Interest rates and those tax cuts

Michael Short the excellent editor of the Age’s excellent business pages asked me at pretty short notice to write a little op ed – 300 words – on the issue du jour – which is whether the bipartisan policy of handing back the revenue windfall from the mining boom will increase interest rates (which it already has and will continue to do).

I responded with a column published yesterday that alludes to one of my pet ideas about politics.

We are forever being told about how ‘poll driven’ governments are and how they make decisions based on focus groups. Well, we haven’t had a purely poll driven politician in my adult lifetime. For good or ill, every one of our PMs – the last possible exception I can think of is Billy McMahon and there I’m only going on his reputation as I wasn’t quite old enough to figure it out for myself – has been a conviction politician in some kind of way. With Howard it’s been the culture wars, the GST (oddly enough) and beating up on the unions with WorkChoices.

With Keating it was his own culture wars – the republic and all that – and his own idea of himself as a class act (cough). It might have lost him votes, but he was with Whitlam in his (selective) unpreparedness to change for the sake of voter optics. Hawke was a ‘reconciliation’ guy even when people told him it wouldn’t work. He and the ACTU managed to make it work for a decade or so initially to the surprise of Keating but later with his involvement as one of the central parties.

The ability for governments to get a lot done by controlling agendas, setting long term goals and then working towards them is much greater than people typically think. It is one of our misfortunes that the current government has never done anything like that with economic policy (though they’ve not been without political courage on a range of one off issues).

Of course when the government is scrambling from one bit of improvisation to the next, nothing much is possible. That’s the situation we have now. It is the situation we had in many respects after the recession we had to have. But at least before then quite long term goals were articulated and then pursued in politics – viz tariff reform, reducing real wages and compulsory super are three that come to mind.

Anyway, the piece is below the fold.

When an economy approaches full employment, additional spending simply feeds into inflation unless it expands production. With a central bank unwilling to tolerate inflation, tax cuts raise interest rates. Thats Economics 101.

Like Renaissance Popes, the Government (with the Opposition tagging along) has issued an indulgence to suspend this economic law doesnt wherever budget surpluses remain above one percent of GDP.

But when the inflation numbers come out tomorrow, think whether inflation might have been a teensy bit lower without all those goodies in 2003, 2004, 2005 and 2006.

If wed hung onto all that tax revenue from the mining boom, the surplus would be around 10 per cent of GDP though itd be somewhat less if wed indexed tax rates.

Investment and productivity would have been higher. Interest rates lower. Our yawning external deficit would probably be a surplus, though if it was not that would be because investment was higher.

But all thats impossible isnt it? In a democracy?

Not so. Norway set up a government fund to invest the proceeds of its own resources boom. Its government surplus this year? Nearly 10 per cent of GDP. Its external surplus? Well over 10 per cent.

In a democracy a little forethought goes a long way. It frames the debate. Weve begun the process of redefining budget balance with the Future Fund though its a tiny afterthought compared with Norways foresighted equivalent.

And who would have thought Australians would cop nine per cent of their pay being locked up until retirement? We did that like the Norwegians did with some political vision and some long term planning gradually changing expectations.

If inflation continues to alarm on the upside tomorrow, our politicians will still be focused on the next month. After the election lets hope they turn their minds to the next decade.

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Brendan Halfweeg
14 years ago

Nicholas,

What is the exact difference between government spending and private spending from consumer price index point of view? As far as I can tell more government money chasing a slowly expanding supply of goods and services will generatre similar price increases as more private money chasing a slowly expanding supply of goods and services? Or is there something special, magic even, about how when the government buys more concrete to build schools and hospitals it doesn’t increase the price of concrete than when BHP buys similar concrete to build more mines?

Price increases is not the same as inflation. Inflation is the devaluation of money, meaning you can’t exchange it for the same value over time. If everyone needs steel, some will value it more, so that in a recession 1000 tonnes of steel does not represent the same value as 1000 tonnes of steel during a building boom, since some will clearly need the steel more than others and be prepared to pay more. This is not inflation and price rises give people an indication on how much to value products and services.

Simply think about the effect of price controls on the supply of goods and services, trying to do the same by controlling the price of money (interest rates), even indirectly, is similarly misguided. Interest rates should be floated and there should be no central bank, as was the case at the time of federation.

Denying tax cuts to taxpayers makes no economic sense. Price rises due to increased current demand will give indication to consumers to delay their consumption through saving and attract new producers, lowering price and increasing wealth. The proportion of the tax cut they spend or save will depend largely on their time preference, but nevertheless they will be better off by being able to make that decision. Denying them the choice by refusing to consider tax cuts does not make them better off.

Doctor Patient
Doctor Patient
14 years ago

I think our politicians’ minds are concentrated on all those empty seats on outward bound Qantas jets. The world beckons: Paris, Rome, Vienna, New York, London and Rome. Phew! Such a lot to see and only 3 years to take it all in. As for the serious stuff at home……well, as usual they’ll just poke around the edges and hope for the best.

Bingo Bango Boingo
Bingo Bango Boingo
14 years ago

You spend a lot of time in airports, don’t you Doctor Patient?

BBB

James Farrell
14 years ago

Did you read what Nicholas wrote, Brendan. He wants to substitute private consumption with public saving, not public consumption. If you want to disagree with that, by all means make an argument, but don’t make things up. And where did he say anything that contradicts your breathtakingly insightful clarification of the definition of inflation?

observa
observa
14 years ago

Can’t disagree with your general analysis PROVIDING it’s not more funny money Treasury is holding. Gerry Jackson reckons it is here http://www.brookesnews.com/072210ms.html

While a famous central banker scratches his head
http://www.news.com.au/business/story/0,23636,22626286-31037,00.html
In particular-
Central banks around the world have essentially lost control over the markets beyond three or four or five years out, Greenspan said, noting that long-term interest rates did not rise as the federal funds rate was increased, starting in 2004.
I have a hunch a Rudd govt should start buying gold with the funny money, in anticipation of the world going back to a gold standard, after the manure from all this funny money finally hits the fan. Get in early with our funny money before the price rises and we have to pay for it with real wealth for toil eh?

observa
observa
14 years ago

Cant disagree with your general analysis Brendan…

Doctor Patient
Doctor Patient
14 years ago

No I don’t BBB. Thanks to Australian politicians on those dangerous but necessary fact-finding-missions the Qantas departure lounge has no spare seats. I gave up some time ago.

observa
observa
14 years ago

What should our public savers invest in James? The same inflated assets their private peers are investing in? What makes you think public servants can do it any better? Why not just give it back via a govt subsidy to the employer paid SGL, or are you hinting Labor should probably nationalise the super industry for a more appropraiate investment strategy and returns?

derrida derider
derrida derider
14 years ago

observa – no, no, no. Never mention the g*ld standard, funny m*ney, fractional res*rve banking or things of that ilk.

Already Bird will be bombarding the spam filter with furious comments, accusing us all in colourful and (to give him his due) original language of being Commie Islamofascist idiots.

observa
observa
14 years ago

“When an economy approaches full employment, additional spending simply feeds into inflation unless it expands production. With a central bank unwilling to tolerate inflation, tax cuts raise interest rates. Thats Economics 101.”

