How the Economy Works
(as seen through IEA charts)

How to Read The Economy Through IEA Charts

Part I. How the Economy Works
(see also Part II of this series: "A Brief Description of IEA Indicators")

This is Part I of a document describing how IEA's analytical charts help with economic analysis. Part I explains how the economy works, in terms of the IEA conceptual framework. Part II is a brief explanation of the individual IEA indicators and their arrangement into panels. If you are in a big hurry, skip on to Part II. Most of the chart series are familiar "old friends" to economists (although sometimes presented differently) and are not dependent on IEA's new analytical approach.

However, most users will find helpful the following brief summary of the analytical and conceptual framework underlying their selection and presentation. The IEA approach differs in several key respects from the traditional "Keynesian," "monetarist," and "business cycle" economic theories (all of which are now generally recognized as inadequate both as explanations of how the economy works and as guides to effective policy).

(Where the text refers to specific data concepts, there are parenthetical references to the IEA charts of these concepts. However, it is suggested, for the sake of continuity, that these not be referred to on a first reading.)

Contents

A. The Business Cycle is Obsolete and Should Be Abolished
       "Forecasting" vs. Structural Analysis
B. Key Aspects of Balanced Economic Growth
       The "Circulation" of Money
       The "Credit Detour"
       Money Inventories and New Money
       The Money Multiplier
       The 3 Key Balances of National Economic Accounting and Balanced Growth
C. Key Aspects of Investment Spending and Financing
D. Significance of the Money Flow Balances
E. Inflation
       Definition
       Key Causes
       Key Myths (the "non-causes")


A.  The "Business Cycle" is Obsolete and Should Be Abolished From Economic Thinking and Policy

IEA study of the past 30 years' economic history has found that the long accepted concept of an autonomous, natural, built-in "business cycle" now has very little theoretical validity or analytical utility. Rather, it is clear that each recession and each recovery was caused by specific government policies, and that the overall economic fluctuations which have plagued us for so long could be largely eliminated by responsible government economic policies designed to maintain stable full-employment growth with stable prices and interest rates.
 
"FORECASTING" vs. STRUCTURAL ANALYSIS FOR MORE EFFICIENT ECONOMIC MANAGEMENT

Because government policies so largely control the economy, "economic" forecasting must, of necessity, be primarily concerned win analyzing and forecasting these government policies.

IEA charts will undoubtedly prove useful in such forecasting. However, their primary purpose is not to forecast overall economic fluctuations, but rather to show structural and causal relationships so clearly and precisely that government policy-makers can recognize and counteract destabilizing imbalances before they can have any significant adverse effect on the economy's overall growth rate and unemployment rate -- and so that businessmen and others who need to plan ahead can see more precisely where national policy is actually appropriate to the needs of the economy and where it isn't.

In IEA's balanced growth, normative approach, the key "turning points" of most charts are not their peaks and troughs but rather the points at which the data cross their normal lines. These are the points where structural imbalance in one direction is ending and where a shift in policy may be required to avoid an imbalance in the opposite direction.

However, to help IEA chart users to identify genuine causal economic factors and to analyze more precisely the sequential relationships of various series, subscriptions also include a transparent lead-lag overlay imprinted with the ORE (1.1), GRE (1.2), money supply (2.1), key price series (Panel 5), and a lead-lag scale.


B. Key Aspects of Balanced Economic Growth:
       The Dynamic Relationship of Money Flows and Money Stocks

One of the chief purposes of IEA charts is to help de-mystify economics. A key step in this process is to look at the economy first as if it were a single huge business enterprise (rather than as a complex system of markets), and then to understand the relationship of its money-flows. The following explanation is purposely "oversimplified" because these relationships are so fundamental and yet so potentially tricky to understand.
 
THE "CIRCULATION" OF MONEY

In a modern industrial economy like ours production and distribution are controlled by money payments. And since each person's spending is someone else's income, money itself (the "medium of exchange") is never "used up," but continues to circulate in a never-ending flow.

