At least two decades ago I tried to co-author a paper with someone (who deserves to retain his innocence for what I'm about to write) over what initiates inflation versus what sustains inflation. The old Friedman statement that "inflation is everywhere and always a monetary phenomenon" seemed to us to be more a statement about what sustains an inflation. If you never print money, you shouldn't get inflation that lasts long at all. Indeed, you'd think you would get no inflation at all (some define inflation purely as an increase in the money supply without reference to price indices of any type.)

So the question was, what causes an increase in the supply of money? Not too long ago reaction functions were all the rage, replaced by Taylor and McCallum rules, but basically making the money supply or a policy interest rate a function of observed economic phenomena. What's in those functions? "Policy choices", you say, and I say "sure, but why did you make those choices?" We argued that the institutions of a country mattered for that; so too do the preferences of the polity. Germany has a greater aversion to inflation than Italy; it chose institutions that expressed that preference. Thus the things that initiated monetary accommodation -- that led to the monetary expansion that sustained the inflation -- could be different things in different places. My co-author and I share an aversion to one-size-fits-all explanations of inflation.

But I never found this a terribly satisfying explanation. Why do Germans hate inflation more than Italians? Sure, the Germans had hyperinflation, but the Hungarians had worse -- are they somehow more foolish than Germans? Made no sense to me. And so when the paper drew rejection letters from several fine journals, we got the message: Bad idea, go back and try again. We went back, came up with different stuff, moved on.

I write all this as prologue to reading John Palmer's explanation of the current macroeconomic situation.

Every time I look at the data, it seems pretty clear to me that if aggregate demand is pushed upward, then in the short run the economy will experience reduced unemployment rates and (often with a lag) higher rates of inflation. During such a period, the unemployment rate drops below the natural unemployment rate (or the NAIRU), and that seems pretty much like what the North American economies were experiencing during the past few years.

And I keep reading that, and I ask: what initiated that increase in aggregate demand? He's suggesting that the inflation is, in the old language of my grad school days, demand-pull. But what was the first thing that pulled demand? War spending? Investment? Housing boom? Or perhaps the first shock came by a slowdown in productivity, which led to a cost-push inflation. Which is it?

Commenting on that post, Mike Moffatt says that "treating the current situation as a demand-side problem is terribly misguided." But even a supply shock is often accommodated by easy money because that's what the system prefers; the economy's closeness to a national election affects that choice. So too does the possible rapid loss of liquidity in the system, which is what I think Arnold Kling means when he says "The central bank matters more as a lender of last resort than as a monetary authority." If the central bank faces a suddenly illiquid financial system, it may accommodate inflation in order to provide liquidity. Some might see that as seat of the pants monetary policy, but it feels vaguely familiar.

John's story, as I read it, seems to assume a constant level of full-employment GDP. I mentioned the productivity slowdown before -- but even there, it's growing more than it did in the 1970s. knzn suggests it's actually better than you think.

Labels: economics, inflation

Courtesy of Mark Perry, we learn that Zimbabwe is printing new currency:

President Robert Mugabe's government, stricken by chronic hyperinflation, announced Thursday it was to introduce a 10 million Zimbabwe dollar note. Economists said they believed it was the highest denomination of any currency in the world.

Central bank governor Gideon Gono was quoted on state radio as saying that the bank would begin releasing a set of three new notes - 1 million, 5 million and 10 million - on Friday.

The issue of new notes follows nearly three months of banking chaos as cash dried up and queues, sometimes hundreds of metres long, became a permanent feature outside commercial banks.

I am going to guess, following Larry White's suggestion, that price increases in Zimbabwe are exceeding the rate at which the central bank could print currency. I have a hard time finding money supply data for Zimbabwe post 2004 so it's hard for me to show this, but it appears money supply growth was under inflation in 2005 and 2006 from what data I can find. Therefore real money supply is falling. Using more zeroes will help monetary growth to catch up.

Of course, Zimbabwe has four zeroes to go to catch up with the Yugoslav dinar. But with inflation worth less than 0.05% of what it was 1 year ago, it might set the record yet.

Labels: economics, inflation

Controlling P-R-I-C-E.

Seeking to tame galloping food prices ahead of parliamentary elections in early December, the Russian government on Wednesday signed an agreement with major food producers instituting temporary price controls on basic products.