No, that’s the consumption drives production fallacy which Gerry Jackson points out. If the govt taxes real output and reallocates its distribution that’s not necessarily inflationary or deflationary, although it may have some impact on the factors of production. Of course it could borrow some of that real output domestically for govt consumption and investment, but that would reduce the output available for private consumption and investment and impact the real rate of interest. The question is, what happens when there’s too much credit chasing too few goods and the govt has a fair pile of that funny money sitting in its coffers at or near full employment. Gerry would argue that’s right about the time Keynesians stop believing that consumption drives production.

“If wed hung onto all that tax revenue from the mining boom, the surplus would be around 10 per cent of GDP though itd be somewhat less if wed indexed tax rates.
Investment and productivity would have been higher. Interest rates lower.”

Well that’s the fallacy of confusing real and nominal money, as a measure of consumption and investment. In a real world of an unchanging medium of exchange as distinct from a nominal, funny money, one that’s nonsense? Basically the govt taxes real output, uses it for democratically determined, govt C&I. To the extent that it does that, that’s less real C&I by the private sector. Short of piling up warehouses of cars, plasmas and widgets for our future, what further, useful purpose is there in taxation than govt C&I? FFs I hear you say, as if the current level and composition of private S&I were judged to be unwise(actually the Austrians reckon they know why Keynesians suspect that’s the case now and would agree on that point) compared to the more omniscient public one. In fact if this were so, the govt could simply tax more and more, or alternatively borrow more output from the private sector and invest it in their perceived higher return. The fact they’re comfortable to cut tax and hand the management of ‘surpluses’ back to the private sector now, suggests that’s unlikely to be the case, even with the funny money.

I haven’t considered the external sector at all to simplify matters, but the deal’s essentially the same with foreigners involved, unless there’s more funny money about.

observa
observa
14 years ago

I put it to you that this admission by a prominent central banker, totally vindicates the critique of targetting interest rates over money supply-
Central banks around the world have essentially lost control over the markets beyond three or four or five years out, Greenspan said, noting that long-term interest rates did not rise as the federal funds rate was increased, starting in 2004.
What the hell did Greenspan and Co expect to happen long term when they flooded the market with cheap credit? When you quickly run out of real investments in the here and now with cheap money, you go looking for borrowers/returns in the future, as well as any current malinvestments you can possibly get into. Real savers are much more circumspect than that and don’t need public servants to tell them how and where to invest their hard-earned for the future. It’s the money supply stoopids!

trackback
14 years ago

Turn the Tampa around and let’s sail to Norway……

Norway is an interesting country to compare to Australia. Its population is much closer to New Zealand’s than ours, but in comparison to the fairly sclerotic Kiwi economy (where real wages, growth and productivity have never really recovered sinc…

Brendan Halfweeg
14 years ago

So what exactly is saving? Does public saving involve putting physical currency in a vault and locking the door? Or does it involve buying financial instruments like bonds? If government money starts chasing a limited supply of bonds, what happens to their price? Public saving would displace private saving!

Please define what you mean by public saving. Programmes like the Future Fund simply replace private investment in financial instruments with public investment in the same. This investment eventually pays for current consumption as all saving is doing is lending your money to someone who needs it today to buy something in return for a larger return later. You delay your consumption and someone else funds current consumption, even if that consumption is of consumer goods or capital goods. Whether the source of saving is public or private it funds current consumption, and thus increases demand which leads to price rises in either capital goods or consumer goods.

Do you refute that by refusing to give tax payers a choice in how to allocate their resources provides them with a cost rather than a benefit? If your focus is on creating a strong state rather than a free and prosperous populace, then your public saving will do so, and displace the ability of individuals to fund their dreams and desires. Yeah for the state, boo for the little guy!

Nicholas, you have said that additional spending fuels inflation. How does spending devalue currency if the base value of the goods and services (how much people want them) changes because of increased scarcity? The value of the currency hasn’t changed, but the value of the goods and services have. Inflation is caused by central banks issuing currency (money supply) faster than the demand for currency is growing. If this is not what you mean by inflation, then we are talking at cross purposes and I think you are using an incorrect definition of inflation.

observa
observa
14 years ago

“what further, useful purpose is there in taxation” -discuss
I suppose I’m thinking of real savings on our behalf by our govt, as distinct from our own. The notion of govt skimming off cars, plasmas and widgets to store them in govt warehouses for our future is not as silly as it sounds.(it goes back to the lord of the manour days) Perhaps the Chinese govt’s actions are a case in point. They keep the yuan deliberately undervalued (ie not real)and grab the ensuing surplus (which would have been used for private C &I) and then lend it essentially to US citizens, who buy that surplus. Now the question remains as to whether that is sound investment of Chinese citizens’ sweat and toil, particularly if it comes back as defaulting sub-prime paper. Would Chinese citizens have been so casual with their real savings, if given the choice, one has to ask? They might have wanted the real value of their toil to consider more carefully their options and risk in the first place.

observa
observa
14 years ago

Notice also that by keeping the value of the yuan artificially low and further mandating Chinese cits can only invest their savings in The Chinese Peoples Great Leap Forward Future Fund there’s a double whammy. The masses ultimately get less sub-prime bang for their Yuan, while they worked like coolies to forgo even more consumption for it than necessary, via the restricted (read below real market rate) Peoples Fund access in the first place. Trust us we’re from the govt and we’re here to help. Somehow you get the feeling the ungrateful sods would be happier with warehouses full of washing machines and plasma screens now.

James Farrell
James Farrell
14 years ago

Brendan, I have the feeling from that last comment that you’ve never worked through a macroeconomics textbook. It’s not clear whether you’re genuinely seeking enlightenment or whether, along with one or two other eccentrics who hang around here, you think that mainstream economists are all trapped under a raft of conceptual and logical errors. In case it’s the former, here is the textbook story.

Public saving is tax revenue minus public consumption expenditure. The difference between public saving and public capital expenditure is the government’s financial surplus or deficit, which can be positive or negative. If positive, it can be used to repay public debt or buy other financial assets.

In a closed economy, or at least in one without international financial flows, a decrease in the Public Sector Borrowing Requirement, as it’s called, results (as you imply) in a fall in the interest rate, which stimulates private fixed capital expenditure. In an integrated global financial market, for practical purposes there is no fixed supply of bonds: we can buy them from anywhere in the world. When the government adds to the demand for foreign assets, the exchange rate is weaker and net exports accordingly higher than they would otherwise be.

Taxation reduces households’ disposable income, so their consumption and saving are both less than they would otherwise be. But the part that would have been saved is bound to be very fairly small, so national saving (public plus private) is higher than it would be if the government didn’t collect the tax from the households. (This has been the whole thrust of fiscal policy in Australia in the last fifteen years.)

A cut in taxes will increase household consumption, which, in a fully stretched economy dictates a fall in net exports or fixed capital expenditure or both. A higher interest rate will probably play a role, not really because the reduced public saving pushes down bond prices, but because the higher consumer spending temporarily adds to economic activity, creates inflationary pressure, and prompts the central bank to raise the interest rate.

I can’t make head nor tail of your last paragraph. Perhaps Nicholas can. The definition of inflation is very straightforward: a reduction in the purchasing power of a unit of currency over some specified, general basket of goods. No sensible discussion of these issues should ever get bogged down on the definition of inflation.