Fig. 1 is a very simplified diagram of the main spending-and-income (S & I) flows -- from households (HSLD) to business (BUS) for purchase of goods and services, and then back again to households as wages, interest, dividends, rent and profits. (In each sector, its MONEY INVENTORY -- see below and Fig. 4 -- serves as a "reservoir" to allow for differences in timing and amount of its periodic inflows and outflows.)  


Figure 1.  Spending-and-Income (S & I) Flows

(Within the business sector, the National Income Accounts net out purchases from other businesses and add up only the "value added" -- which is conceptually equal to the "income distributed" -- at each stage of production, to get the value of the total Gross National Product, or GNP, represented by the S & I flows in the diagram.)
 
THE CREDIT DETOUR

However, there is a crucially important "detour" from this main S & I circuit: the flow of financial saving, investment, and borrowing.

Most people save part of their income, at least part of the time. With today's high interest rates on "good-as-gold" government-guaranteed savings deposits and Treasury Bills (Panel 6). it doesn't pay to keep their savings in the form of checking deposits or currency which earn no interest (and which also lose value in inflation). Rather, most people "invest" the funds in reserves, stocks, bonds, etc. (Panel 16B). These investments can earn interest because other households and business firms want to borrow the money to spend.

Thus, money which is withdrawn from the basic S & I circuit in the form of financial saving is returned to the S & I circuit through other people's borrowing (Panels 11 and 12) and credit-financed spending (Panel 8). (See Section C, below, for analysis of the close relationship between borrowing and investment spending.) Most of the funds in this "Credit Detour" do not go directly from saver to borrower, but through banks, savings and loans, insurance companies, securities dealers or other financial intermediaries. In Fig. 2 these are labeled collectively CREDIT MARKET (CRED MKT). The credit flows are shown as dashed lines.  


Figure 2.  
Fig. 1 plus "Credit Detour"

 
MONEY INVENTORIES AND NEW MONEY

There is a third basic money-flow which is not "circular" but has a distinct beginning and end: the flow of NEW MONEY into the S & I circuit and its effective withdrawal from this circular flow when it becomes "locked into" people's "normal-and-necessary" MONEY-INVENTORIES.

As noted above, money as such (as distinguished from the money-value of other assets) is our "means of payment" -- i.e. what we buy things with and pay bills with. By dollar volume, most payments are made by check. Thus, three-fourths of our money supply is in the form of checking deposits -- "checkbook money." The rest is currency -- "pocketbook money". These are our transaction balances, our stock of MONEY-INVENTORY.

MONEY-INVENTORIES.  Functionally, this MONEY-INVENTORY performs much the same role as the inventory stock on grocery store shelves. Our bank balance goes up when we deposit our paycheck, then gradually declines as we pay bills and withdraw cash for shopping, reaching a minimum just before the next paycheck -- just as the grocer's inventory goes up the day he gets a new shipment, then declines as he sells to customers, reaching a minimum just before the next shipment.

Thus, in terms of economic flows, our income and spending "flow through" our checking account in much the same way that the grocer's incoming shipments and sales "flow through" the stock on his shelves (the basis of the traditional concept of the "turnover" of physical inventory and the "velocity" of money), with the stock of MONEY-INVENTORY, like the stock of physical inventory, tending to vary greatly from day to day.

In both cases, however, the average STOCK/FLOW RATIO over a period of several months tends to remain close to the trend value (9.3a, 19.3a) which has been found to be "normal-and-necessary" with the existing level of interest rates and methods of managing the stocks, inflows, and outflows. The whole economy's stock of MONEY-INVENTORY is merely the sum of all the individual cash balances.

NEW MONEY.  The key factor that makes NEW MONEY so important is that checking deposits are "created out of thin air," so to speak, in the process of bank lending -- and on the basis of reserve deposits which are also "created out of thin air" by the Federal Reserve System. (This unnecessarily mystifying process is described in the IEA Chart Manual, and in textbooks on money and banking.)

