The Return of Lord Keynes
The Economist magazine is at it again. They asked, last week, if we are in a return to the 70s. Based on what ? Loose monetary policy in the U.S. and Japan, oil prices rising, reckless credit expansion in China, and . . . not much else.
From the back pages, I read: %change in CPI Japan, -0.4, EU 2.5, U.S. 3.1. Are you scared? Well, these are year-on-year rates, and current monthly rates are higher. On the other hand, oil prices are down 8% in the last month - from very high levels. All in all, this may be a bit like the early 70s, but it is not the stuff of a Central Banker’s nightmares.
This log is not about rebutting the Economist. Everybody has to sell their product, and the Economist deals in prognostication for effect as often as it does for accuracy. (Remember their prediction that oil prices might fall to, was it, $5 per barrel? Just five years ago, when oil was at $10?) But it is interesting to compare their complaints about excess liquidity to the money supply numbers. Broad money in the Euro area has been growing at only 5.6%, in the U.S. at 5.5% and in Japan at 2.0%. Narrow money looks a little worse: 10.9%, 5.1% and 4.2%. But the highest growth is in the region with the highest unemployment and the most slack in general.
Rather I want to focus on oil prices, and commodity prices in general, to see if they can tell us anything useful. It is a vexed subject. The Wall Street Journal, in the days of radical monetarism of the early 80s, proposed that central banks anchor the price of gold as a preventative against inflation (and a quick fix for expectations of high inflation that are otherwise painful to wring out.) Later in the decade, when they were beginning to absorb the logic of economists concerning the problems of being so inflexible, they shifted to settling for fixing prices of a basket of commodities. Then commodity prices began falling in the 90s, inflationary expectations finally passed away with the Clinton budget deal, and the call fell silent. (Too bad the Argentine quick fix, the Currency Board, wasn’t scrapped before it straitjacketed them into a depression. But then, they were more desperate to fight inflation than the U.S. was.)
All this to say, one interpretation of the current surge in commodity prices is that it simply represents a return to normalcy. Consider the Economist’s commodity price index. By comparison with 1995, the entire index (presumably with a proper weight on oil) is down 6%. It would be down more if you adjusted for inflation. This is no longer an artifact of the high dollar - the Euro index is only up 2% (in 9 years) and the yen index up 10%. Commodities in general, especially foodstuffs, are experiencing deflation as much as inflation, and on average are just catching up after their incredible fall in the 90s. We could clamp on the monetary brakes like the Fed did in response to rising prices in 1937. Or we could take the view of Franklin Roosevelt, when assuming office in 1933, that what the economy needed was to get prices back up again.
This idea of a proper minimum level of prices is a tricky one. It could easily lead to abuse. In its essence it captures the notion that demand deflation is a bad thing, and can leave a residual drag on the economy for a long, long time.
But it might be more manageable for the moment to translate into concrete microeconomic terms. Roughly speaking, it corresponds to the idea of pricing to cover long-run costs, i.e. costs taking into account the per unit cost of capacity investments. Costs have been falling during the 90s for most minerals, as exploration and exploitation got cheaper. In fact it is one of the basic regularities at the heart of development economics that primary commodities tend to fall in price over time. It is believed that this happens because better technology makes it easier to find and extract resources, but also because bulky goods take a declining share of income as people get more affluent. This second, unfamiliar idea is that higher income leads people to spend more mainly on the vast array of knowledge-intensive goods and services that become available, from medical care and ski gear to electronic entertainment and impressive looking packaging, rather than on proportional increases in food, housing, clothing, etc.
However these two trends should always be set against the more familiar basic fact that non-renewable natural resources get scarcer as they are used up. In fact, the price would always be expected to reflect a “scarcity rent” on the basic resources, so that the price is not just the explicit cost (for labor, machinery, energy, etc.) of extracting the resource, but also reflects two parts of the scarcity of the resource. The first part is the extra payment that is required to bring in higher cost resources to production, if they are needed for satisfying the next unit of demand. So for example, if demand is not met from low cost sources of oil, one must pay enough to cover costs of North Sea oil. These are “quality rents” or “rents to easy extraction,” and the highest cost supplies won’t receive any.
