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Monday, April 14, 2014

"Pop Econ," The Federal Reserve, and inflation

What is "pop psychology"?

You ever hear someone use the term "pop psychology"?  Pop psychology is an oversimplified version of real psychological knowledge, typically applied to some mundane and specific problems of an individual.

They're fairly easy to spot.  When Dear Abby, a self-help speaker, or that weird coworker starts off a sentence with "Studies have shown..," you can bet what follows is a good example of pop psych babble.

The "left-brained vs right-brained" myth is a pretty ubiquitous one, as is the "opposites attract" legend.  And who could forget that age-old masterwork of bull: "we only use 10% of our brain" (Hint: you are using 100% off all your organs, all of the time.  I want you try using only 43% of your stomach.  Right now.  I'll give you a minute.)  Oh, there's so many of them!

Difficult persistence

Pop psych myths tend to be a mound of wacky built on top of a grain of truth.  This makes them hard to stamp out.  That tiny, inconsequential speck of accuracy mixed into the myth gives true believers a channel to rationalize and excuse their treasured folklore.

They are myth's based in truth.  But being so oversimplified and distorted, they just not usable in the real world.

What about "pop economics"?

Anyway, so what's my point?  

Ok, so the other day, I was thinking to myself: "Are there any 'pop economics' ideas out there in the same vein?"  Economic "facts," which most people understand to be true, but really aren't?

I think so.  The problem is that most people (present company excluded, of course) find economics massively boring.  They don't think economics is fun to analyze, so they just don't.

This probably somewhat abates the unfettered speculating, myth-making machine that is the popular consciousness.  Nobody takes the time to work out that these things don't make sense.

HOWEVER - economics is important stuff.  It effects all of us, everyday.  Whats more, we're all aware of our economic position in the world, and spend a lot of time considering the positioning of those around us.

So take these two points together, and what do you get?  The populous might not be passionate about economics, but they think/care about it nonetheless.  

And with everyone thinking about it, especially in a casual manner...well, that gives you the necessary environment for an odd myth or two to take root...

An example

Of course, the fact that I'm struggling to identify "pop econ," and the fact that the term "pop econ" doesn't really exist outside of this blog post, makes it pretty clear that pop econ isn't nearly the cottage industry pop psych has come to be.

But I think I can see a few contenders for the mantle.  

In today's post, I want to address the following bit of conventional wisdom, that nicely represents "pop econ" thinking:

"When the Federal Reserve prints money, it always leads to inflation."

What makes this statement wrong is the "always."  Increasing the number of dollars in existence can cause inflation.  Might.  May.  It's possible.  

However, a lot of the time - it just plain doesn't.

Take a look at the below charts.  I won't offend you with too many details (you can learn some nitty gritty here), but Chart B shows the amount of cash in existence, in the US economy.

Chart A tracks the CPI - line going up means prices are increasing, falling is decreasing.

Plain as the nose on your face...between Fall '08 and Fall '09, the Fed stepped up the rate it milled cash.  Yet at the same time, prices were falling.  We had an injection of cash without inflation - in fact, prices fell - a period of deflation!

(Data for Chart A, Chart B)

Understanding the pop econ thinking

So what's going on here?  

Let me first delve into the logic behind the pop economics legend, and make sure we're all clear as to what the myth's believers think is going on.  Then I'll explain why deflation can coexist with a splurge of money printing like in the above charts.

Ok, back to the original story.  When the Federal Reserve prints money, it always leads to inflation.

Let's first understand the thinking behind this idea.  Why would the Fed printing cash increase inflation?

You might think of inflation as "prices going up," but its better to view it in reverse: "the value of money is going down."

Try this: picture a nation with exactly $100 in cash circulating throughout its economy.  

In Year 1, a loaf of bread in this country costs $1.

Now imagine that in Year 2, the government prints $100 more dollars.  Now there's a total of $200 in circulation.  (Everything else - the nation's population, bread making capacity, demand for bread, etc. - stays the same).

In Year 2, bakers are going to look around and say "Hey, all of a sudden, my customers are a lot richer!  There's twice as much money flying around here!"

They realize they can raise prices without losing business, since all their customers are now "rich" enough to afford pricier bread!  Suddenly, bread goes for $2 a loaf.

(And what if there's one baker out there who decides he's a nice guy and won't raise prices to his customers?  Who cares!  He won't be around for long.

His flour distributor, land lord, employees, and utility company will likely be raising their prices too, for all the same reasons he would.  As the baker's overhead goes up, his prices must to, if he is to stay afloat.)