Thus, the borrowing associated with the creation of NEW MONEY differs from other borrowing in the "Credit Detour" described above in that the new money was not previously withdrawn from the circular flow of spending-and-income through anyone's prior financial saving, but actually represents the beginning of a money-flow.

The significance of this distinction is emphasized by noting that the flow of financial saving and the corresponding flow of borrowing in the "Credit Detour" flow could even double without having any direct net effect on the total flow of GNP spending-and-income. But a similar doubling of the flow of New Money would tend to double the growth rate of nominal GNP.

The source of NEW MONEY is represented in Fig. 3 as  Mn.  From there the NEW MONEY flows first into the "Credit Market" where it is "put into circulation" -- i.e. enters the S & I circuit through a bank loan.  


Figure 3.  
Fig. 2 plus NEW MONEY

 
THE MONEY MULTIPLIER

Because the creation of this NEW MONEY represents an "exogenous" net addition to the circular S & I flow, it is the primary source of the growth of nominal (current-$) GNP. (Theoretically, IF all prices, wages, etc. were "downward flexible", "real" GNP could increase even with no increase in the money supply. But in the "real world" where most prices behave quite differently -- see analysis of inflation in Section E -- it is the growth of the "real" money supply which largely determines the growth of "real" GNP.) Moreover, the ultimate increase in GNP is far more than the initial increase in the money supply because each dollar of NEW MONEY is actually spent and re-spent over and over.

However, this "MONEY MULTIPLIER" effect is limited by the fact that the increasing flow of spending-and-income also increases the amount of MONEY-INVENTORY needed to service it. Thus, the NEW MONEY is gradually "withdrawn from the circular flow" in the sense that it becomes "locked into"--- the ever-larger "normal-and-necessary" MONEY-INVENTORIES, and thus is no longer available for spending -- in the same sense that physical goods become "locked into" a business's "normal-and-necessary" physical inventory stocks and are thus (in a net sense) no longer available for sale to final consumers. In Fig. 4 these MONEY-INVENTORIES are shown as small "pocketbooks," labelled Mi,  


Figure 4.  
Fig. 3 plus MONEY-INVENTORIES

(This conceptual treatment of money is one of the chief ways in which the IEA analysis differs from the traditional Keynesian, or "National Income," and monetarist theories. In particular, it explains the transmission mechanism by which the growth of the money supply causes the growth of GNP, and how this effect is mainly direct, rather than indirect through interest rates.)
 
THE 3 KEY BALANCES OF NATIONAL ECONOMIC ACCOUNTING AND BALANCED GROWTH

The macro-economic money flows illustrated in Figs. 1-4 have their counterparts in the following key balances in the national economic accounts:

  1. The "real" or spending/production balance (Fig. 1) -- the relationship between the total physical production of goods and services and the nation's total "real" GNP spending (which is the same as the total "real" income distributed in the process of production). (In the diagrams, the solid-line S & I flow is the money-flow counterpart of the flow of "real" goods and services in the opposite direction.)
  2. The credit balance (Fig. 2) -- the relationship between total "borrowing" (the total demand for credit, including corporate stock issues) and total lending (the total supply of credit from financial saving and NEW MONEY).
  3. The monetary balance (Figs. 3 & 4) -- the relationship between the amount of NEW MONEY actually provided by the Federal Reserve monetary policy, and the increase in the amount of MONEY-INVENTORY which businesses and households (and other sectors) keep to "service" their current flow of spending and income.

Static accounting balance vs. dynamic functional balance.  In a static accounting perspective, the two sides of these "balances" must always be equal, because spending-and-output, spending-and-income, borrowing-and-lending, NEW MONEY-and increase in MONEY-INVENTORY are merely the different names given to the two sides of the individual transactions which make up the flows.

