Friday, November 12, 2010

Massive Blob Thinking or Why You Hated Economics Courses in College

Do you really want to know why you hated econ 101 class? It's because you realized the theories made no sense. The profs spin you around with a lot of whiz bang contradictions, throw in some Keynesian nonsense and then leave you off where you started.

WSJ's Kelly Evans attempts to mimic Keynesian econ 101 profs in her most recent column:
Fed chief Ben Bernanke sees little sign of inflation on the horizon. But U.S. households don't feel the same way.


Take the preliminary November consumer-sentiment index, produced by Reuters and the University of Michigan, due out Friday. It likely will show that households think prices will be about 2.7% higher in a year than they are today. That isn't exactly hyperinflation, but it is two-and-a-half times the current inflation rate.

That kind of gap is somewhat unusual. Typically, inflation expectations follow the behavior of actual inflation rates. That hasn't been the case this year. Inflation, as measured by the year-on-year change in the Labor Department's consumer-price index, has dropped from 2.7% in January to 1.1% in September. Yet households' expectations barely have budged.


One likely reason: food and energy costs. Barclays Capital notes that inflation expectations are most influenced by these two frequently purchased items. Prices at the pump average $2.86 nationwide, according to AAA, up from $2.65 a year ago. Meanwhile, the recent run-up in commodities like sugar, corn and wheat is gradually feeding through to store shelves and restaurant prices.


That is no small matter. What households and investors think about inflation can influence the actual outcome of price changes, which is why Federal Reserve policy makers like Mr. Bernanke follow the data zealously.

Right now, the Fed actually may be cheered rather than troubled by the persistence of higher inflation expectations. That is because it wants to boost inflation, which is running below its target. And consumers are more likely to spend, spurring economic growth, if they believe prices will be higher in a year.

But there is a major caveat: Consumers will spend only if they can afford to. Higher food and energy costs that aren't matched by income gains leave consumers with less to spend on other purchases and undercut efforts to stimulate the U.S. economy. That is the risk right now. Only 12% of consumers in the October sentiment survey expected their family incomes would be up more than prices over the next year.

Little wonder that sentiment overall fell to its lowest level since November 2009. The message from households isn't as inflationary as it first appears.
What Evans doesn't understand here is the desire to hold cash balances, which soared during the Great Recession. She also must have forgotten about QE2.

Prices can change based on the desire to hold cash balances, without changes in income. Evans seems to get this for a minute, in a Keynesian sort of way, but demolishes her own thinking on this in her next paragraph. She writes:

[The]Fed actually may be cheered rather than troubled by the persistence of higher inflation expectations. That is because it wants to boost inflation, which is running below its target. And consumers are more likely to spend, spurring economic growth, if they believe prices will be higher in a year.

But she then blows away this thinking as idiotic:

Consumers will spend only if they can afford to. Higher food and energy costs that aren't matched by income gains leave consumers with less to spend on other purchases and undercut efforts to stimulate the U.S. economy.
So she is basically saying that her paragraph about higher expectations is nutty and won't work.  This is just the start of this acid trip.


During periods of  high inflation expectations, people will have a much lower demand for cash relative to other goods. That is, if they think prices will go up and they will buy today rather than wait until tomorrow, thus keeping their cash balances low--and pushing prices up. This is what econometricians and other mathematical economists call velocity, which is really a distortion of the non-mathematical more precise term, desire to hold cash balances. (Expect Evans and other WSJ reporters to start babbling about climbing velocity in about six months.) Thus, contra Evans, overall inflation can climb without an increase in incomes--though incomes are likely to climb because of QE2.

(Changing desires to hold cash balances can also act to put downward pressure on prices, which is a period we are coming out of. Because of the Great Recession people were in fear, not knowing what was going to happen next, so they increased their demand to hold cash balances. This is really what Krugman's babbling about deflation is all about. The price economy adjusting to a greater demand to hold cash.)

In addition to her failure to understand the influence of the desire to hold cash balances and its impact on prices, Evans amazingly doesn't recognize the influence of QE2. With Bernanke blasting for weeks that QE2 was coming, a couple of people might actually think that inflation will be climbing and these people might also suspect that their rank on the totem pole is very low for getting a chunk of the new QE2 money. Thus their thinking might be, "Yeah, incomes are going to climb because of QE2, but it won't be mine."

Evans mass aggregation, typical of confused Keynesian thinking, lumps everyone into one massive blob. That's why she is confused about people thinking inflation will be higher but that those same people are thinking that their incomes will not climb. People know damn well that inflation is coming because of QE2, but they also know not to mass aggregate. They know the new QE2 will get out there, but they are not on Bernnake's Christmas list of those who will receive QE2 money.  In other words they are, correctly, not making the Evans error when she writes as though climbing incomes blanket everyone at the same time:

But there is a major caveat: Consumers will spend only if they can afford to. Higher food and energy costs that aren't matched by income gains leave consumers with less to spend on other purchases and undercut efforts to stimulate the U.S. economy. That is the risk right now. Only 12% of consumers in the October sentiment survey expected their family incomes would be up more than prices over the next year.

There is no caveat needed here. Consumers know prices are headed higher, but they also know they are not going to be the first to get that money. End of story.

Understanding this eliminates the confusion that Evans has as to why people can expect higher prices, but not higher incomes.

Bottom line, Evans is going to be very surprised about the huge uptick in inflation that is coming. The desire to hold cash is declining and Bernanke's QE2 is going to bomb the planet with hundreds of billions in new high powered money.

Her analysis will look as nutty as it sounds, given households are expecting higher inflation (My emphasis):

Fed chief Ben Bernanke sees little sign of inflation on the horizon. But U.S. households don't feel the same way.
Take the preliminary November consumer-sentiment index, produced by Reuters and the University of Michigan, due out Friday. It likely will show that households think prices will be about 2.7% higher in a year than they are today. That isn't exactly hyperinflation, but it is two-and-a-half times the current inflation rate....
The message from households isn't as inflationary as it first appears.

4 comments:

  1. Where I come from, the streets, the proper response to this would be Oh, snap!

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  2. Why aren't there any more journalists like Hazlitt and Mencken?

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  3. Bob: I think we actually agree on this topic more than we disagree - your point that "Consumers know prices are headed higher, but they also know they are not going to be the first to get that money. End of story." is precisely what I was illustrating in the piece. Where we seem to differ is on how significant a hurdle that will be for an inflationary outcome; from your point of view, if I follow correctly, it is but a speed bump - I suspect it may prove more of an obstacle. In any case I am glad to draw attention to the importance of inflation expectations here.
    -Kelly

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  4. Kelly, it shows great character and intelligence to comment on this. Although not unfair, it is rather harsh on you in places, and to be able to calmly respond is rare these days!

    I don't read WSJ (or any MSM economic or political papers) but you've turned me into a fan, and I will look forward to reading your articles in the future. I hope you will continue to read Robert's blog- it's the best economic analysis I've found on the 'net. Even if you disagree, hopefully his uncanny ability to see through the BS pumped out by 99% of the so-called "economic analysts" in the media will help inform your own POV.

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