A tersely worded statement posted on the Web site of the Agriculture Ministry said the producers had signed the agreement “at their own initiative.”

“Producers and retail organizations, understanding the social responsibility of business in the balanced and stable development of the consumer market in Russia, will take necessary measures over the course of the agreement to ensure that the most vulnerable strata of the population can purchase products at acceptably stable prices,” the statement read.

Prices for products like cheese and vegetable oil have jumped and even doubled in some regions in the past two months.

Here's the Nixon period from Commanding Heights. Arthur Burns at the Fed raised the money supply 13% in that period in advance of Nixon's re-election. M2 in Russia at this time is up almost 28%.

A deep recession followed the relaxation of price controls in the US in 1974-75. Those investing in Russia are hereby warned.

(h/t: Greg Mankiw.)

Labels: economics, inflation, money

Jim Knoblach, former state representative from here in St. Cloud and former chair of the MN House Ways and Means Committee -- meaning, the guy who knows the budget as well as anyone in MN -- has a Your Turn in today's St. Cloud Times (which, unfortunately, is not up on the Times' website. UPDATE: Randy Krebs, the opinion editor, acted fast and got the article up. Thank you Randy! Link is updated) In it he points out that if the DFL wants to have inflation figured in budget forecasts it need only do one thing:

I said at the beginning that some legislators want to have their cake and eat it too.

What did I mean? Simply this: If big-spending legislators want to have inflation included in current forecasts, all they need do is pass laws mandating that all programs get automatic inflationary increases.

So why, do you think, doesn't the DFL do this?

Personally, I think this would be a terrible idea. Yet even big-spending legislators are unwilling to propose this, in part because they might have to make unpopular spending cuts the following year if there was not enough tax revenue.

It is far easier to advocate for a forecast that assumes everyone gets an inflationary increase, than to have to make the tough choices that might come if you pass laws that actually give one.

And to those who think having inflation would the budgeting easier, Knoblach also has some tough words:

Most recipients of state tax dollars assumed they would get an inflationary increase, and then added their wish list on top of that assumption when presenting their budget request.

In addition, determining the actual budget base for an agency was confusing. Legislators weren’t always sure if the base budget numbers they received were the amount an agency was legally authorized to spend, or authorized spending plus inflation.

Having no inflation in the expenditure forecast, except for those spending items indexed by law, provides more rather than less clarity.

Labels: inflation, legislature, Minnesota

In yet another defense of the concept of budgeting for inflation (a topic I've discussed here, here, and here in case you haven't come across this before since Gov. Pawlenty's veto), State Auditor Rebecca Otto tells a whopper.

Minnesota has performed very well over the years because we lived by a guiding principle regardless of which party was in control. That principle was that we allowed fiscal experts to create a budget forecast that gave a straightforward, honest picture of our state finances. This gave us as a baseline snapshot of where we were headed if nothing changed.

This gives the impression that Governor Pawlenty's was the first administration to remove inflation from budgeting. That is in fact wrong. The law that required inflation of expenditures was only passed in 1994 (Chapter 587, Article 7, Section 2, Subd. 1). When the law was changed in 2002 (Chapter 220, Article 13, Secs. 1 and 2), the House Fiscal Analysis unit created a document that discusses the use of "planning inflation". I highly recommend people to read it. Two sentences jump off their pages:

Even though the inflation adjustment is applied to most appropriations, the Department of Finance has always argued that inflation should not be seen as a commitment to adding funding to any particular program to offset the impact of inflation in the next biennium. (page 4)

[T]he inflation increases are all increases that have not been built into current law
formulas or base budgets. (p. 5)

If there is no commitment, and no building into current law or base budgets, how exactly can Auditor Otto claim that a budget with inflation " gave us as a baseline snapshot of where we were headed if nothing changed"? That would be at least a mischaracterization of the history of inflation increases.

The beauty of this system was that it allowed the fiscal experts to give Minnesotans, lawmakers and the media an honest assessment of our financial picture.

As the quotes above would show, this is not true. The experts did not want to have that data included. And according to those I talk to, they still don't.

Politicians did not intrude in their work...

And yet they passed laws first requiring them to inflate expenditures, then to require them not to. Pre-1991, Finance sometimes included some estimates and sometimes did not. They applied it to some expenditures at first, and then to all of them. As the House Fiscal document explains, they even ended up giving two inflation adjustments to local government aid, since there were inflation adjustments in the LGA formula, which were applied after the general inflation adjustment was made. (No wonder the LGA crack addicts have been jonesing for a new fix.)

