase wealth inequality.

The median price of a house in the US, even adjusted for inflation, is nearly twice what it was in 1993.

This wasn’t a slow and steady climb; housing prices moved with inflation for most of the 1980s and 1990s, and then surged upward just before the 2008 crash. Then they plummeted for a few years, before reversing course and surging even higher than they were at their 2007 peak:

https://fred.stlouisfed.org/series/CSUSHPINSA

[housing_prices_US_2.png]

https://fred.stlouisfed.org/series/USSTHPI

This is not a uniquely American problem. The UK shows almost the same pattern:

https://fred.stlouisfed.org/series/HPIUKA

But it’s also not the same pattern everywhere. In China, housing prices have been rising steadily, and didn’t crash in 2008:

https://fred.stlouisfed.org/series/QCNN628BIS

In France, housing prices have been relatively stable, and are no higher now than they were in the 1990s:

https://fred.stlouisfed.org/series/CP0410FRM086NEST

Meanwhile, in Japan, housing prices surged in the 1970s, 1980s, and 1990s, ending up four times what they had been in the 1960s; then they suddenly leveled off and haven’t changed since:

https://fred.stlouisfed.org/series/JPNCPIHOUMINMEI

It’s also worse in some cities than others. In San Francisco, housing now costs three times what it did in the 1990s, even adjusting for inflation:

https://fred.stlouisfed.org/series/SFXRSA

Meanwhile, in Detroit, housing is only about 25% more expensive now than it was in the 1990s:

https://fred.stlouisfed.org/series/ATNHPIUS19804Q

This variation tells me that policy matters. This isn’t some inevitable result of population growth or technological change. Those could still be important factors, but they can’t explain the strong varation between countries or even between cities within the same country. (Yes, San Francisco has seen more population growth than Detroit—but not that much more.)

Part of the problem, I think, is that most policymakers don’t actually want housing to be more affordable. They might say they do, they might occasionally feel some sympathy for people who get evicted or live on the streets; but in general, they want housing prices to be higher, because that gives them more property tax revenue. The wealthy benefit from rising housing prices, while the poor are harmed. Since the interests of the wealthy are wildly overrepresented in policy, policy is made to increase housing prices, not decrease them. This is likely especially true in housing, because even the upper-middle class mostly benefits from rising housing prices. It’s only the poor and lower-middle class who are typically harmed.

This is why I don’t really want to get into suggesting policies that could fix this. We know what would fix this: Build more housing. Lots of it. Everywhere. Increase supply, and the price will go down. And we should keep doing it until housing is not just back where it was, but cheaper—much cheaper. Buying a house shouldn’t be a luxury afforded only to the upper-middle class; it should be something everyone does several times in their life and doesn’t have to worry too much about. Buying a house should be like buying a car; not cheap, exactly, but you don’t have to be rich to do it. Because everyone needs housing. So everyone should have housing.

But that isn’t going to happen, because the people who make the decisions about this don’t want it to happen.

So the real question becomes: What do we do about that?

Good news on the climate, for a change

PNRJ macroeconomics, politics, public policy , , , , , , , , , , ,

Aug 7 JDN 2459799

In what is surely the biggest political surprise of the decade—if not the century—Joe Manchin suddenly changed his mind and signed onto a budget reconciliation bill that will radically shift US climate policy. He was the last vote needed for the bill to make it through the Senate via reconciliation (as he often is, because he’s pretty much a DINO).

Because the Senate is ridiculous, there are still several layers of procedure the bill must go through before it can actually pass. But since the parliamentarian was appointed by a Democrat and the House had already passed an even stronger climate bill, it looks like at least most of it will make it through. The reconciliation process means we only need a bare majority, so even if all the Republicans vote against it—which they very likely will—it can still get through, with Vice President Harris’s tiebreaking vote. (Because our Senate is 50-50, Harris is on track to cast the most tie-breaking votes of any US Vice President by the end of her term.) Reconciliation also can’t be filibustered.

