Re: Clarification from Randall Wray

[GGard97342@xxxxxx]

In a message dated 18/12/00 16:06:44 GMT Standard Time, aisaac@xxxxxxxxxxxx
writes:

> Subj:  Re: Clarification from Randall Wray
>  Date:    18/12/00 16:06:44 GMT Standard Time
>  From:    aisaac@xxxxxxxxxxxx (Alan G. Isaac)
>  Sender:  pkt-owner@xxxxxxxxxxxxxxxx
>  Reply-to:    pkt@xxxxxxxxxxxxxxxx
>  To:  pkt@xxxxxxxxxxxxxxxx (pkt@xxxxxxxxxxxxxxxx)
>
>  On Sat, 9 Dec 2000, Henry C.K. Liu quotes
>  Randy Wray as saying:
>  >> ``the interest rate is a RATE (the rate at which one's liabilities
>  >> grow over time), not a LEVEL. thus, increasing the RATE cannot lead to
>  >> a one time shift of the LEVEL of prices. rather, it dictates the RATE
>  >> of price increase that will be required, all else equal, to maintain
>  >> solvency. in a monetary production economy, nominal prices must grow
>  >> at a rate that is above the interest rate.  (there is some room for
>  >> fudging, as some units can "die", some costs can fall, some income can
>  >> get redistributed, and so on)
>
>  Since this strange argument has appeared a
>  couple of times on this list, let us see
>  if it has any validity.  To keep things
>  conceptually simple, we will consider a firm
>  that produces to contract a fixed number of
>  widgets per year using only labor.
>  Also to keep things simple, labor will be
>  paid only once at the beginning of the year,
>  with funds borrowed against payment for the
>  product. Finally, the firm prices as a
>  simple markup over labor and interest costs
>  (where the interest expense is incurred in
>  order to be able to pay labor before the
>  product is sold).
>  Last simplification: we will work with a fixed
>  average productivity of labor.
>  Hopefully it is clear that these simplifying
>  assumptions are innocuous, in the sense that
>  more realistic models will imply the same
>  final result.
>
>  So total revenues will be
>  PY=(1+m)(1+i)WN
>  where P is price, Y is number of widgets,
>  m is the markup, i is the interest rate,
>  W is the nominal wage, and N is labor input.
>  Equivalently, price is
>  P=(1+m)(1+i)W/A
>  where A is the average productivity of labor.
>  Does an initial interest rate of say 5% imply
>  that prices must rise at 5% annually?
>  Of course not. It is clear that *any* initial
>  interest rate is compatible with a constant price.
>
>  Does an increase in i from say 5% to 10% imply
>  that prices must rise by an additional 5% annually?
>  Of course not. There is the one time increase in P
>  that several people have mentioned (including myself
>  in my original post to this thread), and that's the
>  end of the story.
>
>  Just to reiterate: I am trying to make a simple point
>  in the simplest possible way.  I hope any comments will
>  focus on the core conceptual point and not on the details
>  of this ``model'' (which however incorporates many features
>  that should be familiar to PKs).
>
>  Alan Isaac

Alan's maths are obviously indisputable, and supported by the empirical
evidence too which I think does show a stabilisation of prices at the higher
interest levels. But there are other factors which can make Randy right too.
The trouble is that when interest rates rise, a producer should not only
price his product to cover the increased cost of interest, but in theory he
should also price in the effect of the ensuing general inflation as well.
That means that if one practices inflation accounting, the correct price rise
will be higher than the increased interest cost.

Fortunately for slap-happy central bankers, accountants mostly do not want to
know about inflation accounting. Few understand it. As long as the historic
cost accounting results look right they are happy. Back in about 1981 I was a
guest at a dinner of the Chartered Accountants of Manchester attended by 650
people. The national President of the Institute was a speaker, and he took
the opportunity to urge the members present very strongly to adopt current
cost accounting (CCA) techniques. He was barracked vociferously by the
majority present who opposed what he was saying, and I recall a poll of
members showed 51 per cent against CCA.

But there are psychological factors too. As I have mentioned before, it is
accepted here in Britain that wage inflation is driven by mortgage costs.
When mortgage interest rises the wage claims follow like night follows day.
Having won a rise, employees discover how easy it is to get a rise, and the
wage claim process becomes an annual ritual, regardless of inflation.

We have seen this ritual develop with regard to pensions too. Last year
inflation was very low and state pensioners got last April an increase in
pension of only 75 pence a week, in line with inflation to October 1999. That
was entirely correct, but it was not seen that way. There has been so much
agitation about it that the government has had to concede that next April all
couples in receipt of state pensions will get £8 a week more regardless of
the then rate of inflation. With such a spineless attitude what possible
sense is there in murdering industry with high interest rates in the vain
hope that it will ameliorate inflation?

Once originally bred in the incubator of high interest rates the inflation
bug takes a lot of killing.

Henry has pointed out that a rise in interest rates has to be either absorbed
by profit or prices have to go up, so he accepts that higher interest means
higher prices in the short term. He argues however that the resultant
recessionary effect of higher interest will mean that in the longer term
prices must fall as workers accept lower wages. This argument looks valid but
it is only an assumption, without supporting statistical evidence. The
trouble is that at the moment the rate of price inflation falls, that is
exactly the moment when the interest rate is going down too. So the graphs of
short term interest rates and of inflation match perfectly. From the graph it
is quite impossible to deduce which factor has caused the fall in price
inflation.

Pity!

We do know of course that nowadays wages are very sticky in a downward
direction. And public sector wages have always been immune to recession. One
recalls that in the last 80 years British civil servants have only once had a
wage cut, ten per cent in 1931. That cut was far less than the rate of
deflation over the period 1920 - 1937 as readers of the new third volume of
Skidelsky's life of Keynes will be able to see from the data published there.
In 1931 workers in one "sheltered" industry, banking, were deprived for one
year of their annual scale increment. Private sector workers suffered
reductions in the twenties and thirties, but since 1945 highly unionised work
forces have often preferred to put their firms out of business rather than
concede a wage reduction.

Therefore my analysis is that in modern conditions in Britain an interest
rate rise never achieves actual price deflation. What it does achieve, I
repeat, is "stagflation," the condition unknown until Horsley Palmer's 1832
theory was first put into effect in the 1960s.

Incidentally I would prefer to leave out of the argument the effect of
interest rate rises on import prices. Domestic cost inflation is the
important issue. Anyone who tries to fight inflation by causing the exchange
rate to rise seems to me to be very myopic, to put it mildly. Sadly that
means that most of my country's politicians need spectacles.

Geoffrey Gardiner

Merry Christmas. Hope Santa brings everyone a copy of Skidelsky, vol III.