The second part is a rent for future demand. Because copper ore that is left in the ground can be used next year (or next decade), part of its price should reflect that foregone opportunity. Roughly speaking, we expect the price to rise by the rate of interest: if the price is higher than next year’s expected price discounted by the price of money, then it would pay to mine more now and the price this year would fall while the price next year would rise. Of course if next year the copper will be worth less, because of a foreseeable decline in the future cost of production, this can drive the future demand rent down. It can never drive the current price below current production cost, of course. But when there is no scarcity rent for future value, we might want to ask if demand is growing as fast as it should.
There is a case to be made that the commodity standard is best thought of as an indicator of when demand is too slow (rather than, as the Wall Street Journal thought, too fast.) By contrast with finished goods, which are mostly produced oligopolistically and so have prices that are sticky downward, competitively produced resources will lower prices when the economy is sagging. They sometimes drop well below the full cost, in fact. Presumably they can still be worth producing below full cost because the cost of extracting the next ton is often low once the ore is located and the infrastructure in place.
So the question of whether the price declines of the 90s represent mainly technological improvements or mainly slow demand is a vital one for assessing policy, and for assessing current trends. We know that prices fell below full historical costs for at least some producers. Oil prices, for example, fell below the price of extracting new oil from the North Sea, let alone from Greenland. But there is plenty of evidence that technological improvements were responsible (both improvements in location techniques and improvements in Russia’s functioning technology). (Someone should calculate how much the overstatement of reserves contributed to low oil prices). Likewise for minerals - liberalizing countries allowed in new investment, that achieved dramatically lower costs (though sometimes at the expense of the environment). Field crops took a dive when Republicans took over Congress, because they eliminated setasides and so increased supply. They are barely recovering now, presumably after enough marginal producers have given up.
But remember that prices of raw materials are not supposed to match the lowest cost available. There should be at least some “quality rents” to low cost sources. In general, economists are not comfortable with saying what is the “right” price. It smacks too much of just prices and attempts to repeal the laws of supply and demand. But I would like to suggest that raw materials prices are a kind of indicator. One way to think of the question is whether there is slack in the (world) economy. If some resources that are already under development begin to be priced out of the market by new sources, we know for sure that in that market at least, demand is not keeping up with supply. That would be an indicator of slack.
We like to point out the issue on the other side, when there is too little slack and economic stimulus seems to be creating pent-up pressure on prices. Public discussion of the issue has traditionally focused on unemployment rates, but those are really just one indicator. Central bankers in practice must also look at capacity utilization rates, queues for machinery making (and computer programming, if we had the data), and excess reserves in the banking system, to name a few of the most prominent indicators. But we can’t just measure these items and plug them into a formula. We need to assess them in light of the correct questions.
First, the question needs to be put in terms of growth rates. Since supply is always growing, the question is primarily whether demand is growing too fast. There will be a natural self-regulatory process in which demand that is growing too fast will slow itself down by raising interest rates. The essence of monetarism is that government can frustrate this process by generating too much artificial credit, based only on money creation, and not at all on setting aside current resources through the saving process. The result, after a period of low nominal and real interest rates, will be inflation.
The essence of Keynesianism is that there is no self-regulatory process to speed up demand if economic growth is too slow. Not lower interest rates? Well, yes, a mild slowdown will stimulate additional demand using lower interest rates. But it is very easy for the growth rate to fall below the rate that can be sustained by pushing down interest rates. Certainly when nominal rates hit zero that is a sure sign that demand for investment is too low to sustain growth near its potential. Many of us think it happens well above that point, (or the point of zero real interest rates). In other words, you can have inflation even though there is too little demand for the supply. The “sacrifice ratio” needed to squeeze inflationary expectations out of the economy is an example of this.
To understand why demand does not easily restore itself to proper levels, think about bottlenecks. If demand is going too fast, bottlenecks will develop. That is, there will be sectors of the economy that are slowing down overall growth because of their limited capacity. Suppose the economy needs lots more steel, but steel capacity is still too small, because previously, it wasn’t needed as much. Steel will be a bottleneck for the economy. And its prices will almost surely rise, rationing demand for steel to the highly valuable uses. So we have a story about the emergence of inflation.
But if you study development economics, you run into a somewhat different story about bottlenecks, in the context of growth theory. Hirschman suggested long ago that flexible prices provide a signal of where development would be most valuable. If steel prices are high, then investment in steel would be of high value. In this view, bottlenecks are there to be cleared. If you don’t have bottlenecks, then you don’t get signals.