While it includes a lot of expenditures, particularly tax credits for clean energy and electric cars, the bill includes tax increases and closed loopholes so that it will actually decrease the deficit and likely reduce inflation—which Manchin said was a major reason he was willing to support it. But more importantly, it promises to reduce US carbon emissions by a staggering 40% by 2030.

The US currently produces about 15 tons of CO2 equivalent per person per year, so reducing that by 40% would drop it to only 9 tons per person per year. This would move us from nearly as bad as Saudi Arabia to nearly as good as Norway. It still won’t mean we are doing as well as France or the UK—but at least we’ll no longer be dragging down the rest of the First World.

And this isn’t a pie-in-the-sky promise: Independent forecasts suggest that these policies may really be able to reduce our emissions that much that fast. It’s honestly a little hard for me to believe; but that’s what the experts are saying.

Manchin wants to call it the Inflation Reduction Act, but it probably won’t actually reduce inflation very much. But some economists—even quite center-right ones—think it may actually reduce inflation quite a bit, and we basically all agree that it at least won’t increase inflation very much. Since the effects on inflation are likely to be small, we really don’t have to worry about them: whatever it does to inflation, the important thing is that this bill reduces carbon emissions.

Honestly, it’ll be kind of disgusting if this actually does work—because it’s so easy. This bill will have almost no downside. Its macroeconomic effects will be minor, maybe even positive. There was no reason it needed to be this hard-fought. Even if it didn’t have tax increases to offset it—which it absolutely does—the total cost of this bill over the next ten years would be less than six months of military spending, so cutting military spending by 5% would cover it. We have cured our unbearable headaches by finally realizing we could stop hitting ourselves in the head. (And the Republicans want us to keep hitting ourselves and will do whatever they can to make that happen.)

So, yes, it’s very sad that it took us this long. And even 60% of our current emissions is still too much emissions for a stable climate. But let’s take a moment to celebrate, because this is a genuine victory—and we haven’t had a lot of those in awhile.

Krugman and rockets and feathers

PNRJ critique of neoclassical economics, current events, macroeconomics, personal, public policy , , , , , ,

Jul 17 JDN 2459797

Well, this feels like a milestone: Paul Krugman just wrote a column about a topic I’ve published research on. He didn’t actually cite our paper—in fact the literature review he links to is from 2014—but the topic is very much what we were studying: Asymmetric price transmission, ‘rockets and feathers’. He’s even talking about it from the perspective of industrial organization and market power, which is right in line with our results (and a bit different from the mainstream consensus among economic policy pundits).

The phenomenon is a well-documented one: When the price of an input (say, crude oil) rises, the price of outputs made from that input (say, gasoline) rise immediately, and basically one to one, sometimes even more than one to one. But when the price of an input falls, the price of outputs only falls slowly and gradually, taking a long time to converge to the same level as the input prices. Prices go up like a rocket, but down like a feather.

Many different explanations have been proposed to explain this phenomenon, and they aren’t all mutually exclusive. They include various aspects of market structure, substitution of inputs, and use of inventories to smooth the effects of prices.

One that I find particularly unpersuasive is the notion of menu costs: That it requires costly effort to actually change your prices, and this somehow results in the asymmetry. Most gas stations have digital price boards; it requires almost zero effort for them to change prices whenever they want. Moreover, there’s no clear reason this would result in asymmetry between raising and lowering prices. Some models extend the notion of “menu cost” to include expected customer responses, which is a much better explanation; but I think that’s far beyond the original meaning of the concept. If you fear to change your price because of how customers may respond, finding a cheaper way to print price labels won’t do a thing to change that.

But our paper—and Krugman’s article—is about one factor in particular: market power. We don’t see prices behave this way in highly competitive markets. We see it the most in oligopolies: Markets where there are only a small number of sellers, who thus have some control over how they set their prices.

