The Great Inflation: Structural Factors

Background

In the last edition of the Pulse we reviewed the monetary factors underlying the inflation of the past half century. The growth of these factors is captured in the following table:

This table shows that while output grew about fourfold, money and credit grew about twenty-twofold, or over five times as much. The monetary increase was made possible by progressive cuts in required bank reserves that enabled credit growth to proceed with little restriction.

Our next step is to relate this monetary growth to the actual inflation that occurred. This is shown in three different price indexes:

These indices measure different parts of the economy, which is why they differ. But the essential feature is that while prices rose about fivefold, the increase was far below the twenty-twofold increase in money and credit. This leads us to consider which parts of the economy experienced the most inflation and which the least.

The implicit price deflator is the most comprehensive index for our purpose. It represents the percent by which real GDP differs from nominal GDP in one year, and this measures the overall inflation for that year. In addition we have a breakdown by broad category summarized as follows:

These categories show considerable variability from personal durables that rose twofold to personal services that rose six fold. Two broad categories stand out particularly, services expenditures and structures (residential and nonresidential) expenditures. This variability is borne out by the consumer price index where the items rising the most are housing and medical care, and those rising the least are apparel and energy. These variations indicate that inflation has come from a variety of factors affecting specific sectors rather than from one background factor affecting all of them. The rise in general, however, would not have been possible without the much greater increase in the money supply previously discussed.

Structural Developments

As remarked by economist G.L. Bach almost 50 years ago, inflation's roots lie deep in our economic and political processes. Some of these roots can be identified, but others may be operating and we are not aware of them.

• Though not new, administered prices remain a major contributor to inflation. Administered prices are those established by management based on what it believes the public will pay rather than those established by an impersonal market place of buyers and sellers such as a cattle auction. A good example is a new drug, Viagra, that is protected by patent against competitive production. Such products are priced at the level the company calculates will return the greatest total profit regardless of what the production cost may be. Typically , when such a drug comes off patent protection, the price immediately falls. This kind of price inflation has grown steadily as industries consolidate throughout the economy in order to gain "pricing power" and a "dominant position". Prices thus attain a rigidity that prevents substantial downward movement.
• More than 80 percent of payroll employment is now in the services sector, an indication of its dominant position in today's economy. This development has contributed to inflation in several ways. Most prices in services are administered and thus resistant to any downward tendency. The services sector overall has not achieved productivity gains comparable to those in manufacturing. Health care, the item that has risen the most in the consumer price index, is part of this sector, and impacts the price level by boosting insurance costs and by underwriting excessive drug costs. Services in many cases do not face the same direct market place competition that manufacturing does.
• The growth and consolidation of the corporate world has brought developments that contribute to inflation. The pricing power that comes with size has already been mentioned. Another is the enormous growth of advertising costs. National marketing of products requires the promotion of brand names throughout the country. Television advertising is the ideal vehicle for this purpose, and sports/family entertainment came to be the core material. Sports and performer salaries exploded in this environment paid ultimately by consumers in the price of the products they buy. Similarly, health care insurance came to be provided by employers with the same result - rising costs passed on to consumers in the price of products. Now, as in the case of Enron and Global Crossing, we are finding that insider greed is an important source of inflationary pressures. For many years, corporate managers and directors have raised their own compensation at rates far higher than those of their workers. Shareholders, ironically, abetted this escalation under the illusion that by doing so they would profit in the form of "increased shareholder value". This is just one of the abuses that are still to be addressed.
• Structures, both residential and nonresidential, were identified as a sector showing above average inflation in the GDP price deflator. Rising land prices are undoubtedly part of this rise as development sites grow less available and developmental costs rise. Residential structures have become increasingly designed for the affluent buyer, with larger units and more amenities. The standard three car garage in suburban developments almost equals some housing that was built in the early part of the last century. Stores and office buildings also show this same tendency to larger size and more luxurious features.
• The primary goal of public policy has been to maintain economic growth. The Federal Reserve constantly reiterates its "long-run goals of price stability and sustainable economic growth". Congress and the White House see growth as the solution to every problem from unemployment to fiscal deficits. Even a faltering of growth, as at the present time, is considered a major threat to the nation. Maintaining growth, therefore, becomes essential.
  
