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-- Brad Delong

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Monday, December 20, 2010

Of Deficits and Inflation - Part 2

In Part 1, I took a hard look at deficits and inflation, from 1951 through 2009, and wound up with some questions.  One them was - "What does the very different look of the first chart before and after 1980 mean?"  Here, for your convenience, is the first chart.

I constructed cloud charts, as in part 1, for the data up to 1980, and after 1980.  The differences between the two time frames are striking.  The differences with different time delays are not.  I'm only presenting 3-year delay here.  Basically, all the charts up to 1980 make a pretty similar set, irrespective of time delay; and all the charts after 1980 make another similar set that is very different from the first.


As in part 1, The year over year change in CPI is plotted as a function of the deficit (as a percentage of GDP) three years earlier.  The slope is 1.73 - an increase of inflation of 1.73% CPI for each % of deficit, with a three year lag.  The correlation coefficient is an impressive .672.

Here is a similar plot for the years after 1980.


For this plot, the slope is only 0.168 - less than a tenth of the slope for the previous period.  The correlation coefficient is only .31.

Here is a plot of slopes and correlation coefficients for the two time frames, with CPI lags from 0 to 5 years.



In the earlier period, the inflation measure peaked three years later than the subject year, as did the correlation coefficient.  For this period, correlations in the two to four year range are all greater than .5 - the strong correlation region.

In the later period, the effect is slight, the response from 2 to five years flat, and the correlation coefficient low, indicating weak correlation.

The first time frame is based on 29 data points, so there is a pretty high level of statistical significance to the data.  The second time frame has a varying number of points, depending on the time lag chosen, but never fewer than 24.

The conclusion I draw from this is that from 1951 to  about 1980, and from about 1981 on represent two quite different economic environments.  The earlier period was characterized by secular inflation, and deficits led to higher inflation.  The later period was characterized by secular disinflation, and inflation has been quite insensitive to deficits.  Based on this data, I think we can make those statements with a high degree of confidence.

OTOH, I have no confidence at all about the future.  I'm afraid we've slipped into actual deflation, or something very close to it.  My guess is running deficits will do nothing to spur inflation, but that is speculative.  We shall have to see what we will see.

What this exercise suggests very strongly is the map of the economy has different regions, each having different characteristics that require different approaches (a la Keynes, frex.) I'm convinced that before and after about 1980, the post WW II era is divided into two distinctly different realms: an expansion phase followed by the great stagnation. The M1 multiplier had been sagging since the mid 80's, before it fell down in '08 and couldn't get up.

If I may editorialize a bit, the problem with Libertarians and Austerians is not that they are absolutely wrong, but they are right within a certain realm; and they let that make them think they are right in all realms - because, in their absolutism, they refuse to recognize that different realms exist.

Because of this one-concept-fits-all-circumstances mind set, they end up exploring the jungle in parkas and snow shoes. They forget (or deny) that Keynes didn't overturn classical economics (his big mistake, IMHO) he expanded it, the way Einstein expanded Newtonian mechanics.

What do you think?
.

10 comments:

Jerry Critter said...
This comment has been removed by the author.
Jerry Critter said...

An interesting couple of posts. Clearly there are two different things at play before and after about 1980. You haven't said it, but I will -- Reagan, and Reaganomics. Reagan moved us from a high income tax, low deficit realm to a low income tax, high deficit realm. And we now can see the effects -- "the great stagnation".

Jazzbumpa said...

Jerry -

Actually, I have said that - plenty of times.

But this is different, I think. The inflation coming into the 80's looks like a bubble - really quite similar to the shape of the price chart for a typical asset bubble.

As much as I thing Reaganomics is wrong, wrong, wrong, This looks like a secular trend that transcends policy decisions.

That's all guess-work of course.

But the effect does validate my Great Stagnation concept - I think.

Cheers!
JzB

nanute said...

Jazzbumpa,
What do you mean by "this looks like a secular trend that transcends policy decisions."? I would argue that what we are experiencing right now is a direct result of wrong headed policy decisions, from both the Fed and Congress starting in about 1980. The push by the monetarist's thinking that all that is required is to focus on monetary policy while disregarding fiscal policy is the primary cause of our current economic malaise.

Since the 80's we are now constrained by outside forces like never before in our history. We willingly joined the global economy at the expense of a middle class standard of living. Once the assault on organized labor commenced, it has been a downward spiral for workers and real wage growth. (This is not to say that organized labor is blameless in this condition.) Once the private sector corporations saw the results of Reagan's success in breaking the PATCO union, it was only a matter of time till private sector unions would feel the effects. When US Steel purchased National Steel in bankruptcy proceedings the courts ruled that any rights held by pensioners of National were no longer valid. (A deals a deal, except when it isn't.) Whatever concessions that couldn't be gained by collective bargaining were then gained by setting up shop in developing countries with cheap labor where workers have no expectations of being treated as human beings. It's all about the bottom line, and damn the consequences of the detrimental social impact. (But, I digress.)

I think you are right in the assumption that we are in for a long protracted period of stagnation. It's going to get much, much worse before it gets better. State and local governments are hemorrhaging deficits, and political leaders at all levels, are in no mood to raise taxes in a time of economic distress. The answer, the Austerians say, is to cut public sector jobs and benefits, and get spending under control. Never mind the fact that political leaders have now, in effect, sanctioned criminal activity by financiers and corporate entities.