Krugman explains it as follows:

When oil prices shoot up, owners of gas stations feel empowered not just to pass on the cost but also to raise their markups, because consumers can’t easily tell whether they’re being gouged when prices are going up everywhere. And gas stations may hang on to these extra markups for a while even when oil prices fall.

That’s actually a somewhat different mechanism from the one we found in our experiment, which is that asymmetric price transmission can be driven by tacit collusion. Explicit collusion is illegal: You can’t just call up the other gas stations and say, “Let’s all set the price at $5 per gallon.” But you can tacitly collude by responding to how they set their prices, and not trying to undercut them even when you could get a short-run benefit from doing so. It’s actually very similar to an Iterated Prisoner’s Dilemma: Cooperation is better for everyone, but worse for you as an individual; to get everyone to cooperate, it’s vital to severely punish those who don’t.

In our experiment, the participants in our experiment were acting as businesses setting their prices. The customers were fully automated, so there was no opportunity to “fool” them in this way. We also excluded any kind of menu costs or product inventories. But we still saw prices go up like rockets and down like feathers. Moreover, prices were always substantially higher than costs, especially during that phase when they are falling down like feathers.

Our explanation goes something like this: Businesses are trying to use their market power to maintain higher prices and thereby make higher profits, but they have to worry about other businesses undercutting their prices and taking all the business. Moreover, they also have to worry about others thinking that they are trying to undercut prices—they want to be perceived as cooperating, not defecting, in order to preserve the collusion and avoid being punished.

Consider how this affects their decisions when input prices change. If the price of oil goes up, then there’s no reason not to raise the price of gasoline immediately, because that isn’t violating the collusion. If anything, it’s being nice to your fellow colluders; they want prices as high as possible. You’ll want to raise the prices as high and fast as you can get away with, and you know they’ll do the same. But if the price of oil goes down, now gas stations are faced with a dilemma: You could lower prices to get more customers and make more profits, but the other gas stations might consider that a violation of your tacit collusion and could punish you by cutting their prices even more. Your best option is to lower prices very slowly, so that you can take advantage of the change in the input market, but also maintain the collusion with other gas stations. By slowly cutting prices, you can ensure that you are doing it together, and not trying to undercut other businesses.

Krugman’s explanation and ours are not mutually exclusive; in fact I think both are probably happening. They have one important feature in common, which fits the empirical data: Markets with less competition show greater degrees of asymmetric price transmission. The more concentrated the oligopoly, the more we see rockets and feathers.

They also share an important policy implication: Market power can make inflation worse. Contrary to what a lot of economic policy pundits have been saying, it isn’t ridiculous to think that breaking up monopolies or putting pressure on oligopolies to lower their prices could help reduce inflation. It probably won’t be as reliably effective as the Fed’s buying and selling of bonds to adjust interest rates—but we’re also doing that, and the two are not mutually exclusive. Besides, breaking up monopolies is a generally good thing to do anyway.

It’s not that unusual that I find myself agreeing with Krugman. I think what makes this one feel weird is that I have more expertise on the subject than he does.

Why do poor people dislike inflation?

PNRJ core principles, current events, heuristics and biases, macroeconomics, public policy , , , ,

Jun 5 JDN 2459736

The United States and United Kingdom are both very unaccustomed to inflation. Neither has seen double-digit inflation since the 1980s.

Here’s US inflation since 1990:

And here is the same graph for the UK:

While a return to double-digits remains possible, at this point it likely won’t happen, and if it does, it will occur only briefly.

This is no doubt a major reason why the dollar and the pound are widely used as reserve currencies (especially the dollar), and is likely due to the fact that they are managed by the world’s most competent central banks. Brexit would almost have made sense if the UK had been pressured to join the Euro; but they weren’t, because everyone knew the pound was better managed.

