Tag: inflationreductionact

Originally published on LinkedIn on September 14, 2022

Sometimes my students ask questions that set me to writing. Here is one from Kaden this morning. Are there any safeguards against high prices? Can the government help? I use the price of gasoline as an example.

The market is the safeguard against higher prices. If an item is ‘too highly’ priced, demanders will not purchase it or seek alternatives. I make cutting boards. If my competitors charge a price I think is too high, I can offer my boards at a lower price. It doesn’t matter whether the item is ‘worthless’ or not to some or even to many.

Both phrases in the above paragraph, ‘ too high’ and ‘worthless,’ are normative statements and have no use to us in analytics. But we all think it. Why would I ever pay a price that I believe is too high for a worthless item? I would not.

What if the item was a necessity for me? Then my demand inelasticity would show me not responding to the negative price as much as I might think I would or as much as my complaints suggest. Say 10 gallons of gas per pay period is necessary to keep your job, then you will buy the gas at whatever high price, at least until you can figure out an alternative.

Before I write the next paragraph, you must understand:

There are only three ways prices can come down:
(1) market demand decreases, (2) market supply increases, and/or (3) the government enforces a regulatory price cap.

The first two are self-healing. Consumers back off high price items, and firms offer new and substitute products at lower prices to get in on the action. Less demand and more supply always lower prices.

Is there a role of the government to step in and force prices down? In my opinion, never.

The reason is simple. The market is dynamic while price cap regulation is around forever. There is nothing as permanent as a government law or regulation. But let’s do that anyway.

The elected officials think gasoline prices are too high, so they regulate the gasoline market, forbidding the local gas station from charging more than a specific price, say $2 per gallon. When this happens, and the market clearing price is $3.35 per gallon, gas station owners will only get revenue of $2.00 but then cannot buy as much gas from the wholesaler at the higher price. The gas station either has less gas to offer or will go out of business, or may restrict gas to its own favorite customers. (Back in the 1970s, it paid to be friends with the local gas station). Less and favored supply means fewer people can get their needed 10 gallons a pay period.

But lowering the gas price to $2 per gallon encourages consumers to buy more. The market price requires people to evaluate just how much gas they need and are willing and able to pay. The artificially low gas price set by the government encourages consumers to buy much more, and to the extent they can, they will stock up.

The market guarantees that the people who value the gas the most will get it. The government guarantees the low price only to those who participate in some extra rationing scheme, such as standing in line and first-come-first-served.

Valuing is not the same as having an income. Poorer folks can value an item highly. At the market price, there is gas for them. At $2, there may not be, and they aren’t guaranteed to be at the front of the line.

Isn’t $2 gas better than $3.35 gas? Not if the government has enforced regulation on the market. At $2, there is less gas to be had, and it will never be allocated to those who value it the most.

Finally, how did the high price get there in the first place? If it is market-based, the market is self-curing. But what if the high price was because government regulation limited supply, limited how many gas stations there could be? By restricting the supply and likely collecting a nice permit or license fee, there are fewer outlets for consumers to get the gas, and prices would be artificially higher than the market-clearing price.

You can imagine the government granting a patent to a life-saving drug. With only one seller (a monopoly) that exists because of government enforcement, prices are higher than the competitive market would dictate, but the competitive market can’t exist. It is illegal for anyone to make and sell that drug without the permission of the drug owner (and for payment of the requisite fees).  I am not saying patents are bad or good, just that there are consequences to action. 

Now imagine the government coming in and putting a price ceiling on a drug with a high price propped up by the same government. All of the signaling value of the market price fails.

We have only begun to think of these issues in our class, which is why I love economic analysis. 

Originally published on LinkedIn on August 2, 2022
Repeated with a comment on LinkedIn, November 4, 2022 (LinkedIn link)

Inflation hurts us all. Why is it here? Why is inflation that is usually under 2 percent suddenly approaching 10 percent?

We have been here before. I lived through the 1970s until the Volker / Reagan approach broke inflation with large and massive, at that time, back-to-back recessions. Before Volker / Reagan, we heard of the term stagflation, a period of high inflation and declining growth that is now being cast about for our present case. The fix in the 1980s was painful, interest rates rose to 20 percent, and two significant recessions occurred before a quarter of a century of low and no inflation followed. Any fix now will also be painful, but you must know what to fix. Blame is levied on the supply-side disruptions, on consumers, and on the war in Ukraine. All of these contribute, but is there a larger contributor?

It is excess government spending.