The sources-and-uses-of-funds equation expressing the three money-flow relationships is:

I   +   B   +   Mn   =   S   +   L   +   Mi


=  
Income  
Spending  
+   Borrowing  
+   Lending   (i.e. non-money financial saving)  
+   NEW MONEY  
+   addition to MONEY-INVENTORIES

But what really matters -- in macroeconomic analysis as in business accounting -- is the way in which they are dynamically brought into balance, and at what Operating Rate of the Economy and what rate of inflation. The money-flow diagrams and balances, in themselves, merely provide an incisive analytical framework which helps both to ascertain which are the key independent, causal factors in present (and prospective future) economic developments, and to formulate and evaluate economic policies.

The balanced-growth, full-employment balances.  When the government finally adopts effective means to systematically coordinate the presently independent economic "interventions" of Congress, the Administration and the Federal Reserve, so as to actually make possible the "fine tuning" of economic management for stable full-employment growth, it will use the three money-flow balances in normative terms:

  1. the amount of GNP expenditure needed to "buy" the economy's full-employment output;
  2. the amount of borrowing needed to return to the spending-and-income circuit the full-employment amount of financial saving and NEW MONEY;
  3. the amount of MONEY-INVENTORY needed to service the full-employment volume of GNP.
Therefore, wherever appropriate, the norm-lines of IEA charts are estimated on this basis.


C.  Key Aspects of Investment Spending and Financing

In Keynesian economic theory, the rate of business investment (charts 8.5, 9.1) is considered the key "independent" (exogenous) factor determining the Operating Rate of the Economy (ORE, chart 1.1), and the rate of investment is determined by prospective profitability, which in turn is determined by a complex of factors in which "confidence" and optimism or pessimism loom very large.

In actual fact, in the present-day world of giant corporations, scientific management techniques, market analysis and computerized forecasting, business "confidence" and prospective profitability of investment depend very largely on the present and prospective ORE, which in turn depends primarily on government management of the economy. Thus, realistically, the rate of business investment probably has only a very limited degree of functional independence.

However, the rate of business investment does have a key functional significance, both because it provides most of the economy's future physical productive capacity (inadequate capacity makes it difficult to reach full employment without running into inflationary bottleneck shortages) and because fluctuations in the rate of investment tend to cause corresponding fluctuations in the business demand for credit (12.1), with all that that implies for the overall credit balance of the economy (11.1) and for the federal government's own fiscal balance (12.3).

Furthermore, in their significance for the productive capacity and financial balance of the economy, household investment in houses, automobiles and other service-producing equipment -- and even government investment in plant and equipment -- are rather similar to business investment. (See also the explanation of CHARTFOLDER pages 3 & 4 in Part II.) Thus, it is useful at this point to review (in very broad-brush and over-simplified terms) the key functional relationships between investment spending and financing.

  1. Except for the largest corporations and wealthiest families, individual "capital" investment expenditures -- for a house, car, factory, power plant, school -- tend to be relatively large in relation to the flow of current income, and thus tend to be financed by borrowing from other people's savings. Such capital assets are creditworthy from the point of view of a saver-investor-lender because they provide financially sound mortgage security.
  2. In a growing economy, the longer the economic life of an investment asset (and the longer the corresponding credit-repayment period), the larger tends to be the amount of net borrowing (the greater the net increase in total debt) in relation to the amount of current investment -- the higher the borrowing/investment ratio (Panel R-10). This is because, during any given period, most of the repayments on such long-term debt reflect the much smaller rate of investment and borrowing many years earlier -- a difference which may be greatly increased by inflation.

    This difference in the debt-generating capacity of different types of investment is strikingly illustrated in the case of houses and automobiles. Although household spending for new houses (8.12) usually has been much less than household spending for new automobiles (8.9), the amount of net mortgage borrowing (11.8) for houses has been five to ten times greater than net automobile borrowing (which is usually only a little over one-third of total installment borrowing (11.9). (See also their respective borrowing/investment ratios, R-10.2, R-10.4). There tends to be a similarly greater amount of borrowing generated by long-lived business investment such as office buildings, apartments, schools, and electric utilities, as compared to equipment with more rapid obsolescence such as oil refineries and automobile body dies.