It is easy to exaggerate this notion. In truth, industries may expand even though they already have excess capacity, and will not be raising prices. These are quantity signals to invest. The question is whether quantity signals alone are enough when the overall economy is too slow. Will declining interest rates tell you to invest despite some excess capacity, even though demand projections are fading at the same time as a “pause” sets in? Will quantity signals be enough to sustain investment at a level that generates equilibrium growth?
If you define equilibrium as zero inflation, the answer is probably yes. Recall that some industries, usually electronic these days, advance rapidly enough that they need to replace old capital before it begins to wear out. Thus demand would have to collapse to get this investment demand to disappear. And these same industries are generally lowering prices. This leaves room for some bottlenecks in other parts of the economy, consistent with zero inflation.
But the appropriate standard is whether demand is sufficient to utilize capacity without accelerating inflation. So, in other words, without excess credit creation. I am suggesting that investment can easily fall below levels at which this will happen. Note that it also implies reduced capacity in the future, so that a zero-inflation strategy will be forced to live within the constraints of the underbuilt capital stock. The question needs to be phrased broadly enough to encompass the issue of whether the economy is growing as fast as it can. My claim is that if no sectors are raising prices due to limited capacity, growth is almost certainly too slow. Even stronger, if more bottlenecks are being cleared than being generated, growth is probably still too slow.
Why bottlenecks? Aren’t they really proving that slack is gone? Isn’t it dangerous to push the economy so hard that it faces supply constraints, practically guaranteeing some inflation? But zero inflation is a goal only in the unrealistic world of economic theory, in which forecasts are infallible and all inflation represents an excess of monolithic, single-commodity “demand” over equally simple “supply.” In the messy world of actual investment decisions, we need a more subtle view of where inflation comes from and what policy (or at least what policy “experiments” in the Tobin-esque sense) will bring this inflation about.
Ask yourself whether, if demand suddenly doubled (all the Chinese, Japanese and European consumers suddenly began spending, instead of saving) whether there would be enough capacity to meet their demand. In the short-run, surely not. But in the long run, as we teach in microeconomics, the capacity would increase and it is possible that the doubled demand could be met. At least, ability to build factories would not be the ultimate constraint. Maybe we couldn’t train enough doctors for the resulting demand. Or enough carpenters. But maybe, we could train plenty of both, partly by adding productivity to all the service workers we have, and by convincing people to do without the ones that are easily replaced like service station attendants and bank tellers have been replaced. At any given point in time, there is probably plenty of excess potential capacity that could be met given a bit of time to build.
Inflation (not one-time price increases needed to signal for more resources) comes when the demand increase is persistently ahead of the rate at which capacity can be added across many sectors. And surely it is obvious in today’s economy that productive capacity, in the sense of physical capital, is not the constraint on the pace of growth. I propose that the pace of innovation is probably the limit today.
Isn’t it enough to have the innovation that is naturally generated by electronics and other fast-improving sectors? Isn’t other investment sufficient, if it occurs when firms are just keeping capacity ahead of demand? Maybe, but I think that vastly underestimates the innovative capacity of modern production. If there are bottlenecks, innovation will naturally be targeted at the spots in the economy that are limiting growth. An acceleration in demand that generates bottlenecks will be followed some years down the road by innovations that relieve them. The supply will naturally accommodate itself to the evolving pace of demand, but only with some pressure.
We can have a slow-growing equilibrium, with supply of funds equalling demand for them, where the demand comes only from the innovations that are most obviously profitable in a slowly evolving economy. In a different, fast-growing equilibrium, capital is allocated toward innovation that will best permit growth. In the slow-growing equilibrium, capital is allocated (at a lower interest rate) toward capacity that is under-innovative and accommodates the priorities of under-competitive oligopolies. And the cumulative under-innovation goes unnoticed, especially if all the economists have been trained to believe in the mystical power of equilibrium forces to reveal all.
Thus I am proposing that policy be deliberately aimed not at zero inflation, but at (reasonably low) inflation that is sufficiently far from price stability to avoid the situation of too few bottlenecks. It must also be sufficiently sustainable that many or most bottlenecks are being reduced by innovative activity faster than they are being increased by further stress on the overall economy. Whether this situation is possible is not yet known, but would (as the late James Tobin would have said) make an interesting experiment.