Today, and throughout the time of the current administration, we have allowed politics to enter into the forecasting process. We no longer get a straightforward assessment of our financial baseline.

No, politics has always been there, as House Fiscal explains.

Planning estimate inflation has also been a tool to provide more flexibility for a Governor and Legislature in assembling a new budget. The inflation creates a cushion of several hundred million dollars that is already counted as spending in the budget forecast. For example, in the November 1998 forecast for fiscal years 2000-01, almost $800 million was set aside as planning estimate inflation. That amount allowed the Governor to make budget recommendations for $800 million of spending above the base level budget that did not count as new spending relative
to the budget forecast.

In other words, Governor Ventura could hide new spending without being accountable for it.

As I noted the other day, the budget does include an inflation measurement, it just puts it below the line rather than above the line in terms of stating the current surplus or deficit. An accurate baseline is being provided. What they want is the cover for spending increases under the rules that Carlson and Ventura (and no previous governors) have had. Had you taken the opportunity to read the history, Ms. Otto, rather than hang around DFL fundraisers, maybe you'd know that.

Labels: inflation, legislature, Minnesota

I said something on the air Saturday that, based on a couple of phone calls after the show, appears to require some explanation. What I said was that there are two entirely different types of forecasting one is discussing in this budget inflation debate.

One type of forecasting is forecasting of an event. The revenues generated by the tax code are the result of an event -- what happens in the economy -- multiplied by a vector of tax rates that collect revenue based on a matrix of flows of income and stocks of wealth or assets in the hands of economic agents. The tax rates are constant; the movement in tax bases comes from the Global Insights forecast (as I mentioned earlier). Insert the numbers from that economic forecast in the matrix, plug and chug, and there you are, a revenue forecast.

What I said on the air was that you can't forecast decisions. That's not right exactly; there's a very good example of decision-forecasting in the Taylor Rule, which is a forecast of the Federal Funds rate target set by the Federal Reserve as the basis of its monetary policy. It is a description of how monetary policy was being set under the leadership of Chairman Greenspan. (Does it describe Chairman Bernanke? Look at the graph and decide for yourself. The Taylor Rule, properly understood, is not a mechanism that predicts an economic event but a heuristic used to try to understand how the FOMC is deciding policy at that point in time. The rule is not independent of the committee whose behavior it is forecasting.

Legislatures and executives do not automatically adjust spending to inflation. The budget forecast provided, as noted by the House Fiscal Analysis Department, is the budget's structural balance, i.e., "how much more is being collected than spent before any tax or spending decisions are made." (Emphasis added.) They may do so as an element of policy; the budget forecast provides information on what additional spending would occur if all non-indexed items were to be raised by inflation as measured by CPI. But is it appropriate for an arm of the executive branch to forecast a policy decision of the legislative branch? I think it is not.

There is, by the way, a very simple solution. The Federal government has both an Office of Management and Budget (reporting to the executive branch) and a Congressional Budget Office. If the DFL wants a forecasting arm that reports budget figures the way they would like to read them, have the Senate and House Fiscal Analysis Department provide you that information. What the DFL is doing instead is censoring the information the Finance Department can provide, but not allowing it to report spending without inflation. This is a bad policy.

Labels: economics, Final Word, forecasting, inflation, legislature, Minnesota

While we interviewed Brian McClung, spokesman for Governor Tim Pawlenty on Saturday's edition of NARN's The Final Word, he said something that perked me up. He reminded me on the inflation issue that the Finance Department in fact does print the data in its report. That was news to me and so I looked up the latest report from February. Sure enough, there it was on page 7.

	FY2008	FY2009	FY2010	FY2011
Projected revenues	$16,551	$17,127	$17,818	$18,889
Projected Spending	$16,143	$16,494	$16,785	$17,123
Balance	$408	$633	$1,033	$1,766
Forecast Change	$64	($45)	($187)	($231)
Estimated Inflation (CPI)	$320	$700	$1,060	$1,430
Forecast Change	($20)	$50	$90	$130

The impact of inflation is not reflected in expenditure projections. Inflation for FY 2008 and FY 2009, based on the consumer price index, is expected to be 2.0 and 2.2 percent.