    Thus, changes in the relative proportions of different types of investment spending may have an important effect on the economy's overall credit balance and therefore implications for appropriate monetary and fiscal policies. (This is a factor which tends to be overlooked in the Keynesian emphasis on the overall amount of investment spending).

  3. To the extent that investment expenditure is financed to the maximum degree with borrowed funds, the debt repayments (on any credit-financed investment) will tend to correspond closely with its depreciation allowance (so that the outstanding debt remains below the remaining mortgage value of the asset). As a result, there also tends to be a fairly close relationship between the economy's total net investment (i.e. the excess of total investment over total depreciation allowances) and its net borrowing (the excess of new borrowing over repayments -- see Panel R-11B).

    Since both depreciation allowances and debt repayments reflect mainly past (and often distant past) rates of investment and borrowing, a change in the GROWTH RATE of the economy (GRE, 1.2) tends to cause a disproportionately large change in the rate of NET investment and NET borrowing (Panel 11). This effect has been called the ACCELERATION PRINCIPLE.

  4. Since all inventory investment (9.1, 10.2) -- i.e., the net increase in inventory stocks -- is also net investment, the acceleration principle applies particularly to inventory investment and related business borrowing (12.1, 10.4). (However, as with capital investment, there tends to be a lag in the degree to which businesses can actually adjust their inventory investment to sharp changes in the rate of sales.)

    Thus, as businessmen try to maintain a normal STOCK/FLOW RATIO (9.2a) between their inventory stocks and their current volume of sales, changes in both inventory investment and business borrowing normally tend to be determined very largely by changes in the Growth Rate of the Economy.

    Furthermore, although the normal amount of inventory investment (9.1) is only about one-twentieth the normal amount of capital (plant and equipment) investment (8.3), the fluctuations of inventory investment (deviations from normal) are often almost as large in absolute amount -so large, in fact, that they may actually dominate the fluctuations of the whole GNP (cf. charts 18.7, 18.6).

  5. Because consumer durable goods tend to be financed largely with "borrowed purchasing power," there tends to be a close relationship between consumer durable goods spending and consumer installment borrowing, a relationship in which either one can play a relatively independent role. When credit terms are sharply eased -- as they were in 1954-55, and to a lesser extent several other times -- this tends to produce a "boom" in consumer durable goods and housing expenditure On the other hand, when there is an increase in durable goods spending not related to credit -- as when a "war scare" or anticipated price increase tends to increase durable goods spending at the expense of saving or nondurables, or when an abnormally large increase in disposable income enables consumers to make larger installment payments, the expenditure side of the relationship may be predominant.

D.  Significance of the Money-Flow Balances for Coordination of Fiscal and Monetary Policy

Economic policymakers who think primarily in terms of "stimulus" and "restraint" are like a doctor whose prescriptions are limited to dexedrine or Valium whenever the patient feels bad, whether the cause is flu or appendicitis. Such simplistic policy thinking is unworthy of a modern industrial economy, which needs much more precise and functionally appropriate economic management.

The role of interest rates.  Interest rates (Panel 6) are a key factor in the cost of housing, public utilities, government debt service, etc., and are thus a key factor in any inflationary spiral. They are also a key factor in determining the cost of the debt and equity capital needed to finance the new business plant and equipment needed to prevent inflationary shortages. But interest rates, as the "prices" of credit, tend to reflect the overall balance between the total supply and demand for credit.

The functional relationship of monetary and fiscal policy.  Monetary and fiscal policies are the key independent ("exogenous") factors influencing interest rates. The supply of NEW MONEY (2.2) is the chief independent factor in the total supply of primary credit; the high-employment component of federal borrowing (12.5) is the chief independent factor in the total demand for credit. Household borrowing (11.7), business borrowing (12.1), the "automatic stabilizer" component of federal borrowing (12.4, 13.3) and the supply of credit from financial saving (16.3) are determined primarily by the Operating Rate of the Economy (ORE, 1.1).