The Euro also doesn’t have much inflation, but if anything they err on the side of too low, mainly because Germany appears to believe that inflation is literally Hitler. In fact, the rise of the Nazis didn’t have much to do with the Weimar hyperinflation. The Great Depression was by far a greater factor—unemployment is much, much worse than inflation. (By the way, it’s weird that you can put that graph back to the 1980s. It, uh, wasn’t the Euro then. Euros didn’t start circulating until 1999. Is that an aggregate of the franc and the deutsche mark and whatever else? The Euro itself has never had double-digit inflation—ever.)

But it’s always a little surreal for me to see how panicked people in the US and UK get when our inflation rises a couple of percentage points. There seems to be an entire subgenre of economics news that basically consists of rich people saying the sky is falling because inflation has risen—or will, or may rise—by two points. (Hey, anybody got any ideas how we can get them to panic like this over rises in sea level or aggregate temperature?)

Compare this to some other countries thathave real inflation: In Brazil, 10% inflation is a pretty typical year. In Argentina, 10% is a really good year—they’re currently pushing 60%. Kenya’s inflation is pretty well under control now, but it went over 30% during the crisis in 2008. Botswana was doing a nice job of bringing down their inflation until the COVID pandemic threw them out of whack, and now they’re hitting double-digits too. And of course there’s always Zimbabwe, which seemed to look at Weimar Germany and think, “We can beat that.” (80,000,000,000% in one month!? Any time you find yourself talking about billion percent, something has gone terribly, terribly wrong.)

Hyperinflation is a real problem—it isn’t what put Hitler into power, but it has led to real crises in Germany, Zimbabwe, and elsewhere. Once you start getting over 100% per year, and especially when it starts rapidly accelerating, that’s a genuine crisis. Moreover, even though they clearly don’t constitute hyperinflation, I can see why people might legitimately worry about price increases of 20% or 30% per year. (Let alone 60% like Argentina is dealing with right now.) But why is going from 2% to 6% any cause for alarm? Yet alarmed we seem to be.

I can even understand why rich people would be upset about inflation (though the magnitudeof their concern does still seem disproportionate). Inflation erodes the value of financial assets, because most bonds, options, etc. are denominated in nominal, not inflation-adjusted terms. (Though there are such things as inflation-indexed bonds.) So high inflation can in fact make rich people slightly less rich.

But why in the world are so many poor people upset about inflation?

Inflation doesn’t just erode the value of financial assets; it also erodes the value of financial debts. And most poor people have more debts than they have assets—indeed, it’s not uncommon for poor people to have substantial debt and no financial assets to speak of (what little wealth they have being non-financial, e.g. a car or a home). Thus, their net wealth position improves as prices rise.

The interest rate response can compensate for this to some extent, but most people’s debts are fixed-rate. Moreover, if it’s the higher interest rates you’re worried about, you should want the Federal Reserve and the Bank of England not to fight inflation too hard, because the way they fight it is chiefly by raising interest rates.

In surveys, almost everyone thinks that inflation is very bad: 92% think that controlling inflation should be a high priority, and 90% think that if inflation gets too high, something very bad will happen. This is greater agreement among Americans than is found for statements like “I like apple pie” or “kittens are nice”, and comparable to “fair elections are important”!

I admit, I question the survey design here: I would answer ‘yes’ to both questions if we’re talking about a theoretical 10,000% hyperinflation, but ‘no’ if we’re talking about a realistic 10% inflation. So I would like to see, but could not find, a survey asking people what level of inflation is sufficient cause for concern. But since most of these people seemed concerned about actual, realistic inflation (85% reported anger at seeing actual, higher prices), it still suggests a lot of strong feelings that even mild inflation is bad.

So it does seem to be the case that a lot of poor and middle-class people really strongly dislike inflation even in the actual, mild levels in which it occurs in the US and UK.

The main fear seems to be that inflation will erode people’s purchasing power—that as the price of gasoline and groceries rise, people won’t be able to eat as well or drive as much. And that, indeed, would be a real loss of utility worth worrying about.