What is different this time? It is excess government spending. It is a normal function of government to spend and provide for roads, our military, and all of the services we have come to expect. There is plenty of room to argue whether we should have the government spend more on this and less on that. And democrats want to spend on things that republicans do not and vice versa. That is normal and a result of who wins elections. That is not the problem. What we are seeing now, with the assistance of hindsight (and data), is that government spending in 2020 and 2021 is and was excessive on a historical scale. The excess government spending currently is unprecedented in post-WWII history. It is massive.

In this article, I am only looking at annual amounts of the National Income Product Accounts and looking for historical anomalies. Doing that is eye-opening..

In the last 22 years, government spending was 18 to 23 percent of the GDP in 17 of those years. Government spending is expected to rise during economic downturns and fall during times of plenty and indeed did rise to 24 percent following the recession of 1980-82, and rose again to 25 percent because of the 2008 Great Recession. So normal spending by the government is now around 22 percent, and it rose to 25 percent in two prior large recessions. in nominal terms, GDP is currently 24.9 Trillion dollars. So a three percent rise we saw in previous recessions is about 750 billion dollars.

However, Government spending was 33 percent in 2020 and 31 percent in 2021. That is 11 and 9 percent higher than the 1979 to 2019 stable average of 22 percent that government typically spends. In dollar amounts, today, 9 percent of the GDP is over 2.2 trillion dollars in spending, north of the typical 22 percent level. The 2020 and 2021 levels of Government Spending are historically unprecedented. (I show broader data here)

Inflation is not the fault of the Consumers

There are no excess personal consumption expenditures in the current record, consumers spend about 68 percent of the GDP, which has not appreciably changed in the last two years. It has been this percentage for the last 22 years. Since 1979 and including the current year, personal consumption has never been less than 66 percent and more than 69 percent.

Inflation is not a result of Private Investment

Private investment is critical to building capital for the future, which is critical to growth. Private Investment averages 17 percent of GDP and varies from 13 percent (in the depth of the Great Recession) to 21 percent (in 1979), depending on the business cycle. In 2019 before the pandemic, investment was 18 percent, 17 percent in 2020, and 18 percent in 2021. There is no appreciable variation there to indicate it is somehow a prime mover of inflation (and no theory to back up such an idea either).

Referring to the chart, it is typical that investment is lower during recessions (see 2009), but in the 2020 recession, it was higher than the baseline.

GDP = C + I + G + (X-M)

definition of gross domestic product

It isn’t C, and it isn’t I; it has to be G

In the inflation of the 1970s, there was too much money in the economy, which is why it had to be removed to lead to low inflation. Milton Friedman told us that inflation is always and everywhere a monetary phenomenon. Clearly, inflation is too much money chasing too few goods. Government spending in the excess that we see in 2020 and 2021 led to massive borrowing creating deficits that by far are the highest in history.

In the chart, I show annual consumption, investment, and government spending as a percentage of GDP with adjustments for what is typically the case. Consumption is typically 68 percent of GDP, Investment is 17 percent, and Government spending is 22 percent. When the typical is removed, the exceptions represent excess spending.

What is typical?
C = .68*GDP
I = .17*GDP
G=.22*GDP

Didn’t we have to do all that spending?

This will be debated forever, but I think the arguments for spending in 2020 were more valid because of the 33 percent drop in GDP in the second quarter. However, GDP came roaring back. In 2020 one could argue that the government spending made up for the loss of productive output in the economy, but by 2021 with GDP growing fast and the strongly recovering labor market adding back jobs previously lost to the shutdowns, the need for stimulus spending by the US government was not a strong case and the government spending of 2021 became the primary mover of present inflation. If the federal government continues to spend at rates far above the 22 percent level of GDP they will be pouring fuel on the fire.

The American Rescue Plan, in aggregate, seems too late and added more debt to a recovering economy. Rather than stimulating recovery, it heated an already hot economic engine. When Government Spending exceeds Tax revenue, we have to get the money from somewhere, and evidence is that came from the actions of the Federal Reserve. A FED that already had put an amazingly high amount of money in circulation to recover from the great recession had begun to withdraw it and now has a major crisis on its hands, trying to remove the excess money from the system to calm the inflation. This crisis for the FED does not need more excess Government Spending to further worsen the deepening inflation.

And currently on the table is massive proposed spending through the “Inflation Reduction Act.” The future is far from clear.

No new Government Spending Plans over and above the 22 percent, please!

Update: The Inflation Reduction Act passed congress and was signed into law by President Biden on August 16, 2022. https://en.wikipedia.org/wiki/Inflation_Reduction_Act_of_2022.

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