Brendan Halfweeg
14 years ago

James,

I agree completely with your statements on the definition of public saving, but your idea that it has no effect on consumer prices is false. If you change the terms of trade by lowering the value of the Australian dollar by purchasing overseas assets, then you are increasing the price of imports by extension. By increasing the price of imports and lowering the price of exports, you are hitting consumers a double whammy price increase, since foreign goods and services are more expensive due to a weaker dollar, and demand for Australian goods and services that can be exported will increase, increasing the price for local consumers as well. Sure, the increase in demand for Australian exports may not be as significant as the increase in price of imports, but I thought the purpose of public saving was to reduce pressure on consumer prices, not increase it!

Weakening the Australian dollar also makes opportunities for Australians to invest their wealth overseas more expensive, so their savings options are decreased. You are still crowding out private savings and influencing the time preference of individuals. Your assertion that only a small proportion of tax cuts will be saved is not backed up, but you may in fact make it less attractive for people to save some of the money you say they are allowed to keep and make decisions on for themselves!

But all of these shenanigans with exchange rates fails to address the issue of whether the tax surplus is rightfully the state’s to play with in the first place and whether or not taxpayer utility is actually increased or decreased by public saving. Making plasma TVs and Mitsubishi Evo VIIIs more expensive by weakening the dollar does not make Australians wealthier. I can tolerate the state raising revenue to pay for its agenda and programmes it has been elected on (although I may disagree with them), but unless it has gone to the electorate and said “we are going to tax you beyond our current spending and debt servicing requirements”, then there is no mandate and the money should be returned. Talking of excessive taxation as a windfall is deceptive and hides the fact that the government in confiscating more wealth that it can spend! Either we are not being bribed enough, or we are paying over the top for public goods! Either way we are getting ripped off!

Wikipedia defines inflation as follows:

Inflation is measured as the growth of the money supply in an economy, without a commensurate increase in the supply of goods and services. This results in a rise in the general price level as measured against a standard level of purchasing power.

Notice that loss of purchasing power through price increases is a symptom of inflation, not a cause of inflation. Price increases due to increased scarcity due to increased wealth is not a symptom of inflation. Inflation is when the RBA increases the money supply by X% and the growth in goods and services only grows by Y% and X is greater than Y.

I don’t doubt that increases in monetary supply in excess of economic growth together with increased wealth both feed price increases, but you have to separate the different causes of price rises. One is caused by more wealth chasing a slowly increasing pool of goods and services, the other is caused by more money supply doing the same. Inflation reduces the value of money, increased wealth increases the value of goods and services because more people can afford them and they can only increase in supply slowly.

Price rises due to increased wealth is a good thing, because increased prices will attract new suppliers and encourage investment in more productivity. Competition then tends to lower the cost to the consumer, making goods affordable to more, and increasing the purchasing power of individuals. Trying to say that price rises are bad due to increase disposable income is short term thinking and ignores the long term benefits of increasing wealth and growth.

Denying people choice decreases their wealth now, limits their choices and denies them the benefit of future growth.

conrad
conrad
14 years ago

“Now the question remains as to whether that is sound investment of Chinese citizens sweat and toil, particularly if it comes back as defaulting sub-prime paper”

Its probably not a bad political investment, although they seem to have gone into overkill with the extent of it. What can the US ever try to do to China when they can simply threaten to sell a few hundred billion dollars in a short period?

observa
observa
14 years ago

Well it’s like some arm wrestling contests conrad. You can get too excited with the goings on above the table to notice they’ve both got their other hand on each other’s ghoulies beneath it.

James Farrell
14 years ago

Brendan

It’s true that, assuming it happened, a depreciation would cause a one-off increase in the price of tradable goods. That’s how it’s supposed to work. For a given level of GDP, greater national saving means less ‘foreign saving’, i.e. greater net exports — and this may need to be facilitated by an adjustment of the real exchange rate. But in the context of a fiscal contraction, that would be the end of the story.

However, I’m not sure whether you are seriously arguing that a big tax cut or tax increase has no effect on aggregate demand and the general price level. If so, you are in heroic defiance of conventional views on how the macroeconomy works. The only theoretically respectable basis for such a claim is the ‘Ricardian Equivalence Hyopthesis’, but I doubt very much that that’s where you’re coming from.

The question of whether the government can spend our money better, in some sense, than we can, is a totally separate issue that I have no desire to debate at the moment.

As to your definition of inflation, the Wikipedia entry has been written by some self-styled ‘Austrian’ with an axe to grind. Everyone else defines inflation as a general rise in prices or a decline in the purchasing power of money. Of course you can define it how you like, but it’s pretty pointless disputing someone else’s arguments about inflation on the basis of your own idiosyncratic definition.

observa
observa
14 years ago

I see the ungrateful sods are beginning to cotton on
http://www.atimes.com/atimes/China_Business/IJ25Cb01.html

“As to your definition of inflation, the Wikipedia entry has been written by some self-styled Austrian with an axe to grind.”
Well that’s Gerry Jackson’s point really James. If you don’t agree with his broad critique that most of the govt surplus is really funny money, go right ahead and spend it, as distinct from perhaps taking our Chinese friend’s advice(see link) and buying gold with it. One can only wonder how the world would be different now if the Great Leapers had turned Chnese citizens’ real savings into gold over the years. I have a hunch the penny would have dropped a lot sooner than it’s about to.

Brendan Halfweeg
14 years ago

James,

Well at that juncture, we are at an impasse then, since I agree with the Austrians and to a lesser extent the Chicago School, and if you don’t want to discuss the utility of tax cuts from a taxpayers perspective, then we have nothing to discuss. I’m clearly not going to agree with your Keynsian analysis and you’re not going to agree with my libertarian analysis.

I have argued that public saving will ultimately affect the CPI and the cost of capital goods simply by lowering the exchange rate and increasing the demand for capital goods. Private savings will do the same. Your argument seems to be along the basis that a rise in price level caused by public saving which results in more expensive imports and more expensive domestic capital goods is OK, whereas an increase in price level caused by private consumption and saving doing similar things is bad. I disagree. The only difference is the mix of price increases, but at a macroeconomic level, price rises will be seen simply because more wealth is chasing goods and services, be they foreign or domestically produced.

I am not arguing that tax cuts won’t affect price, I most certainly agree that they will. But such price rises are good for the reasons I have previously outlined:

– efficient allocation of resources
– increased competition as new suppliers are attracted by high profit margins
– a shift in time preference to delay consumption

Now the shift in time preference depands on whether they believe that the dollar in their pocket will maintain value and that the price of the goods they want to buy will decrease in price as supply increases. We see this in people’s decision to delay buying the latest and greatest products like plasma TVs until their price drops.

However if people believe that the dollar in their pocket won’t maintain value and that the price of goods will continue to rise because of inflation, rationally they will spend their money as soon as they can. We see this in the photos of people from 1920s Germany wheelbarrowing mountains of money straight from getting paid to the market to buy food lest their money become worthless and more valuable as fuel for the fire than a unit of exchange and a store of value. Incidently, this may explain the German’s penchant for large denominations, like the old 1000 Deutschmark and the current 500 note, a throw back to when Germans could not trust the government’s printing presses.