But in fact this makes very little sense: Most forms of income—particularly labor income, which is the only real income for some 80%-90% of the population—actually increases with inflation, more or less one-to-one. Yes, there’s some delay—you won’t get your annual cost-of-living raise immediately, but several months down the road. But this could have at most a small effect on your real consumption.

To see this, suppose that inflation has risen from 2% to 6%. (Really, you need not suppose; it has.) Now consider your cost-of-living raise, which nearly everyone gets. It will presumably rise the same way: So if it was 3% before, it will now be 7%. Now consider how much your purchasing power is affected over the course of the year.

For concreteness, let’s say your initial income was $3,000 per month at the start of the year (a fairly typical amount for a middle-class American, indeed almost exactly the median personal income). Let’s compare the case of no inflation with a 1% raise, 2% inflation with a 3% raise, and 5% inflation with a 6% raise.

If there was no inflation, your real income would remain simply $3,000 per month, until the end of the year when it would become $3,030 per month. That’s the baseline to compare against.

If inflation is 2%, your real income would gradually fall, by about 0.16% per month, before being bumped up 3% at the end of the year. So in January you’d have $3,000, in February $2,995, in March $2,990. Come December, your real income has fallen to $2,941. But then next January it will immediately be bumped up 3% to $3,029, almost the same as it would have been with no inflation at all. The total lost income over the entire year is about $380, or about 1% of your total income.

If inflation instead rises to 6%, your real income will fall by 0.49% per month, reaching a minimum of $2,830 in December before being bumped back up to $3,028 next January. Your total loss for the whole year will be about $1110, or about 3% of your total income.

Indeed, it’s a pretty good heuristic to say that for an inflation rate of x% with annual cost-of-living raises, your loss of real income relative to having no inflation at all is about (x/2)%. (This breaks down for really high levels of inflation, at which point it becomes a wild over-estimate, since even 200% inflation doesn’t make your real income go to zero.)

This isn’t nothing, of course. You’d feel it. Going from 2% to 6% inflation at an income of $3000 per month is like losing $700 over the course of a year, which could be a month of groceries for a family of four. (Not that anyone can really raise a family of four on a single middle-class income these days. When did The Simpsons begin to seem aspirational?)

But this isn’t the whole story. Suppose that this same family of four had a mortgage payment of $1000 per month; that is also decreasing in real value by the same proportion. And let’s assume it’s a fixed-rate mortgage, as most are, so we don’t have to factor in any changes in interest rates.

With no inflation, their mortgage payment remains $1000. It’s 33.3% of their income this year, and it will be 33.0% of their income next year after they get that 1% raise.

With 2% inflation, their mortgage payment will also fall by 0.16% per month; $998 in February, $996 in March, and so on, down to $980 in December. This amounts to an increase in real income of about $130—taking away a third of the loss that was introduced by the inflation.

With 6% inflation, their mortgage payment will also fall by 0.49% per month; $995 in February, $990 in March, and so on, until it’s only $943 in December. This amounts to an increase in real income of over $370—again taking away a third of the loss.

Indeed, it’s no coincidence that it’s one third; the proportion of lost real income you’ll get back by cheaper mortgage payments is precisely the proportion of your income that was spent on mortgage payments at the start—so if, like too many Americans, they are paying more than a third of their income on mortgage, their real loss of income from inflation will be even lower.

And what if they are renting instead? They’re probably on an annual lease, so that payment won’t increase in nominal terms either—and hence will decrease in real terms, in just the same way as a mortgage payment. Likewise car payments, credit card payments, any debt that has a fixed interest rate. If they’re still paying back student loans, their financial situation is almost certainly improved by inflation.

This means that the real loss from an increase of inflation from 2% to 6% is something like 1.5% of total income, or about $500 for a typical American adult. That’s clearly not nearly as bad as a similar increase in unemployment, which would translate one-to-one into lost income on average; moreover, this loss would be concentrated among people who lost their jobs, so it’s actually worse than that once you account for risk aversion. It’s clearly better to lose 1% of your income than to have a 1% chance of losing nearly all your income—and inflation is the former while unemployment is the latter.