  The primary means of maintaining growth has been the expansion of debt throughout the economy rather than overt legislation. When debt expands, it increases effective demand for goods and services. From 1980 to 2000, nonfinancial debt increased $525.7 bn or an average of $26.5 bn per year-9.2 percent of the yearly increase in national income. These increases are shown in the following graph for the period 1960-2000.
  
  
  Source: Flow of Funds, FRB
  
  This graph captures the essence of the debt expansion that has transpired, particularly over the past 20 years. During this 20 year period, national income expanded about 3-1/2 times whereas non- financial debt expanded about 4-1/2 times. Actual output (real GDP) grew less that 2 times. Thus, we have a dichotomy between real output and financial aggregates. This financial surge has enabled the economy to grow at a higher rate than would be possible if demand depended on current income generated by production. This stimulant, however, requires unending growth of debt to persist.
  
  Some debt growth is natural in a growing economy. It is the growth that is significantly in excess of this natural growth that characterizes the present period. The relation between banker and borrower has been transformed in a single lifetime. From being a grantor of credit, the banker is now a marketer of credit. The public is courted from all sides with offers of credit with minimal requirement to assure ability to repay. It is this persistent lowering of credit standards that distinguishes the present period. Debt has been exploited for the specific purpose of stimulating demand in excess of what might be considered normal demand arising from current income. This process thus becomes a structural factor in explaining the inflation of the past half century rather than a monetary factor.
• Prior to World War II the enormous growth of productivity and output had offset inflationary pressures. This growth continued in the post war period as productivity increased 144.9 percent from 1960 to 2000, an average of 3.6 percent per year. This gain should have been sufficient to allow profits and wages to grow without price inflation. But in an atmosphere of excess demand created by monetary and credit expansion, the productivity gains were all appropriated by management, capital, and labor rather than being shared with the consumer.
• Competition remained intense in the post war period, but it changed significantly. As national marketing and affluence grew, competition increasingly tended to be directed toward persuading consumers, through advertising, to buy one brand or product rather than another one. Competition based on price became secondary to competition based on name recognition. In this environment competition lost much of its potential to restrain price inflation, and, in fact, the high costs associated with national advertising actually contributed to it.

We live in an economy of contradictions with excesses of both money and output. Demand has been artificially stimulated by credit expansion in excess of income growth, a process that cannot be sustained indefinitely. The post war inflation is due to interacting monetary and structural factors that we have attempted to identify. In our next essay we must look at the major consequences and implication for the future of that inflation.

First quarter 2002 data show little improvement in the developed nations. Real GDP changed only about one percent up or down in all five economies while industrial production fell in all five. Retail sales volume remained strong in Canada, Britain, and the U.S. but weak in Germany and Japan.

Economic weakness does appear to be slowing the rate of price inflation except in Japan where it has resulted in price deflation over the past two years. Unemployment rates continue to creep up except in Britain.

On the financial side, economic weakness manifests itself in the form of low interest rates with new lows except in Japan where a zero interest policy is in effect. Money is plentiful, but it is afraid. Credit quality has deteriorated badly so investors seek safety over yield. The stock indices actually rose a bit in the first quarter but those gains have now been erased, with multi-year lows in U.S. markets.

Britain's current account deficit rose in the first quarter while the U.S. deficit declined. The U.S. dollar peaked against major trading partners' currencies in early 2002, but it has now fallen against the Euro to parity. This weakness is another reflection of falling confidence in the soundness of U.S. financial markets.