For FY 2010 and FY 2011 CPI growth rates of 2.0 and 1.9 percent are projected. The inflation forecast is down slightly for FY 2008, but about 0.2 percent for FY 2009-11.

Using current law projections, if spending increases at the rate of inflation, revenues and spending will remain in balance through FY 2011. Historically increases in spending have been greater than those attributable to inflation alone.

Inflation then was going to be about 4.25% for the first biennium. The argument isn't that they are hiding the information. The issue is that the DFL leadership wants the inflation number cooked in above the line, so that the budget would look like this:

	FY2008	FY2009	FY2010	FY2011
Projected revenues	$16,551	$17,127	$17,818	$18,889
Projected Spending	$16,463	$17,194	$17,845	$18,553
Balance	$88	($67)	($27)	$336
Forecast Change	$44	$5	($97)	($101)

Comparing this to the current budget, the latest highlights report from Finance shows spending of $34.5 billion versus the $33.7 billion that would have been reported from the revised budget and $32.5 that Finance actually reported.

So what's the big deal? Pretty clear: Changing the way in which it was reported would have change the tenor of the debate. Rather than having almost no "new money" to finance its new priorities, the revised reporting would have allowed more campaigning, more editorials from compliant (and under-educated) columnists that taxes needed to be raised. Had the same inflation factor been applied to education, they would have screamed that K-12 had been cut (I know, they will anyway.)

Here for example is a paragraph from the faculty union's lobbyist's email to us about the higher ed bill; I've highlighted the inflation parts.

The Governor started off the session proposing $123 million in new funding for the MnSCU system—and $55 million of that was one-time funding that did not continue into the next biennium. He proposed no money for inflation, and $25 million of his proposal was for a one-time “performance bonus.” The legislature listened to the systems, students and faculty, and focused their funding on maintaining and improving the core infrastructure of MnSCU. The House passed a bill providing $168 million in new funding for MnSCU. The Senate passed two bills that together would have provided $187 million for MnSCU. They compromised in conference committee at $150.7 million.

The Governor vetoed the first higher education bill in its entirety, forcing the DFL higher education chairs to make some tough compromises on both policy matters (the Dream Act, ACHIEVE, and performance funding) and funding to get the Governor to support a second bill (there weren’t enough DFLer’s in either the House or Senate to vote to over-ride the veto). However, through patience and persistence, the higher education chairs were able to put together a bill that the Governor ultimately signed. The appropriation for the MnSCU system in the final bill was not only $28 million above what the Governor originally proposed—almost none of the money is “one time” funding.

Budgeting into a base appropriation is an attempt to set the bar higher each period. The budget proposals from the governor's office used a $1 billion budget surplus from the current biennium, thus those were one-time monies which Pawlenty offered to use in the appropriate way: as one-time expenditures. By budgeting then as not one-time money, the "tail" of the bill is higher, meaning the anticipated surplus in FY 2010-11 is less than it would have otherwise been, making the probability of a tax increase in that period higher than it otherwise would be.

Putting up each number by an inflation factor, contrary to Larry Pogemiller's assertion, is in fact hiding additional costs of government. And what that's about, as much as anything, is a lack of growth in government employment. An inflation factor in the budget puts a base under wages for those employees.

Labels: inflation, legislature, Minnesota

Now I really want it vetoed:

The tax bill contains many items Pawlenty supports, including tax breaks for expansions of the Mall of America in Bloomington and Thomson West Publishing in Eagan, a $39 million state guarantee for costs of the 2008 Republican National Convention in St. Paul and tighter tax rules for firms with foreign operations.

But Pawlenty opposes a section that returns projected inflation to the state's official budget forecasts. To eliminate it, he would have to veto the entire bill, because line-item vetoes are allowed only for spending provisions, not policy. He warned legislators before the bill was approved that the inflation provision could bring down the whole measure.

Seriously, in one veto you stop this inflation nonsense and the corporate welfare to Thomson West and MoA? And frankly, Scarlett, I don't give a damn about guaranteeing costs for the RNC. Why does a government have to do that?

Of course, the corporate types will also be pushing for the foreign operations tax veto as well; I think this is as good as dead. $39 mil for the RNC guarantee (which, to be clear, doesn't cost us anything except in very dire circumstances) isn't enough sugar to swallow this lemon.

Labels: inflation, Pawlenty, taxes