Indeed, the only reason you lost purchasing power at all was that your cost-of-living increases didn’t occur often enough. If instead you had a labor contract that instituted cost-of-living raises every month, or even every paycheck, instead of every year, you would get all the benefits of a cheaper mortgage and virtually none of the costs of a weaker paycheck. Convince your employer to make this adjustment, and you will actually benefit from higher inflation.

So if poor and middle-class people are upset about eroding purchasing power, they should be mad at their employers for not implementing more frequent cost-of-living adjustments; the inflation itself really isn’t the problem.

Strange times for the labor market

PNRJ current events, inequality, macroeconomics , , , , , ,

Jan 9 JDN 2459589

Labor markets have been behaving quite strangely lately, due to COVID and its consequences. As I said in an earlier post, the COVID recession was the one recession I can think of that actually seemed to follow Real Business Cycle theory—where it was labor supply, not demand, that drove employment.

I dare say that for the first time in decades, the US government actually followed Keynesian policy. US federal government spending surged from $4.8 trillion to $6.8 trillion in a single year:

That is a staggering amount of additional spending; I don’t think any country in history has ever increased their spending by that large an amount in a single year, even inflation-adjusted. Yet in response to a recession that severe, this is exactly what Keynesian models prescribed—and for once, we listened. Instead of balking at the big numbers, we went ahead and spent the money.

And apparently it worked, because unemployment spiked to the worst levels seen since the Great Depression, then suddenly plummeted back to normal almost immediately:

Nor was this just the result of people giving up on finding work. U-6, the broader unemployment measure that includes people who are underemployed or have given up looking for work, shows the same unprecedented pattern:

The oddest part is that people are now quitting their jobs at the highest rate seen in over 20 years:

[FRED_quits.png]

This phenomenon has been dubbed the Great Resignation, and while its causes are still unclear, it is clearly the most important change in the labor market in decades.

In a previous post I hypothesized that this surge in strikes and quits was a coordination effect: The sudden, consistent shock to all labor markets at once gave people a focal point to coordinate their decision to strike.

But it’s also quite possible that it was the Keynesian stimulus that did it: The relief payments made it safe for people to leave jobs they had long hated, and they leapt at the opportunity.

When that huge surge in government spending was proposed, the usual voices came out of the woodwork to warn of terrible inflation. It’s true, inflation has been higher lately than usual, nearly 7% last year. But we still haven’t hit the double-digit inflation rates we had in the late 1970s and early 1980s:

Indeed, most of the inflation we’ve had can be explained by the shortages created by the supply chain crisis, along with a very interesting substitution effect created by the pandemic. As services shut down, people bought goods instead: Home gyms instead of gym memberships, wifi upgrades instead of restaurant meals.

As a result, the price of durable goods actually rose, when it had previously been falling for decades. That broader pattern is worth emphasizing: As technology advances, services like healthcare and education get more expensive, durable goods like phones and washing machines get cheaper, and nondurable goods like food and gasoline fluctuate but ultimately stay about the same. But in the last year or so, durable goods have gotten more expensive too, because people want to buy more while supply chains are able to deliver less.

This suggests that the inflation we are seeing is likely to go away in a few years, once the pandemic is better under control (or else reduced to a new influenza where the virus is always there but we learn to live with it).

But I don’t think the effects on the labor market will be so transitory. The strikes and quits we’ve been seeing lately really are at a historic level, and they are likely to have a long-lasting effect on how work is organized. Employers are panicking about having to raise wages and whining about how “no one wants to work” (meaning, of course, no one wants to work at the current wage and conditions on offer). The correct response is the one from Goodfellas [language warning].