Traditionally, monetary policy has been thought of as the chief policy tool for controlling interest rates, and this has caused a perennial basic dilemma for the Federal Reserve. For instance, in the first half of 1976, much concern was being expressed in financial circles regarding the very rapid growth of the money supply, combined with statements that the Fed was "trying to slow it down." Actually, the Fed has the power to slow the money supply growth rate any time it wants to if it is also willing to allow a corresponding increase in interest rates.

The key to this dilemma is that, when used independently of fiscal policy, changes in the money supply growth rate are a very inefficient tool for controlling interest rates. The supply of NEW MONEY is normally only about 12% to 14% of the total supply of primary credit (11.3). Thus, a relatively large change in the growth rate of the money supply is required to cause (or prevent) any given immediate change in interest rates.

Furthermore, any change in the money supply growth rate has the serious "side effect" of causing a roughly proportionate change in the growth rate of the whole economy (1.2), which eventually tends to have a much greater opposite effect on interest rates by causing a corresponding change in the demand for credit.

Fiscal policy: spending vs. borrowing.  Keynesian economic theory has traditionally tended to consider federal spending (14.1) -- rather than the money supply -- as the chief policy tool for controlling the Growth Rate of the Economy (GRE, 1.2). There is little doubt that in a depression, an "exogenous" increase in federal spending tends to stimulate the economy. However, it is actually not the spending itself which is most important in achieving this result, but rather that the increase in spending (14. 1) tends to increase the high-employment component of federal borrowing (12.5) at a time when the private demand for credit (11.5, 12.1 has been reduced by the depression. The resulting increase in total borrowing (federal and private combined) permits the Federal Reserve to increase the growth rate of the money supply without causing a corresponding decline in interest rates -- as demonstrated by the tax cut in the second quarter of 1975. (Lower interest rates help to reduce inflation and help to stimulate recovery. But under certain circumstances they may cause a "flight of capital" to higher interest abroad.)

One thing that becomes very clear from analysis of these relationships is that monetary and fiscal policy should be viewed as complementary, rather than alternative, tools of stabilization policy. Monetary policy should be used solely to provide the economy with the additional amount of MONEY-INVENTORY needed to service the growing S & I flow at the desired real GNP growth rate. The stabilization aspect of fiscal policy should be used solely to make sure that the amount of federal borrowing maintains a stable balance between the total national supply and demand for credit (including the supply from NEW MONEY).

The main problem with adjusting federal spending for this purpose is that it is difficult to make the adjustments in the precise amount -- and with the precise timing -- which would be most appropriate for the needs of the economy.

However, the same effect on the amount of high-employment borrowing can be achieved by a change in tax rates (14.2) -- as in the first half of 1964 and 1975 when a relatively small proportionate change in tax rates had a relatively large effect on the high-employment component of federal borrowing. Moreover, tax rates -particularly withholding tax deductions -- are potentially highly flexible, permitting relatively small and precise changes to be made as often as needed to maintain the national credit balance. In fact, fiscal policy could be used in this way to maintain this credit balance with almost any desired level of interest rates, and without having any direct effect on the GNP growth rate.

"Tight money" vs. "fight credit."  Analysis of the real relationship between money and credit also reveals the error of looking at interest rates as reliable indicators of monetary policy. Interest rates indicate only the relationship between the total supply and demand for credit. Thus, rising interest rates indicate "tight credit" but not necessarily "tight money" (in the sense of a relatively slow growth of the money stock). In fact, because the money supply is normally such a small part of the total supply of credit, it is entirely possible for rising interest rates (6.4) to coincide with an abnormally large increase in the money supply if the demand for credit is also increasing rapidly, as in 1965 and the second half of 1972, or if the rate of financial saving is declining, as in the first half of 1968.

A key source of confusion here is a failure to distinguish between the demand for credit (i.e. for spendable funds) and the demand for money (i.e. for additional stock of MONEY-INVENTORY). This confusion is in turn caused largely by the fact that, in our present "fractional reserve" system, NEW MONEY is created primarily in the process of bank lending.