To interpret this for the situation of natural resources, it would suggest that there be plenty of quality rents, but that the pace of innovation and new capacity addition be sustained by the action of prices that are at least not rapidly falling, and probably are rising at a pace similar to the real interest rate.
Suppose we did a quick inventory of the types of resources, to see if the world economy has much slack or not.
China’s economy, bigger now than Britain or Italy, is sucking in more steel and raw materials than any other economy. That is the proximate cause of the increases in metals prices, and perhaps partly for oil price increases as well. Does that mean there is no excess capacity left in mining? Hardly. BHP and Rio Tinto are investing billions to increase mine capacity in Australia, and other locations are also expanding. The potential for expansion is significant. Remember that the issue is not current capacity so much as realizable potential capacity (and long-term sustainability of the pace of expansion).
At the same time, China is putting its formal economy into the modern world. Automobile purchases doubled last year. Obviously they cannot continue doubling forever. Equally obviously there are lots of potential automobile consumers. But how many can afford one? It depends on at what rate the country shifts into the higher gear of modern life. College graduates also doubled in the last few years. Chinese companies are competing world wide in technically sophisticated industries, not just lending cheap labor to foreign investors.
Yet the potential for expansion in China (and India) makes clear that there is no effective labor supply constraint on world production. What about skilled labor? Maybe. But education in developing countries is made cheap by the low cost of its primary input, which is the time of the learner. If you ask the question whether higher relative prices would be necessary to induce more production of educated or trained workers, it does not seem likely.
More likely the constraint is absorptive capacity. That used to be another word for effective aggregate demand. Now it has more to do with what the ability to adopt modern methods profitably. The main problem is not that labor is so cheap that labor-saving technology doesn’t pay. Outside of subsistence agriculture, nothing could be further from the actual situation. Rather, the situation is that today’s technology-intensive methods can move into any fast growing market and use a quality edge to cream off all the high end demand. This is not labor-saving technology in the sense of automating or mechanizing so much as saving on the variations and errors that creep in with straightforward mass production. As a result of this pre-emption effect of global capital, manufacturing employment is likely to grow slower than income, rather than providing positive feedback to growth. Automation of production was the engine of growth in today’s industrialized countries. Outside Mexico and China, there may be no place left in the world where this can happen again.
I conclude that the absorption of advanced economy methods is limited by the pace of opportunities for low-salaried local producers to put together income for buying modern stuff. And thus the creation of skilled labor is limited more by demand than by supply.
The other main constraint in the world today is environmental. What China is doing to its environment is criminal, even by the laws of China. We don’t really need carbon dioxide to be pouring into the atmosphere any faster. But as in the 60s, the problem is not so much overproduction as under-regulation. The environmental industry in industrialized countries is calling for pricing methods on effluents, to give manufacturers an incentive to adopt the pollution control technology that already exists. The shortage of hybrid vehicles is another example of how proper pricing could move demand quickly toward taking advantage of the technology we have. The damage to the environment should be paid for by polluters, period.
The kinship between development economics and Keynesianism is closer than even most economists realize. Much mischief has been done in the name of both, but behind this abuse is the genuine analysis of market failure. Today the world is reaching a stage where the linkage has come full circle, from closed economy macroeconomics, to development planning policy and back to world economy macroeconomics. The Keynesian insights that made their home in inward-looking development policy, mistakenly, now make sense in a world that has been globalized by the rejection of inward-oriented growth policies. By rejecting these policies, nations have forged a world labor market and a world capital market capable of the kind of rapid expansion that probably needs a government push to bring it to fruition.
From the back pages, I read: %change in CPI Japan, -0.4, EU 2.5, U.S. 3.1. Are you scared? Well, these are year-on-year rates, and current monthly rates are higher. On the other hand, oil prices are down 8% in the last month - from very high levels. All in all, this may be a bit like the early 70s, but it is not the stuff of a Central Banker’s nightmares.
This log is not about rebutting the Economist. Everybody has to sell their product, and the Economist deals in prognostication for effect as often as it does for accuracy. (Remember their prediction that oil prices might fall to, was it, $5 per barrel? Just five years ago, when oil was at $10?) But it is interesting to compare their complaints about excess liquidity to the money supply numbers. Broad money in the Euro area has been growing at only 5.6%, in the U.S. at 5.5% and in Japan at 2.0%. Narrow money looks a little worse: 10.9%, 5.1% and 4.2%. But the highest growth is in the region with the highest unemployment and the most slack in general.