Real GDP growth spurted 5.6 percent in the first quarter of 2002. A slowing of inventory liquidation accounted for 3.0 percent of this change, and increases in individual and government spending contributed more than 3 percent. Offsetting these gains, nonresidential investment in structures, equipment and software continued to fall.

Industrial production peaked in the early part of 2000 and declined through 2001. Durable goods production picked up a little in the first quarter of 2002, but the increase did not include business equipment.

Manufacturer's new orders (along with shipments and inventories) are about back to where they were in 1998 before the technology bubble. New construction expenditures, however, continue to surge, concentrated in the residential sector. The average price of new homes reached $224,300, up 6.1 percent from a year ago. But with Fanny Mae pumping money into the market, demand remains brisk. Prices in some markets such as California have been rising at rates that inevitably will fall.

Real gross investment, as we have noted, has been the weak sector of the economy. With the exception of residential housing, this sector continued to fall in the first quarter.

Business sales were little changed in the first quarter whereas retail sales picked up slightly. Business inventories continued to fall, but retail inventories increased, primarily due to motor vehicle dealers who realized strong sales in the preceding quarter.

The upturn in retail sales is reflected in the growth of per capita personal consumption expenditures, which rose 3.2 percent in the first quarter.

The major threat to continued personal income growth is the nonagricultural employment data, and this is not encouraging. Total employment fell about 200,000 in the first quarter, with decreases in both goods production and services production but an increase in government. The weakness in services is especially noteworthy since this is the sector that provided all the job growth in the nineties.

National income growth has held up fairly well during the economic downturn, but compensation of employees slowed after the first quarter of 2001. Continued gains were experienced in per capita income and real weekly earnings.

Gross saving fell in 2001 and the reduced rate continued in the first quarter of 2002. Personal and business saving rose as government saving fell.

The commodity price index rose in the first quarter led by food and nonfood agricultural items. Producer prices, however, have not risen since September, with little difference among sectors.

Corporate profits with i.v.a. and c.c.a adjustments rose in the first quarter. This measure of profits was not affected by tax law changes; profits for tax reporting purposes were significantly reduced by those changes. Thus, accounting fraud, now in the news, is an inherent part of the tax laws.

The 10 year Treasury rate rose to 5.28 in March but fell back in April and May. These low rates reflect weak demand for funds generally. These low rates also appear to be discouraging the growth of small time deposits (C.D.s) and money market fund balances, resulting in a sharp slowing of M-3 money growth.

The federal budget surplus is probably a thing of the past as tax revenues fall while expenditures rise. If deficits rise sharply they may push Treasury rates up considerably.

Commercial bank credit is one of the critical indicators in the present environment of faltering investment. Through April such credit was lower than at the end of December. Over the past three decades there has not been a year when bank credit failed to expand.

Consumer credit continued to expand at a slower rate. Nonfinancial credit market debt rose 5.2 percent in the first quarter, a little below 2001's rate. Financial debt rose 9.9 percent, also a little less than in 2001. Household debt growth increased to 9.0 percent from 8.7 percent while business debt growth fell from 6.0 to 1.18 percent.

The U.S. deficit on goods and services rose in the first quarter due to several factors. Exports of goods decreased mainly due to falling non automotive capital goods, which have now fallen for the last four quarters and are about 20 percent less than a year ago. Imports of goods rose. At the same time the surplus on services shrank as imports rose more than exports. These changes were related to passenger fares and other transportation.

The pace of foreign investment in U.S. securities slowed in the first quarter. Treasury securities were liquidated and purchases of other securities slowed. With falling stock prices, this process may accelerate.

Copyright © Andrew Caughey, 2002

The Pulse of Capitalism is published quarterly. Comments may be sent to Pulse Publication, P.O. Box 140, Gibsonia, PA 15044. Telephone: (724) 443-2396
Material may be reprinted with acknowledgement of the source. Economic statistics are revised routinely and may, therefore, differ from one report to another.

Published July 2002