E.  Inflation

(These are some of the main conclusions from a more comprehensive IEA analysis of the inflation problem.)

The first key to understanding inflation is to clearly distinguish between:

  1. the definition,
  2. the "spiral feedback process,"
  3. the resulting structural distortions and inequities,
  4. the specific potential independent causes, and
  5. the policy tools appropriate for dealing with each of these.
 
DEFINITION OF INFLATION

Analytically, the term inflation refers to a substantial and sustained rate of increase in the "general level" of prices. In Panel 5, the rate of inflation is indicated by the height of the shading above the chart norms, with the 1.5% a year norm for the Consumer and GNP Price Indexes (5.5, 5.4) corresponding to a zero norm for the wholesale commodity indexes (5.1-3). However, a rise in the CPI or GNP index of less than about 3% would not generally be considered "substantial" enough to be a political or economic "problem."

By this 3% definition we have had four periods of significant inflation since World War 11: 1946:2 to 1948: 3, 1950:3 to 1951:2, 1955:1 to 1958:1, and since 1964:4. Each had different primary causes and different characteristics. In fact, during the past 12 years there have actually been several distinct phases of inflation, each with different basic causes.
 
KEY CAUSES OF INFLATION

  1. "Too many dollars chasing too few goods."  In war time, total spending -- "deficit financed" in part by excessive NEW MONEY -- usually tends to exceed the total peacetime CAPACITY GNP. This cause of inflation is the source of most of the myths and half-truths that surround the subject.

    However, since unemployed workers are "unused capacity" (even more versatile and mobile than most unused plant and equipment capacity), and since U.S. unemployment has usually been far higher than most other industrial countries (Panel 3), the truth is that there has probably never been a peacetime year when our total spending exceeded our total productive capacity.

  2. "Bottleneck" shortages.  What is often ignored is that there is both a supply and a demand side to the above "pseudo-definition" of inflation, and that the "too few goods" inflationary imbalance exists whenever there is a "bottleneck" shortage of particular types of products or services, These shortages may be caused by crop failures (e.g. 1972-74) or other natural disasters, by poorly administered price controls and other government regulations, by monopolistic restrictions on output or capacity (e.g. the 1973-74 OPEC oil embargo and building trade apprentice restrictions), and by structural distortions of the output "mix".

    These shortages tend to cause an immediate inflationary imbalance between supply and demand only in their sector of the economy. But a modern industrial economy is highly interdependent, and a "bottleneck" in one sector soon tends to cause inflationary shortages in many other sectors. This was happening all through the economy during 1973-74 even as it slid deeper into recession -- and the specter of such shortages is now again looming over the horizon.

  3. Economic instability and "anti-inflation" depressions.  Except for war, the most subtle and pervasive cause of structural imbalance is continued economic instability -- in recent years actually policy-induced in the name of "fighting inflation."

    The longer a depression is allowed to continue, the further the nation's industrial capacity (4.1) (and worker skills) will fall below what would be needed to fully meet the demand of a fully-employed economy -- and the more powerful the resulting "hidden time-bomb" of inflationary shortages in the path of future recovery.

    Yet the abnormally high rate of economic growth (1.2) which is necessary for recovery also tends to cause a whole Pandora's box of inflationary structural distortions, including:

    1. an abnormally high rate of consumer borrowing (11.7) and durable goods demand (8.9, 8.12) (which tends to put inflationary pressure on both the credit market and the "bottleneck-prone" basic materials industries);
    2. an immediate inventory shortage caused by industry's inability to fill the "inventory pipelines" (9.4) as fast as final demand increases (4.6) and a later abnormally high rate of inventory investment (9.1), which tends to be financed by an abnormally high business demand for credit (12.11);
    3. an abnormally high rate of demand for new business plant and equipment (4.8, 8.8), which puts inflationary pressure on the machine tool industries and the supply of skilled labor (4.4);
    4. an increase in interest rates (Panel 6), which are a key cost element in housing, public utilities, government expenditure (Relays), and many other aspects of the economy (6.5, A-2.26).