Rather I want to focus on oil prices, and commodity prices in general, to see if they can tell us anything useful. It is a vexed subject. The Wall Street Journal, in the days of radical monetarism of the early 80s, proposed that central banks anchor the price of gold as a preventative against inflation (and a quick fix for expectations of high inflation that are otherwise painful to wring out.) Later in the decade, when they were beginning to absorb the logic of economists concerning the problems of being so inflexible, they shifted to settling for fixing prices of a basket of commodities. Then commodity prices began falling in the 90s, inflationary expectations finally passed away with the Clinton budget deal, and the call fell silent. (Too bad the Argentine quick fix, the Currency Board, wasn’t scrapped before it straitjacketed them into a depression. But then, they were more desperate to fight inflation than the U.S. was.)
All this to say, one interpretation of the current surge in commodity prices is that it simply represents a return to normalcy. Consider the Economist’s commodity price index. By comparison with 1995, the entire index (presumably with a proper weight on oil) is down 6%. It would be down more if you adjusted for inflation. This is no longer an artifact of the high dollar - the Euro index is only up 2% (in 9 years) and the yen index up 10%. Commodities in general, especially foodstuffs, are experiencing deflation as much as inflation, and on average are just catching up after their incredible fall in the 90s. We could clamp on the monetary brakes like the Fed did in response to rising prices in 1937. Or we could take the view of Franklin Roosevelt, when assuming office in 1933, that what the economy needed was to get prices back up again.
This idea of a proper minimum level of prices is a tricky one. It could easily lead to abuse. In its essence it captures the notion that demand deflation is a bad thing, and can leave a residual drag on the economy for a long, long time.
But it might be more manageable for the moment to translate into concrete microeconomic terms. Roughly speaking, it corresponds to the idea of pricing to cover long-run costs, i.e. costs taking into account the per unit cost of capacity investments. Costs have been falling during the 90s for most minerals, as exploration and exploitation got cheaper. In fact it is one of the basic regularities at the heart of development economics that primary commodities tend to fall in price over time. It is believed that this happens because better technology makes it easier to find and extract resources, but also because bulky goods take a declining share of income as people get more affluent. This second, unfamiliar idea is that higher income leads people to spend more mainly on the vast array of knowledge-intensive goods and services that become available, from medical care and ski gear to electronic entertainment and impressive looking packaging, rather than on proportional increases in food, housing, clothing, etc.
However these two trends should always be set against the more familiar basic fact that non-renewable natural resources get scarcer as they are used up. In fact, the price would always be expected to reflect a “scarcity rent” on the basic resources, so that the price is not just the explicit cost (for labor, machinery, energy, etc.) of extracting the resource, but also reflects two parts of the scarcity of the resource. The first part is the extra payment that is required to bring in higher cost resources to production, if they are needed for satisfying the next unit of demand. So for example, if demand is not met from low cost sources of oil, one must pay enough to cover costs of North Sea oil. These are “quality rents” or “rents to easy extraction,” and the highest cost supplies won’t receive any.
The second part is a rent for future demand. Because copper ore that is left in the ground can be used next year (or next decade), part of its price should reflect that foregone opportunity. Roughly speaking, we expect the price to rise by the rate of interest: if the price is higher than next year’s expected price discounted by the price of money, then it would pay to mine more now and the price this year would fall while the price next year would rise. Of course if next year the copper will be worth less, because of a foreseeable decline in the future cost of production, this can drive the future demand rent down. It can never drive the current price below current production cost, of course. But when there is no scarcity rent for future value, we might want to ask if demand is growing as fast as it should.
There is a case to be made that the commodity standard is best thought of as an indicator of when demand is too slow (rather than, as the Wall Street Journal thought, too fast.) By contrast with finished goods, which are mostly produced oligopolistically and so have prices that are sticky downward, competitively produced resources will lower prices when the economy is sagging. They sometimes drop well below the full cost, in fact. Presumably they can still be worth producing below full cost because the cost of extracting the next ton is often low once the ore is located and the infrastructure in place.