For the first time in decades, there are actually more job vacancies than unemployed workers:

This means that the tables have turned. The bargaining power is suddenly in the hands of workers again, after being in the hands of employers for as long as I’ve been alive. Of course it’s impossible to know whether some other shock could yield another reversal; but for now, it looks like we are finally on the verge of major changes in how labor markets operate—and I for one think it’s about time.

An unusual recession, a rapid recovery

PNRJ current events, macroeconomics, market failure, public policy , , , , , , , ,

Jul 11 JDN 2459407

It seems like an egregious understatement to say that the last couple of years have been unusual. The COVID-19 pandemic was historic, comparable in threat—though not in outcome—to the 1918 influenza pandemic.

At this point it looks like we may not be able to fully eradicate COVID. And there are still many places around the world where variants of the virus continue to spread. I personally am a bit worried about the recent surge in the UK; it might add some obstacles (as if I needed any more) to my move to Edinburgh. Yet even in hard-hit places like India and Brazil things are starting to get better. Overall, it seems like the worst is over.

This pandemic disrupted our society in so many ways, great and small, and we are still figuring out what the long-term consequences will be.

But as an economist, one of the things I found most unusual is that this recession fit Real Business Cycle theory.

Real Business Cycle theory (henceforth RBC) posits that recessions are caused by negative technology shocks which result in a sudden drop in labor supply, reducing employment and output. This is generally combined with sophisticated mathematical modeling (DSGE or GTFO), and it typically leads to the conclusion that the recession is optimal and we should do nothing to correct it (which was after all the original motivation of the entire theory—they didn’t like the interventionist policy conclusions of Keynesian models). Alternatively it could suggest that, if we can, we should try to intervene to produce a positive technology shock (but nobody’s really sure how to do that).

For a typical recession, this is utter nonsense. It is obvious to anyone who cares to look that major recessions like the Great Depression and the Great Recession were caused by a lack of labor demand, not supply. There is no apparent technology shock to cause either recession. Instead, they seem to be preciptiated by a financial crisis, which then causes a crisis of liquidity which leads to a downward spiral of layoffs reducing spending and causing more layoffs. Millions of people lose their jobs and become desperate to find new ones, with hundreds of people applying to each opening. RBC predicts a shortage of labor where there is instead a glut. RBC predicts that wages should go up in recessions—but they almost always go down.

But for the COVID-19 recession, RBC actually had some truth to it. We had something very much like a negative technology shock—namely the pandemic. COVID-19 greatly increased the cost of working and the cost of shopping. This led to a reduction in labor demand as usual, but also a reduction in labor supply for once. And while we did go through a phase in which hundreds of people applied to each new opening, we then followed it up with a labor shortage and rising wages. A fall in labor supply should create inflation, and we now have the highest inflation we’ve had in decades—but there’s good reason to think it’s just a transitory spike that will soon settle back to normal.

The recovery from this recession was also much more rapid: Once vaccines started rolling out, the economy began to recover almost immediately. We recovered most of the employment losses in just the first six months, and we’re on track to recover completely in half the time it took after the Great Recession.

This makes it the exception that proves the rule: Now that you’ve seen a recession that actually resembles RBC, you can see just how radically different it was from a typical recession.

Moreover, even in this weird recession the usual policy conclusions from RBC are off-base. It would have been disastrous to withhold the economic relief payments—which I’m happy to say even most Republicans realized. The one thing that RBC got right as far as policy is that a positive technology shock was our salvation—vaccines.

Indeed, while the cause of this recession was very strange and not what Keynesian models were designed to handle, our government largely followed Keynesian policy advice—and it worked. We ran massive government deficits—over $3 trillion in 2020—and the result was rapid recovery in consumer spending and then employment. I honestly wouldn’t have thought our government had the political will to run a deficit like that, even when the economic models told them they should; but I’m very glad to be wrong. We ran the huge deficit just as the models said we should—and it worked. I wonder how the 2010s might have gone differently had we done the same after 2008.

Perhaps we’ve learned from some of our mistakes.