    In fact, it is these and other effects of economic fluctuations which are the primary cause of the supposed "Phillips Curve" tendency for full employment to cause inflation -- i.e. it is not the full-employment as such, but the way in which it is approached. It is worth remembering that the postwar period of lowest unemployment, 1951-53, was actually a period of stable prices -- primarily because steps were taken at that time to prevent the inflationary tendencies of recovery towards full employment from becoming locked into a continuing spiral of inflation.

    An even more subtle way in which instability and frequent sub-capacity operation of the economy causes inflation is the way it adds to the basic structure of costs: the "depression-insurance premium," which must be included in interest rates; administered-price profit margins and wage rates in unstable industries like construction; the cost of supplementary unemployment benefit funds and unemployment insurance taxes; the cost of job-saving "featherbedding" and job-sharing "paid days off"; the higher tax rates needed to finance the interest cost (R-14A.5) of government "depression deficits" (Panel 13); the direct cost of depression-induced crime and the indirect cost in higher anticrime insurance and protection; the higher costs due to the slower rate of industrial modernization and more conservative financial-security-minded management; the overhead costs of usually-excess capacity; overtime wage rates during temporary high operating rates, etc., etc. Note that the growth rates of productivity (15.1) and GNP (1.2) correspond very closely. (This is one of the places to use the IEA LEAD-LAG OVERLAY).

  4. "Administered" prices.  The fourfold increase in OPEC oil prices was a blatant example of the abuse of excessive market power. It has often been referred to as a "tax" on consumers. This designation is equally appropriate for excessively high "administered" prices or wages in our domestic economy. Wherever corporations or unions have sufficient market power to decide arbitrarily whether and when they will increase their prices and/or reduce their output, this is a potential cause of inflation. And in a "roller-coaster" gyrating economy, they tend to have "ratchet effect" on the price level, minimizing price reductions during recessions and increasing prices during recoveries.
  5. Import prices,  The 1972-75 inflation has been blamed partly on the sharp price increase of many imported raw commodities. Where these were "free market" rather than "administered" prices, they tended to reflect "bottleneck" shortages where the inadequate capacity (and/or inventory stocks) were ultimately caused by the same fluctuations of our economy -- (3), above -- that caused our own bottlenecks.
 
KEY INFLATION MYTHS (THE "NON-CAUSES")
  1. Too much NEW MONEY.  There probably was a little too much in 1965, 1972-73 and possibly even in 1968 -- not because the resulting stock of money (18.3) exceeded the amount needed to service a CAPACITY GNP rate of spending and income, but rather because the money supply growth rate (Panel 2) caused a GNP growth rate (1.2) that was too fast for those relatively high operating rates in the absence of adequate policy measures to offset any resulting bottleneck shortages, structural distortions or irresponsible and inequitable individual wage or price increases.
  2. Excessive government spending.  Except for the military portion, government spending is no different from many kinds of private spending; government spending tends to cause inflation when, and only when
    1. it is so rapid or concentrated (as in war) that it causes structural distortion of the economy or
    2. it is financed by an excessive amount of high-employment borrowing (12.5).

  3. Government deficits.  Here again, in its potential inflationary effect, government borrowing is essentially no different from most private borrowing: any borrowing tends to cause inflation when, and only when

    1. it causes an inflationary excess of total borrowing,
    2. it displaces private business borrowing needed to finance inventory or plant and equipment capacity, and/or
    3. it is financed by an excessive increase in the money supply.

    The 1955-58 inflation was caused primarily by excessive household borrowing to finance houses and automobiles -- at a time when there was a large surplus in the federal budget. Furthermore, the excessive total borrowing of 1972 was caused more by the sharp increase in household financing of autos and houses than by the simultaneous increase in federal high-employment borrowing.



Written: 1976
Posted: February, 2009
Last revised: June, 2009
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