In this scenario, the govt's actions caused inflation.  As the number of dollars in circulation grows, producers will expect/require more of them in exchange for the same products.  More money out there, chasing the same number of goods, pushes prices up.

In our example, a loaf of bread costs 1% of the economy's wealth in both Year 1 and Year 2!

So bread didn't really go up in price...the price just inflated.  Dollars fell in price (due to the increased supply), meaning they became less valuable, meaning the baker needs more of them before he's willing to part with his goods.

Whats wrong with that thinking?

There's nothing wrong with the logic of the story I tell above.  As a matter of fact, stuff like this has happened in the past.

But that hardly means that it must!

The big problem here is this hypothetical economy is cash only.  People can only buy their bread with the money the govt provides.  In the real world, you have plenty more options.

And the existence of these alternatives make the above narrative just too much of an oversimplification to be right all the time.  It's "pop econ."

Credit cards

Economists refer to actual cash, as in currency, the kind the govt prints, as "M0."  But that's not the only kind of "money" we use.

Think about our bakers.  In Year 1, one loaf is $1.  Now, picture an different Year 2, one in which the govt printed no new money.  BUT, everyone nationwide got a credit card, and began spending twice what would normally.

This economy may only have $100 in cash flowing around, but it acts like a $200 economy.  Prices at the end of Year 2 go up anyway, and we'd get the same inflation as before!

Putting it all together

Ok, again, hit reset on the hypothetical nation.  In Year 1, there's $100 in circulation, and bread is a dollar a loaf.

And let's again say in Year 2, the govt prints no new money, but the population discovers credit cards, and functionally, there's $200 to throw around.  The typical baker raises (or is forced to raise) his price to, say, $2 a loaf.

Ok, now lets move on to Year 3.  In Year 3, there is a economic collapse, and everyone's credit score tanks.  They all lose their line of credit.  We're back to transacting all business with that $100 cash.

And ladies and gentlemen, one moment you've all been waiting for: 
If the govt just prints $100 more, there will be $200 in circulation again!  Prices don't crash, and the deflationary spiral is avoided - and best of all, no new inflation!!

Remember, inflation happens when amount spent goes up, even when the amount purchased stays constant.  When credit disappears, people can afford less stuff - spending goes down.  But if the loss of credit can just be substituted dollar-for-dollar with new M0, inflation will not occur.

And if there's any doubt in your mind that credit spending is large enough to matter so much:  Realize that the overwhelming majority of all purchases in a modern economy are done on credit.  Credit cards are only a small part of it...mortgages, car loans, student loans...

I once worked for a manufacturer that shifted nearly $50 million worth of stuff MONTHLY, and gave most customers 30 days to pay for their orders.  Our company was functionally creating $600 million in credit a year, and we were considered a 'small company.'

Heck, right now, US governments, households and businesses altogether are $41 trillion in debt.  Our GDP is only about $15 trillion a year.

That means that at current income levels, if all govt, households and businesses never borrowed a penny again, and started diverting 10% of their yearly incomes to paying off old debts, it would take 27 years to settle all debts in the US of A.  That's a lot of stuff bought on credit.

Another scenario

I can think of some other instances where the Fed could pump those printing presses without contributing to inflation.

For example, governments can't force people to borrow money from the bank, nor can they force them to make deposits.

Its entirely possible for cash to be printed up, released into the world, wind up in a savings account or two, and then...nothing.  It ends up in the banks, but with no one wanting to borrow/spend the extra cash it never really goes into broader circulation.

If that M0 never sees the light of day, the net effect, of course, would be the same as if the cash was never created at all.  The money never really gets into circulation, and so it can't cause inflation.

And another...

What if the baker improves his process of production.  Maybe through better tech, maybe better management, whatever.  Either way, he manages to make more bread in Year 2 than he did in Year 1 at the same cost.

In this case, if the govt prints up more money, price levels will stay flat, since the ratio of bread to dollars in the world can stay the same.

In fact, if the govt doesn't print more currency, you end up with more goods out there and fewer and fewer dollars available to move them around.

Consumers can haggle down prices (as it's become a buyer's market), and producers will have to come down, leading again to deflation.

Policy makers tend to me much more worried about deflation than inflation, since deflation can be much more dangerous to an economy.

So, can I call it a "myth"?

Gov't printing of cash sometimes causes inflation, sometimes it doesn't.  It's all about the situation.  This clearly puts the "always" version of this pop economics narrative squarely into the realm of myth.

A better version of the this particular bit of pop econ, would be one that understands inflation is always a risk of printing money, but not an inevitability.  Then it just becomes an issue of "how much risk for how much reward?"

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