People act reasonably rationally when faced with price rises depending on their expectation on whether the price rise is structural caused by a true devaluation of their money or temporary, caused by a lack of supply of goods and services. People might have whinged about the lack of bananas and subsequent price rise after the storm damage to Queensland plantations, but they certainly didn’t think the dollar in their pocket had devalued because one particular food product got more expensive, they simply shifted their consumption preferences until supply was re-established and prices dropped. A similar thing happens when prices rise because of the short term price inelasticity of supply, consumers realise that longer term, supply is more elastic in response to price rises, whether they consciously think this or not.

James Farrell
James Farrell
14 years ago

Brandan, I have no idea what you understand by the term ‘Keynesian’ but the mechanisms I’m describing are derived fom elementary macro principles. I don’t think that anyone with a basic knowledge of the topic would disagree, whether they are libertarians or social democrats. Nor have said anything about what’s ‘OK’ – I’m just discussing basic causal mechanisms.

As for your argument about capital goods and so on, I don’t really follow it. If you could supply me a reference to some text where you think a coherent argument is made, that tax cuts are not inflationary in an already over-heated economy, I’d gratefully look at it.

Brendan Halfweeg
14 years ago

James,

A failure to agree on what inflation actually is will mean that we are never going to agree. I believe your view of inflation is Keynesian because of your belief that tax cuts create inflation by demand-pull price rises, increased aggregate demand, in this case private demand for goods and services, and that such price rises permanently devalue the currency. My view is that such price rises are temporary in nature, and thus are do not devalue the currency in the long term.

You have agreed with me that weakening the exchange rate through the public purchase of foreign bonds will cause price rises due to increased import costs, however you seem to be also saying the price rises of imports aren’t inflationary. I’d argue that using a Keynesian definition, this would be cost push inflation. If the cost of some goods increase and the general price level increases, how is public saving not inflationary (using your defintion)?

My argument on capital goods increasing in price goes as follows:

– if the state buys bonds from domestic sources, this money will be used to buy capital goods by the bond issuer, ie. invest in factories, mines etc.
– the goods and services they use to build will suffer price rises due to demand-pull “inflation”
– the price of investing in capital goods will increase, which using your defintion of inflation will be inflationary

– if the state buys bonds from foreign sources, the exchange rate will drop and all imports, including capital goods like steel & Boeing 747s, will increase in price
– capital goods’ price increase

Whether money is spent by the government or by individuals, these effects will be apparent, but in my case I don’t see them to be fundamentally inflationary, even though price rises will be apparent in the short term. All I am saying is that public saving will fund someone’s current expenditure and that this will lead to price rises. Private spending and saving will do the same. To argue that just because it is the state doing the saving, prices won’t rise, is wrong. Therefore tax cuts are price rise neutral overall compared to public saving except that the price rises will affect different sectors of the economy depending on who is spending/saving the money, the state or the individual.

Since my preference is for individual sovereignty, if there are going to be price rises (short term in my opinion) due to increased wealth being spent or saved, then I’d rather the individual allocate their own increased resources, since then they would get the utility of their increased wealth.

If you need a paper on inflation, let me suggest Rothbard:

http://www.mises.org/money.asp

James Farrell
14 years ago

OK, Brendan, let’s take it step by step, and we’ll see if I can figure out where your’re coming from. Let’s eschew the term inflation altogether, and to avoid any confusion let’s agree to use the term investment in the technical sense of fixed capital expenditure.

Suppose the economy is at full employment, and the government budget happens to be in suplus. The government cuts taxes. This increases household disposable income and (unless you believe in the Ricardian Equivalence doctrine) is bound to lead to some increase in household consumption. This means there will be an increase in aggregate demand, unless there occurs a simultaneous dollar-for-dollar decrease in investment or net exports.

Before we go any further, do you have any objections so far?

observa
observa
14 years ago

I see Pete’s dropped the ‘tsunami’ word about all that central banking funny money
http://www.news.com.au/business/story/0,23636,22651654-31037,00.html

Brendan Halfweeg
14 years ago

James,

We are already beyond this point, you seem to be trying teach me how to suck eggs and are not addressing any of my points whatsoever regarding one person’s (or state’s) current saving is another person’s current spending. I already agree that increased disposable income will lead to increased aggregate demand which will put pressure on prices, I believe only in the short term, although the elasticity of price for some goods and services may not be as strong due to already existing significant competition.

If you add fractional reserve banking into the mix, saving actually will increase the credit supply, and thus increase aggregate demand further, putting even more pressure on prices.

Ricardian Equivalence has nothing to do with it.

What is your next point?

James Farrell
James Farrell
14 years ago

Brendan, I can only address your points when I understand the chain of reasoning. Please bear with me.

But it’s good that you agree with my reasoning so far — aggregate demand has increased and the general price level is up. The difference is that you think it’s temporary. So, what I’d like you to explain is the mechanism that’s going to make the general price level fall back to where it was before. (We assume the tax cut isn’t reversed, of course).

I don’t understand your last bit a bit about saving increasing the credit supply. (Which saving and why?) But, with your permission, I’d like to postpone those questions and just concentrate on your main argument. What’s going to make the price level fall again? I can see why it might eventually stop rising, assuming the price level rise serves to alleviate the demand-supply imbalance. But you’re saying, if I understand you correctly, that it will fall back to where it was before the tax cut. So why?

observa
observa
14 years ago
Brendan Halfweeg
14 years ago

James,

Sorry for the delay in responding, have been travelling around Europe, purposefully out of net reach. Not sure whether you are still interested in discussing this, but here goes.

On your first point, when new comsumer demand is injected into the marketplace by larger disposable income from a tax cut, supply will still be operating at the previous equilibrium point, selling at a profitable (long term) price (the market clearing price). The increase in demand will enable suppliers to increase price, increasing their (short term) profits, because more people want their product and supply is limited. This does two things, ensures those that most want the goods and services (values them) get them from scarce supplies, and two attracts new competitors to a profitable market, or inspires existing competitors to compete on price. In other words, the price elasticity of goods and services is limited by the ability of consumers to shop around and new supplies entering the market with cheaper production costs. Whether the increase in demand is stimulated by the tax cut or some other mechanism, these market processes will all work to put downward pressure on the general price level.

Where the market mechanism fails is if at the same time competitive and supply forces are putting downward pressure on prices, the value of the currency itself devalues from excessive supply (the central bank printing more money than there is demand), then prices will still look like they are increasing, especially since medium term contracts like labour contracts will only slowly react to the devalued currency. This devaluation of the currency is far more destructive than price rises due to changes in the supply/demand equilibrium. Even if there is no price rise due to changes in the supply/demand equillibrium, currency devaluation will lead to price rises as more currency chases the same number of goods and services.

When we have more wealth, we consume more, but not only that, as everyone gets more wealthy, things get cheaper for everyone. You can see this in the sheer amount of stuff that people own and the cheapness of goods that 30 years ago would be considered luxuries, like audiovisual and other consumer electronics. The prices of these goods has gone up, but their value has gone down (since more people can afford them). Clive Hamilton and his cronies think this consumerism is a bad thing and it has spawned idiotic nonsense like Namoi Klein’s No Logo and anti-consumer, anti-globalisation (read anti-developing nation) groups that regularly look down their collective noses at Aussies using their tax refund cheques to buy big screen TVs made in Korea.