So the question of whether the price declines of the 90s represent mainly technological improvements or mainly slow demand is a vital one for assessing policy, and for assessing current trends. We know that prices fell below full historical costs for at least some producers. Oil prices, for example, fell below the price of extracting new oil from the North Sea, let alone from Greenland. But there is plenty of evidence that technological improvements were responsible (both improvements in location techniques and improvements in Russia’s functioning technology). (Someone should calculate how much the overstatement of reserves contributed to low oil prices). Likewise for minerals - liberalizing countries allowed in new investment, that achieved dramatically lower costs (though sometimes at the expense of the environment). Field crops took a dive when Republicans took over Congress, because they eliminated setasides and so increased supply. They are barely recovering now, presumably after enough marginal producers have given up.
But remember that prices of raw materials are not supposed to match the lowest cost available. There should be at least some “quality rents” to low cost sources. In general, economists are not comfortable with saying what is the “right” price. It smacks too much of just prices and attempts to repeal the laws of supply and demand. But I would like to suggest that raw materials prices are a kind of indicator. One way to think of the question is whether there is slack in the (world) economy. If some resources that are already under development begin to be priced out of the market by new sources, we know for sure that in that market at least, demand is not keeping up with supply. That would be an indicator of slack.
We like to point out the issue on the other side, when there is too little slack and economic stimulus seems to be creating pent-up pressure on prices. Public discussion of the issue has traditionally focused on unemployment rates, but those are really just one indicator. Central bankers in practice must also look at capacity utilization rates, queues for machinery making (and computer programming, if we had the data), and excess reserves in the banking system, to name a few of the most prominent indicators. But we can’t just measure these items and plug them into a formula. We need to assess them in light of the correct questions.
First, the question needs to be put in terms of growth rates. Since supply is always growing, the question is primarily whether demand is growing too fast. There will be a natural self-regulatory process in which demand that is growing too fast will slow itself down by raising interest rates. The essence of monetarism is that government can frustrate this process by generating too much artificial credit, based only on money creation, and not at all on setting aside current resources through the saving process. The result, after a period of low nominal and real interest rates, will be inflation.
The essence of Keynesianism is that there is no self-regulatory process to speed up demand if economic growth is too slow. Not lower interest rates? Well, yes, a mild slowdown will stimulate additional demand using lower interest rates. But it is very easy for the growth rate to fall below the rate that can be sustained by pushing down interest rates. Certainly when nominal rates hit zero that is a sure sign that demand for investment is too low to sustain growth near its potential. Many of us think it happens well above that point, (or the point of zero real interest rates). In other words, you can have inflation even though there is too little demand for the supply. The “sacrifice ratio” needed to squeeze inflationary expectations out of the economy is an example of this.
To understand why demand does not easily restore itself to proper levels, think about bottlenecks. If demand is going too fast, bottlenecks will develop. That is, there will be sectors of the economy that are slowing down overall growth because of their limited capacity. Suppose the economy needs lots more steel, but steel capacity is still too small, because previously, it wasn’t needed as much. Steel will be a bottleneck for the economy. And its prices will almost surely rise, rationing demand for steel to the highly valuable uses. So we have a story about the emergence of inflation.
But if you study development economics, you run into a somewhat different story about bottlenecks, in the context of growth theory. Hirschman suggested long ago that flexible prices provide a signal of where development would be most valuable. If steel prices are high, then investment in steel would be of high value. In this view, bottlenecks are there to be cleared. If you don’t have bottlenecks, then you don’t get signals.
It is easy to exaggerate this notion. In truth, industries may expand even though they already have excess capacity, and will not be raising prices. These are quantity signals to invest. The question is whether quantity signals alone are enough when the overall economy is too slow. Will declining interest rates tell you to invest despite some excess capacity, even though demand projections are fading at the same time as a “pause” sets in? Will quantity signals be enough to sustain investment at a level that generates equilibrium growth?
If you define equilibrium as zero inflation, the answer is probably yes. Recall that some industries, usually electronic these days, advance rapidly enough that they need to replace old capital before it begins to wear out. Thus demand would have to collapse to get this investment demand to disappear. And these same industries are generally lowering prices. This leaves room for some bottlenecks in other parts of the economy, consistent with zero inflation.
But the appropriate standard is whether demand is sufficient to utilize capacity without accelerating inflation. So, in other words, without excess credit creation. I am suggesting that investment can easily fall below levels at which this will happen. Note that it also implies reduced capacity in the future, so that a zero-inflation strategy will be forced to live within the constraints of the underbuilt capital stock. The question needs to be phrased broadly enough to encompass the issue of whether the economy is growing as fast as it can. My claim is that if no sectors are raising prices due to limited capacity, growth is almost certainly too slow. Even stronger, if more bottlenecks are being cleared than being generated, growth is probably still too slow.