It's rather early, and this is mostly a free association exercise. Please feel free to push back.

Jazzbumpa said...

nanute -

I'm not going to gainsay any of your perfectly valid points, so this isn't much of a push back. In fact, I'll repeat what I've said many times at AB - policy matters.

OTOH, you're always operating in an environment, and that might be imposed on you by outside forces - like playing a football game in a snowstorm.

That's what I mean by a secular trend. Clearly, there was inflation though the 50's to 70's. Since then - not so much. Whether Volker killed the dragon, or the bubble simply burst is more than I can tell.

Tux has pointed out that capitalism NEEDS inflation, like a baby needs mama. I don't have a general theory, but I suspect the lack of inflation has ultimately led to the current malaise - maybe the collapse of the M1 multiplier is a symptom. For many years the economy has been artificially propped up by leverage at all levels, and now those buzzards have come to roost.

There are forces at play that one needs to react to. The wrong reaction makes things worse, and I think that is what we are living in right now. Another example was FDR balancing the budget in 1937, causing the (re)recession of '38.

Plus all the crime you mentioned. I aint hopeful.

Lo siento,
JzB

nanute said...

I've played football in a snowstorm. The opposition was constrained by the same outside forces. This current "football game" has one side playing in the snow, and the other side is playing under perfect field conditions, and with the added benefit of having payed off the officials. I don't disagree with your and Tux's contention that we need some inflation. I just don't see how that will remedy the situation as noted in my metaphor. As you say: policy matters.

Jazzbumpa said...

I guess I chose a poor analogy, but I just watched the Bears and Vikings play in the snow.

Inflation would remedy the situation by stimulating the economy, and giving capitalism what it requires to function - markets. I can't say it any simpler than that.

But I'm convinced we're not going to get any. If QE II seriously raises inflation by working some magic trick with expectations, then I'll be happy to have been wrong.

But we're in an environment where inflation is difficult to manufacture. Keynes showed us the way 75 years ago, but he is generally dissed, and Austerians rule the world.

That is a big part of why I am so pessimistic.

I just heard that NJ has underfunded it's state pension obligation for 13 of the last 17 years. That's why (along with the current downturn) its pension fund is in such bad shape.

Besides fueling capitalism, Inflation favors debtors. Deflation hurts debtors and benefits rent seeking. The U.S. economy is dominated by rent seeking, rather than capitalistic wealth generation by value-enhancing activities (i.e. making stuff.)

Just imagine how much worse it will get when the House is redistricted due to the census results. About 30 seats shift from blue to red states.

It's gonna get rally ugly out there.

JzB

nanute said...

I got the point of your metaphor(I was just breaking balls.) We are in agreement with regard to needing inflation. The problem lies with wrongheaded assumptions by policy makers. Bernake and the Fed are attempting to circumvent the normal process of fiscal policy, which is generally the domain of the Congress. If anyone gets the idea that inflation is what's needed to get us out of this mess, Bernake does. The question is will his policy of QEII be effective in this regard? Most of the conventional wisdom seems to be betting that it will not work. If left unchecked by Congress, (highly unlikely), the policy might have a slim chance of the desired outcome.(Inflation.) Hell, there doesn't even seem to be a consensus of what the actual intent of QEII is. Those of us that argue it is to lower long term rates via inflation are viewed as wrong, wrong, wrong.

As Krugman has pointed out recently, "monetarism is dead. Fighting words, to be sure." The problem is that the Austerians, neoliberals and the like, just can't come to the realization that Keynes was right. The incoming crop of fear of inflation House members, along with a willing partner in the White House, will seek to choke off any meaningful attempt at recovery with cutting spending with no increase in revenue for stimulative measures. And there is talk that Republicans are mounting an effort to force State's and local governments into bankruptcy to negate public sector pension obligations. Brilliant! What Governor Christie forgot to mention with regard to New Jersey's pension liabilities came to a head in 1997 under the leadership of then Governor Christine Whitman. Instead of making mandated payments out of general funds, Whitman floated 2.75 billion dollars in bonds to facilitate tax cuts. The so called revenue stream form the bonds was intended to make up the pension fund liability. To date, the revenue from the bonds, hasn't even been enough to cover the debt service.

I too, am not optimistic for the middle class and what was once a great, prosperous Nation.

Jazzbumpa said...

I certainly don't doubt that Bernanke gets it. Recently, he was BEGGNG congress for some fiscal policy. I don't think it even made the 6 O'Clock news.

You're right - Rethugs are ruining the middle class, and with it a once great nation. This assault has been underway since Reagan.

Most of them are either stupid or bought off. But I don't think it's just happenstance. Conservatives hate democracy. The rich and powerful have been in love with fascism since the 30's. I think they're finally getting their wish. But not in the way that idiots like Jonah Goldberg or tea party dupes imagine.

Lo siento,
JzB

nanute said...

Jazzbumpa: I think you might be interested in this link: http://delong.typepad.com/sdj/2010/12/money-and-marbles.html
They're discussing M1 and velocity.