The problem for me in demonstrating my point is that it is very difficult to separate the price rises caused by equillibrium changes which are happening all the time (in fact a stable demand/supply equillibrium is never reached) and those caused by currency devaluation through excess supply. Currency is a good like any other, and if the monopolistic suppler (the central bank) produces more than is demanded, then its value or utility will decrease, and you will need to trade more currency for goods and services whose inherent value hasn’t changed or have changed for real reasons like scarcity.

If you don’t believe that competitive pressures put downward pressure on prices (value), then I would like you explain why people can afford more of everything, to the point that today, do gooders today are worried about the poor having too much consumption leading to problems like obesity and cheap holidays causing climate change, rather than concerned about the poor not getting enough to eat or getting enough leisure time. If getting wealthier causes inflation, maybe we should outlaw growth?

On your second point, saving increases the credit supply because of a little thing called fractional reserve banking. Fractional reserve banking essentially means that banks can lend more than they hold in deposits. Wikipedia has a good page on it here. Thus, putting money in the bank leads to an increase in the credit supply, and thus an increase in current spending.

In addition, saving or investment represents future consumption for yourself and current consumption for the end user of your savings or investment. No one makes money from storing currency in a vault, they lend it to others to create value, be it a mortgage to build a house, or as equity in a company to build new factories. Saving or investing leads to increased current conmsumption. Thus, hiding consumption by taxpayers through public saving does not ultimately decrease consumption, since the saving will ultimately be used by someone else to buy something today.

James Farrell
14 years ago

Travelling in Europe sounds like much more fun than debating economics with me, Brendan. Where did you go? The Netherlands, by any chance?

Thanks for taking the time to write at such length, but I’m determined to take your argument one step at a time, and just concentrate on your first paragraph at this stage. What I’m not clear on is whether the process you describe involves a net increase in output and employment, or whether there it’s just a reallocation of resources — more domestic consumer goods being produced and less exports or capital goods.

When I’m clear on this we can get back to prices.

Brendan Halfweeg
14 years ago

James,

Increased consumer demand and the subsequent competitive pressures will do two things:

1. Existing suppliers to increase supply without changing their productivity
2. Existing and/or new suppliers increasing supply by improving productivity

Obviously the first leads to passing on price rises down the supply chain as suppliers scramble for scarce goods and services, but two puts downward pressure as suppliers learn to be more efficient in order to make more profit from the high prices. If a supplier can increases his productivity (cut his costs) by 10% and charge 5% less than his competitors to attract customers, his rate of return on his capital increases AND consumers benefit from lower prices. Competitors must either match price decreases or add value, either way consumers win.

So competitive pressure will increase output both from applying more resources (including labour) AND increasing productivity (increasing capital).

Application of more resources will be subject to scarcity as suppliers have to compete with others who have alternate uses for them, but talk of less exports is irrelevent. I really don’t see the point of distinguishing between a customer (or supplier) based on their geographic location. If customers in the domestic market increase demand that incresaes scarcity, resultant price rises will affect foreign markets as well. If the pie increases, how it is divided up between foreign and domestic customers is irrelevent, since those that value the pie most, will pay more for a piece of it.

Brendan Halfweeg
14 years ago

James,

By the way, I did travel to the Netherlands, Amsterdam to be precise, as well as Paris and Brussels, not to mention a bit of Yorkshire and Lancashire. I live in London and I was showing my mother around on her first trip to Europe. Why did you guess the Netherlands? My surname?

Brendan

James Farrell
James Farrell
14 years ago

Yes, your surname. Sounds like a very pleasant trip. I didn’t realise you were in the UK.

If firms can increase their output, on a sustainable basis, without an increase in productivity, then you obviously don’t think we are at full employment. That’s just an emprirical question, and we needn’t disagree on theory at all.

If I’m right, then, in the face of an increase in demand, they will compete for the already fully-employed labour, and wages and prices will keep rising until the excess demand is diffused in various ways — mostly through a reduction in net exports (via real appreciation).

If you’re right, there is enough unemployed or underemployed labour to permit a sustainable increase in production. Prices will rise initially for the reasons you gave, but, provided wages don’t rise proportionately, this rise will be a one-off and won’t develop into continuing inflation. (In the text-book story, real wages will have fallen a little, but that’s precisely what makes it feasible for firms to profitably employ the people who were previously unemployed.)

Now, if the latter story was right, no one would be worried about the tax cuts. Some of us might prefer increased infrastructure instead; others might still prefer a big surplus on the grounds that a recession might be around the corner, or because they are concerned about the current account. But no-one would oppose it on the basis of its inflationary impact. Moreover, the people who approved of the tax cuts would approve of them even if they didn’t believe the second part of your story — about prices coming down again later. And since it’s so rare to see falling prices in an industrial economy, except in the midst of a deep recsession, they probably wouldn’t believe it.

So, to repeat: if you don’t think we’re at full employment, then it’s only an empirical disagreement we’re having.

In this case also, the productivity increase isn’t necessary to or argument. On the other hand, if you do agree with me and the rest of the mainstream that we’re at full employment, then you do need productivity argument: firms would only be able to respond to an increase in demand by increasing their productivity.

But how is this increase supposed to occur? It can only happen through technological innovation or increasing returns to scale. The latter is ruled out if we are already at full employment, and in any case wouldn’t be consistent with your suggestion that the new production come from additional firms entering the market.

So that leaves technological innovation. Is that, in effect, what your argument bolis down to? That a big impulse to demand leads to a kind of shake-up in which fierce competition drives firms to look harder for ways to cut costs? It’s a Schumpeterian kind of argument that doesn’t really lend itself to formal modeling, quantification and prediaction. In short, it’s very hard to refute. All one can say is: yes, that could happen, but who knows when and to what degree?

I promise to get back to your ideas about banking and the money supply and so in due course — if you like — but let’s clear up these points first.

Brendan Halfweeg
14 years ago

James,

I really do understand where you are coming from. If labour is scarce, there will be upward pressure on wages. But that simply isn’t inflation, and we are back to square one, a disagreement about the definition of inflation.

I completely agree with you that if an economy is running at full capacity, then the only way for it to grow is through productivity increases, or in other words the application of capital. Capital doesn’t just involve bricks, mortar and computers on desks, it involves intellectual capital as well, which is why Google shares are making millionaires out of masseuses. Trying to empirically represent entrepreneurialism and innovation is impossible, however it cannot be discounted, economics is not just about what you can model, but what motivates individuals in the decisions that they make.

My argument is more general than the specific case of an economy running tight as a drum. However, I’d suggest that an economy running at full capacity with plenty of market pressure from changing demand and supply is exactly the environment that promotes entrepreneurialism and innovation leading to productivity gains, as the incentives for building a better mousetrap are there for all to see and capital is being accumulated as it is diverted away from current consumption (since price rises will provide incentives to save).

Even if you restrict the discussion to supply increases without productivity gains, price rises due to a reallocation of existing resources to those that most value them is entirely appropriate and efficient, as it gives consumers and suppliers information to change their behaviour. Trying to avoid upsetting the applecart by preventing dynamic changes within the market only creates new problems and delays any correction.

