Thursday, May 15, 2008

Assume martians are really poor

... and they buy nothing. In that case, the economy of the earth is a completely closed system. I realize that this sounds silly, but I feel that one of the fundamental mistakes people make when thinking about economics is to forget this. Marx, for example, went astray in part because he forgot this (though also, as Kolakowski makes clear, because his economic theory was always at the service of his philosophy) even though with Marx it was perhaps excusable because "the world economy" when he was writing, only meant Europe, which was in fact able to rely on a sort of alien colonialism. But that age is pretty much over now. Unfortunately, our ability to think about whole inter-connected systems hasn't actually progressed much since Marx, and we still regularly imagine a functional role for the martians.

This is a long-winded prelude to the question of inflation, one of the hot financial topics recently, and one of the topics where the debate seems to suffer especially from this type of fuzzy thinking.

William Buiter
has a post today that clarifies who or what causes inflation.
This one is easy. In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always can be offset by the central bank, given enough time, freedom to act and courage.

So, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices - in the real prices of oil, of food, of oil and of labour for instance - if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation.
There you have it. As far as I understand the terminology, Buiter would be considered a "monetarist" (a la *gasp* Milton Friedman -- who, by the way, when you actually sit down and read him, turns out to be remarkably similar to Lessig and Chomsky on a number of points. Intellectual life is so much more confusing when you actually read the original books, isn't it?). I'm hardly an expert, but up till now I have still found no coherent description of inflation that would be anything other than "monetarist". People tend to blame inflation on oil prices, or labor unions, or greedy corporations, but in a closed system, I don't see how this can constitute an explanation. If I pay more to put gas in my car, I have less to spend getting a hair cut. That's not inflation, that's just a transfer of wealth from people without oil to people with oil. No one is saying that the recent increases in commodity prices don't have importance for a lot of poor people who are paying more for food. It's just that it isn't inflation. For it to be inflation, those price increases would have to continue for the indefinite future -- that is, the price of food would have to continue to increase not simply to stay at a permanently high new level. And the only way those prices could continually increase would be to pay more to the people who are buying these things. This is the wage-price spiral one hears so much about, and it can only be facilitated by someone, somewhere printing more money.

Or by many someones, somewheres, each of whom can blame the others for its profligacy, which is what seems to be happening now. The US prints money buy holding real interest rates negative for years, and exports this inflation to the rest of the world via their willingness to support the dollar, which they do by using their own printing presses to maintain "competitive" exchange rates. Both sides blame the other, and we all suffer, with perhaps a bigger lag than in the past, from the resulting inflation.

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