You wanting to spend other people’s money on capital goods, others want to spend other people’s money on healthcare or education, is all good and well, but it is immoral in my book, moreso when that money is coming from the government over-taxing people beyond the financing requirements of the programmes that they were elected on. A government may have a mandate to fund the programmes they promised during an election, but unless they also state that they are going to tax us in excess of the cost of those programmes and invest it on our behalf, then any budget surplus really is theft and their is no moral basis or veneer of democratic legitimacy in taxing people beyond what you’ve said you will. If the government has a mandate to provide public services, then a budget surplus is like getting shortchanged at the supermarket and I have no truck with any argument that purports otherwise, disagreements on the definition of inflation and how supply can be increased without price rises aside.

I’m not sorry if this sounds like a rant, but it doesn’t really matter if we disagree on the economic impacts of tax cuts, since we are obviously coming from different philosophical positions. I favour individual liberty and the individual freedom to use and manage property (an believe that this results in the best outcomes for individuals), your position seems to be that the government is better placed to allocate an individual’s resources for them, perhaps through fear of the consequences of their personal decisions, I don’t really know.

I would however like to continue discussing the other points we’ve touched on, banking, money supply for instance.

James Farrell
James Farrell
14 years ago

Whoops! Due to the long interlude I forgot my undertaking not to mention the word inflation.

Tell me whether you agree with this: When the economy is ‘tight as a drum’, a reduction in income tax will cause an increase in consumption spending that will cause nominal wages, and in turn the general price level, to keep rising until the excess demand is dissipated.

Note that I’m assuming that:

(1) The central bank doesn’t raise the interest rates, so the ‘dissipation’ occurs, as I said in tbe previous comment, mostly via switching of demand from domestic goods to imports and a reduction in exports. (In the standard macro notation, the rise in C has caused a compensating fall in (X-M), with I, G and Y more or less constant.)

(2) There are no above-trend productivity increases.

If you say yes to this, then I have some comments on your thoughts about productivity.

Brendan Halfweeg
14 years ago

James,

I agree with you thatn price rises until demand disipates with the following caveats:

1. there must be no productivity gains
2. there must be no demand diversion through indirect or direct substitution
3. exchange rates must stay unchanged (making imports cheaper)
4. new (foreign) suppliers in markets with excess capacity must not be attracted to the market

The reason I don’t think this matters very much is because it is purely a demonstration on the efficiency of markets in allocating resources to those that value them most. If the underlying value changes, price rises do not represent inflation, but rather a reflection of the new equilibrium, or market clearing price.

For example, in a barter economy, say you are able to exchange two days labour to have your car repaired, but there is only one mechanic in your area. Then another neighbour signs up with the same skills to trade as you. Instead of trading two days labobour, your neighbour is willing to trade 3 days to get his car fixed. Since the mechanic has only limited use for day labourers, you are forced to match (or better) your neighbour’s offer if you want your car fixed. Is this inflation? Or more simply is it a change in the value of the labour to the mechanic?

If instead of bartering directly, an organisation like bartercard step in and you start trading barter credits instead of actual goods and services. So a days labour is worth so many credits, a mechanics time is worth so many, and so on. You happily work away building up credits in anticipation of using them. Then the barter company decides to start issuing more credits for the same goods or services. Initially you think great, I’ve got 3 credits for a days labour when last year I was receiving 2, now I can afford to keep my car on the road by working less. But the mechanic still wants 3 days labour in return for fixing your car, and will only trade 3 days labour worth of credits to do so. So you find yourself in the position that your previous labour and the credits you earnt are actually worth less than present credits, because the barter organisation has inflated the credits by issuing more than are demanded. Worried that they will do this again in the future, you opt to spend your credits as soon as you recieve them, thus putting even more pressure on the trade of credits, but only because you don’t trust barter people to value their credits with any kind of stability. Soon you find yourself needing to trade 4 days labour, because the barter credits are depreciating in value faster than you can earn them or renegoiate your contract. This is inflation, driven by the central organisation changing the underlying value of the currency and the change in time preference is a symptom of inflation, aggravating the pressure on prices.

Price changes because of changes in the value of goods and services are simply price increases. A bottle of water in the desert is worth more than a bottle of water in an oasis, and the price difference reflects this. If an oasis turns into a desert, the rise in price of water is not therefore inflation, but a reflection of the change in its value.

James Farrell
James Farrell
14 years ago

Re. your conditions:

1. there must be no productivity gains

Well, that was my condition, but what I meant was, nothing that wouldn’t have happened anyway. In other words, I am ruling out, for the purpose of making my point, the sort of productivity surge that were suggesting would occur as a consequence of the additional consumption spending.

2. there must be no demand diversion through indirect or direct substitution

I don’t understand this one.

3. exchange rates must stay unchanged (making imports cheaper)

Exactly.

4. new (foreign) suppliers in markets with excess capacity must not be attracted to the market

If this just means an increase in imports, then I’m confused, because that’s what I’m saying is the main release-valve by which excess demand will be disipated (note my amended spelling!), and I thought you were agreeing about that with this in (2).

Brendan Halfweeg
14 years ago

James,

1. I never mentioned a surge, nor intended my argument to hinge on magical innovation leading to supply increases, only that modest productivity gains would put downward pressure on prices. Real breakthroughs in productivity do occur though, and dynamic economies are the cost innovative. I’d be interested to know why you don’t think people and firms (particular Australian ones) are not capable of productivity gains in a growing market, and why particularly in a growing market that has been facilitated through tax cuts?

2. Subsititution, the process of using alternatives that are either direct replacements, or indirect replacements. Say road transport demand goes up, but rail transport has spare capacity, you switch to rail, lessening the demand surge on road. Clay tiles are in demand, you switch to aluminium roofing. Demand can be satisfied many ways, and where resources are scarce, this is what people do.

3. At last we agree.

4. If new supply can be obtained elsewhere (overseas for instance), is the economy really “drum tight”, since foreign suppliers are simply suppliers as far as the consumer is concerned, and a domestic supplier will have to price compete with a foreign one if they want to stay in business? Prices will only rise if alternative suppliers, including foreign ones, are not available (or willing) to fill demand. If a supplier with access to a market in which prices are rising and has spare capacity, then they would be motivated to start supplying to that market. By increasing supply, downward pressure would be put on prices.

James Farrell
James Farrell
14 years ago

1. Of course productivity gains happen all the time and reduce some prices, and this is a point I’ll get back to. But I had the impression earlier you were claiming that a demand shock in a drum-tight economy induces some of extra productivity surge that serves to resolve the disequilibrium. If that’s not the case, or at least your argument doesn’t depend it, that’s great — we can move on.

2. Right: I wasn’t referring to a situation where there are just a few specific bottlenecks.

3. By definition, if there was a perfect import substitute for eveything, then prices wouldn’t need to rise to resolve the disequilibrium. But there isn’t, and they do, so, again, I think we can move on.

Basically, we seem to be in agreement so far. The next question is — what happens next? There has been a rise in the general price level — can we call this an RGPL for short?. Consumption has increased and net exports have deteriorated – perhaps to the tune of three or for percent of GDP (assuming no monetary contraction and no effect on business investment.) We assume that the exchange rate hasn’t deteriorated, so evidently foreigners are happy to finance our higher level of consumption for the time being.

Suppose for argument’s sake that the central bank is not concerned about the current account for its own sake, and doesn’t particularly fear a depreciation either. What they will worry about is that the RGPL will prove not to be a one-off after all. Central bankers subscribe to the view that inflation becomes self-fueling and even prone to accelerate once it’s built into people’s expectations. That’s why they are always eager to keep the genie in the bottle, and not prevent these one-off bursts from happening in the first place.

Do you think this is a legitimate concern? Will the RGPL be a one-off (under our assumptions), or could it develop into a self-fueling and ongoing RGPL?

Brendan Halfweeg
Brendan Halfweeg
14 years ago

James,

This analysis seems way too static for my liking, however, let’s follow through your argument. If the central bank is worried about a RGPL caused by increased demand (for whatever reason)1, and they want to curb that demand to reduce pressure on the GPL, they have two instruments, interest rates and money supply. A rate rise and a contractionary monetary policy would do three things:

1. raise the price of credit
2. increase the value of the currency
3. reduce the available money

which would serve to put downward pressure on the GPL by reducing demand.

It doesn’t really matter whether they think the RGPL is permanent (under the assumptions previously stated) or temporary if they are concerned that a RGPL will be harmful in the short term to certain sectors of the economy. But both of these assume that the central bankers know what is best for everyone.

Even if you advocate central bank manipulation of demand using these controls, it does not contribute to your argument regarding witholding tax cuts, unless you believe that intervention by the central bank (money supply, interest rates)is worse than intervention by the government (taxation) to control demand. I still argue that even with central bank intervention (which I disagree with), individuals would still be better off controlling more of their income than less, and making their consumption/savings choices for themselves. Individual utility and liberty would be increased, even marginally, by tax cuts, whereas, no tax cuts increases the state’s control over individuals.

____
1. As you may have guessed, I don’t really believe that a central bank should be worried about increased demand causing price rises. I agree with a non-interventionist central bank strategy, since trying to second guess individual actors in the economy and the sum of their actions is impossible, not to mention an unnecessary interference in the market process. My contention is that a bank issuing money should only worry about the money supply, interest rates should be set by the market. A monetary policy that increases the money supply in line with economic growth forecasts would be preferable to second guessing and trying to control demand. Better yet, free banking!

James Farrell
James Farrell
14 years ago

I started off trying to make sense of your denial at #26

…that tax cuts create inflation by demand-pull price rises, increased aggregate demand, in this case private demand for goods and services, and that such price rises permanently devalue the currency. My view is that such price rises are temporary in nature, and thus are do not devalue the currency in the long term.

Now, however, you seem to be agreeing that there will be a permanent RGPL (that is, a one-off rise that isn’t reversed, and which may or may not become self-fueling and ongoing) unless the central bank applies a contractionary monetary policy.

But that’s exactly what I and everyone else are saying. We can, and will need to, stop the RGPL in its tracks by means of a monetary contraction. (With a sufficiently severe tightening, we could even engineer a fall in the GPL, taking us back to the pre-tax rise level, if we saw some point in doing that. Churchill tried it in the 1920s and it was messy business).

So the the real disagreement, at the end of the day, is that you favour tax-cuts despite the fact they will necessitate a monetary contraction.

There are at least three reasons why mainstream economists don’t think this a good idea. The first is that they see the current surplus as mostly cyclical rather than structural. That is, we have a big surplus because we’re in a boom. And if the aim is to keep the budget roughly balanced ‘over the cycle’ then we need surpluses so that we can tolerate a big deficits when the next slump arrives. (Of course, since business cycles are more like random fluctations than cycles, it’s hard to know where we are in the ‘cycle’, but it pays to be cautious because an expensive public debt can become a drag on growth.)

The second reason is that interest rates are a very blunt instrument. A monetary contraction can precipitate a recession even if this is not the aim.

Finally, even if it was a precise instrument, a monetary contraction would reduce investment in plant and equipment. We would be substituting consumption for investment.

Presumably you reject some or all of these arguments. If that’s right, then perhaps we have gotten to the heart of the disagreement, and it’s not about RGPLs and their causes at all. (I’m sorry if this is all too static for your taste, by the way. I wish I could be more groovy and dynamic, but I trust you’ll make allowances.)

Footnote: You mentioned ‘reducing the available money’. Presumably you realise that in a modern credit economies the authorities can’t control the money supply very exactly. They can control the money base, but the relationship between the base and the money supply is very loose — there is no stable multiplier like the ones in the text books. So a concerted attempt to reduce the money supply could be very dangerous.

Brendan Halfweeg
14 years ago

James,

Don’t put words in my mouth, my agreement that there would be a RGPL was only made on the basis on a set of conditions outlined in #39, not back in #26. I still disagree that it will be a permanent RGPL, because suppliers and consumers will change their behaviour. Irrelevant though, I’ve already stated I’m against intervention by the central bank or the government to control demand. I advocate a non-interventionist policy, with a belief that market forces will adjust the decision making process of individuals, under the belief that

a) central banks are notoriously bad at applying interest rate changes and contractionary monetary policy to control demand
b) taxation is a necessary evil, however taxation beyond current spending levels and debt servicing is immoral
c) markets operating through individuals will adjust to the paradigm shift in prices better than central organisations like the state and the central bank can

I completely agree with your last paragraph, but I am trying to get you to understand that (income) taxation to control demand is a similar blunt instrument. Raising the GST while handing back income tax cuts would be better and less distortionary. If the consensus is that demand absolutely must be curbed, the GST is the best tool, letting individuals still allocate their wealth as they see fit, while influencing their time preference. I still disagree that the state should intervene to control demand, but there are freedom enhancing policies that are less worst than others.

What exactly are your fears in rising prices anyway? How will price rises cause a recession?

I am interested to know whether you have any concerns about the growth in the money supply that is undercutting the value of the dollar?

Which is worse, price rises through supply constrict or price rises through devaluing currency (expansionist monetary policy)?

James Farrell
James Farrell
14 years ago

So this is the position: You’ve agreed that the tax cuts will cause an RGPL. But you still think that this well be reversed in subsequent months or years, so that the GPL is back where it was at the beginning. This happens without any unusual surge in productivity and without a monetary contraction. And it happens because firms and households change their bahaviour.

Could you confirm that this is what you’re saying, and tell me what changes in behaviour are going to cause a FGPL that reverses the RGPL.

Two points of clarification, First, I don’t advocate taxation as a device to control inflation. The role of taxation is to pay for government spending, but not necessarily contemporaneously. Attempting to maintain a balanced budget amplifies macroeconomic fluctuations, a point that you haven’t disputed. On the other hand, there is no reason to run a structural surplus unless the government has very large unfunded liabilities. But as long as the economy is drum-tight I would reduce any unnecessary surplus very gradually .

Second, I don’t think RGPLs cause recessions. It’s the monetary contractions directed at reigning in the RGPLs that cause recessions.

Brendan Halfweeg
14 years ago

James,

What do tax cuts do? They increase the disposable income of individuals. Since supply cannot respond immediately to this change, prices rise. So far we agree. The rational individual will then balance their desire to spend their new found wealth immediately against saving for the future, both on the idea that goods and services will become more affordable in the future and to increase their capital and future income. So price rises due to tax cuts will occur, but the effect of them will be to change the time preference of individuals, saving more of their new found wealth. Of course, not everyone will save all of their income, and that will put additional strains on the economy, but so what? If they want to pay high prices, then let them.

Price rises that represent a change in how much an individual values the goods and services is OK.

Price rises that represent a change in the value of the unit of exchange because of an over-expansionist money supply policy is bad.

Why does the central bank have to control the value of goods and services? Isn’t it up to individuals to decide how much they value these things, and then reflect this in the amount they are prepared to pay?

Central banks should solely be interested in keeping control of the money supply, a difficult task for any centrally planned activity, which is why I am opposed to central banking in general and advocate free banking.

I know that contractionary monetary policy is bad because central banks are notoriously bad at the timing of their interventions and choosing the size of the interventions.

So, we have gone from you saying no to tax cuts, to saying yes to them, but stringing them out over time.

You have yet to address my points regarding devaluation of the currency through am over-expansionist monetary policy. Do you not see a danger in this, or are you one of these people that see a little inflation as a good thing?

James Farrell
14 years ago

So households expect prices to fall in the future, therefore they save more. In other words, the real interest rate rises and households opt to trade current for future consumption on this basis.

This seems to be a brand new line of reasoning, but that’s OK.

You still haven’t really said what will cause this reversal of the RGPL. The change in bevahiour referred to above is presented as a consequence of the expected FGPL rather than the cause. I can see that a rise in the saving rate in certain conditions might mitigate the RGPL, but not how it would reverse one that has already taken place.

But there are in any case, two fatal flaws in this reasoning. While a change in the GPL has the ability to influence the real income of a particular household or group of housholds, it can’t change change everyone’s income in the same direction. In other words, pricle level shifts can and usually do alter the distribution of income, but not aggregate real income. Second, supposing that the saving ratio does increase — for whatever reason — in response to the initial RGPL, if this saving finances (as you predict it will) an increase in domestic investment, the increase in aggregate demand is the same as if the tax cuts had been spent on consumer goods.

On the question of monetary policy, when you say

Price rises that represent a change in the value of the unit of exchange because of an over-expansionist money supply policy is bad.

does this refer to three conceptually separate things: (1) RGPLs, (2) changes in the unit of exchange, and (3)excessive increases in the supply?

Finally, in response to this:

…we have gone from you saying no to tax cuts, to saying yes to them, but stringing them out over time.

My answer is a qualified yes. If I was convinced that the surplus was structural, I would cut tax rates, but do it in a period of weak growth and rising unemployment.

Brendan Halfweeg
14 years ago

James,

This isn’t an absolutist solution, some households will save most of the tax cuts, others will spend most, there will be an increase in aggregate demand (and hence prices), but not the entire amount of the tax cut. Do you agree?

Have you ever delayed buying the latest and greatest until its price goes down?

The cause of the reversal in RGPL will be an increase in supply in the medium to long term. This decrease in price will be hidden by the devaluation in the currency caused by the central bank issuing too much currency (an over-expanionistic monetary policy), so that although prices rise, their affordability increases, at a faster rate than real income is rising or that the currency is being devalued.

I don’t understand why you doubt that goods and services get cheaper as demand increases in the medium to long term, so long as supply is allowed to expand naturally (I’m thinking housing here). Just look around the average household and compare the sheer amount of stuff that people have got compared to what a similar real income household 20, 30, 50 years ago would have had.

The over expansionist monetary policy I am referring to relates entirely to the central bank issuing new currency at a faster rate than demand for currency is increasing. The central bank is buying too many bonds in open market operations too quickly and is flooding the economy with easy money, often combined with low interest rates, which devalues the currency. I believe this is far worse than price rises due to real growth, which is what tax cuts represent.

I know that my non-interventionist approach is at odds with the current consensus amongst many economists and central bankers, but there is much in the Chicago and Austrian schools that is worth thinking about, which is the angle I am coming from.

I agree that taxation to indirectly control demand will put downward pressure on prices, but I disagree from a philosophical point of view that doing so is moral and from an economic point of view that it is necessary. Trying to cotton wool the economy from price changes is really just delaying the inevitable, and will have unintended consequences. Will the government be able to manage public savings better than individuals? What are the consequences of bad government investments? Or will the government only invest public savings into AAA paper with no risk and only rewards?

Perhaps your thoughts about injecting tax cuts into a recession hit economy is a new form of trickle down Reaganomics? Instead of funding tax cuts through debt, you fund it through past taxation? We tax you now so we don’t have to tax you later?

James Farrell
14 years ago

Do I agree that some of the tax cut will be saved? Yes, but this was never at issue.

Have I delayed buying something until the price goes down? Yes, but I don’t defer consumption in general in response to a rising GPL now on the expectation that the GPL will be steadily falling in the coming years. In any case, as I pointed out in the previous comment, the argument doesn’t work in the aggregate: aggregate real income can’t be altered by a change in the GPL – this is a logical impossibility.

However, this whole question of how households respond to changing prices is neither here nor there, since I was asking you what causes the reversal of the RGPL that you are predicting. As far as that question is concerned, you are now saying that it’s ‘an increase in the supply of goods in the medium to long run’.

So you’re saying that normal economic growth itself tends to push prices down, or would do so if the central bank didn’t create ‘too much currency’. I’m not sure what you mean by currency: I suppose you mean either money or high-powered money, but let’s put that question to one side. The main point is this: we both know that, under the present system or anything remotely resembling the present system, the central bank is not going to engineer an FGPL just in order to reverse an RGPL and restore the GPL to what it was at some arbitrary starting point. Current central banking thinking abhors an FGPL (what they call ‘deflation’, but of course you and I don’t use that word). So, what you really mean is that the price level will fall back to its original level if the central bank behaves as if it were trying to defend a gold standard or something like that.

This brings us right back to the point I was making at #44. What we really disagree about, it seems to me, is how monetary policy should be conducted in the modern world. You would like to fix the ‘value of money’ — in terms of its purchasing over what I’m not sure, but I suspect you have gold or some other ‘commodity’ in mind — and defend this tooth and claw irrespective of the economic dislocation it causes (you may recall my refernce to Churchill). Mainstream thinking, for want of a better word, is that this approach as inflexible, dangerous and unnecessary.

Of course there is a respectable minority view in favour of fixed exchange rates, gold standards and such like. But those who subscibe to this view wouldn’t normally be advocating huge tax cuts — they wouldn’t want to make the central bank’s already difficult life harder still by increasing the pressure on domestic prices.

If you are really keen on the tax cuts you could make your own life easier by adopting an intermediate position, whereby you accept the RGPL as permanent (hoping that it doesn’t become self-fueling via its affect on expectations), call for a modest monetary tightening to ensure that the exchange rate holds up, and greet the resulting current-account blow-out as an acceptable portfoloio arrangement that will sort itself out in due course. But somehow I don’t think you’re about to change your position on my account.

By the way, you didn’t answer my question whether changes in the GPL, changes in the ‘unit of exchange’ and changes in the money supply are three different things.