Why bottlenecks? Aren’t they really proving that slack is gone? Isn’t it dangerous to push the economy so hard that it faces supply constraints, practically guaranteeing some inflation? But zero inflation is a goal only in the unrealistic world of economic theory, in which forecasts are infallible and all inflation represents an excess of monolithic, single-commodity “demand” over equally simple “supply.” In the messy world of actual investment decisions, we need a more subtle view of where inflation comes from and what policy (or at least what policy “experiments” in the Tobin-esque sense) will bring this inflation about.
Ask yourself whether, if demand suddenly doubled (all the Chinese, Japanese and European consumers suddenly began spending, instead of saving) whether there would be enough capacity to meet their demand. In the short-run, surely not. But in the long run, as we teach in microeconomics, the capacity would increase and it is possible that the doubled demand could be met. At least, ability to build factories would not be the ultimate constraint. Maybe we couldn’t train enough doctors for the resulting demand. Or enough carpenters. But maybe, we could train plenty of both, partly by adding productivity to all the service workers we have, and by convincing people to do without the ones that are easily replaced like service station attendants and bank tellers have been replaced. At any given point in time, there is probably plenty of excess potential capacity that could be met given a bit of time to build.
Inflation (not one-time price increases needed to signal for more resources) comes when the demand increase is persistently ahead of the rate at which capacity can be added across many sectors. And surely it is obvious in today’s economy that productive capacity, in the sense of physical capital, is not the constraint on the pace of growth. I propose that the pace of innovation is probably the limit today.
Isn’t it enough to have the innovation that is naturally generated by electronics and other fast-improving sectors? Isn’t other investment sufficient, if it occurs when firms are just keeping capacity ahead of demand? Maybe, but I think that vastly underestimates the innovative capacity of modern production. If there are bottlenecks, innovation will naturally be targeted at the spots in the economy that are limiting growth. An acceleration in demand that generates bottlenecks will be followed some years down the road by innovations that relieve them. The supply will naturally accommodate itself to the evolving pace of demand, but only with some pressure.
We can have a slow-growing equilibrium, with supply of funds equalling demand for them, where the demand comes only from the innovations that are most obviously profitable in a slowly evolving economy. In a different, fast-growing equilibrium, capital is allocated toward innovation that will best permit growth. In the slow-growing equilibrium, capital is allocated (at a lower interest rate) toward capacity that is under-innovative and accommodates the priorities of under-competitive oligopolies. And the cumulative under-innovation goes unnoticed, especially if all the economists have been trained to believe in the mystical power of equilibrium forces to reveal all.
Thus I am proposing that policy be deliberately aimed not at zero inflation, but at (reasonably low) inflation that is sufficiently far from price stability to avoid the situation of too few bottlenecks. It must also be sufficiently sustainable that many or most bottlenecks are being reduced by innovative activity faster than they are being increased by further stress on the overall economy. Whether this situation is possible is not yet known, but would (as the late James Tobin would have said) make an interesting experiment.
To interpret this for the situation of natural resources, it would suggest that there be plenty of quality rents, but that the pace of innovation and new capacity addition be sustained by the action of prices that are at least not rapidly falling, and probably are rising at a pace similar to the real interest rate.
Suppose we did a quick inventory of the types of resources, to see if the world economy has much slack or not.
China’s economy, bigger now than Britain or Italy, is sucking in more steel and raw materials than any other economy. That is the proximate cause of the increases in metals prices, and perhaps partly for oil price increases as well. Does that mean there is no excess capacity left in mining? Hardly. BHP and Rio Tinto are investing billions to increase mine capacity in Australia, and other locations are also expanding. The potential for expansion is significant. Remember that the issue is not current capacity so much as realizable potential capacity (and long-term sustainability of the pace of expansion).
At the same time, China is putting its formal economy into the modern world. Automobile purchases doubled last year. Obviously they cannot continue doubling forever. Equally obviously there are lots of potential automobile consumers. But how many can afford one? It depends on at what rate the country shifts into the higher gear of modern life. College graduates also doubled in the last few years. Chinese companies are competing world wide in technically sophisticated industries, not just lending cheap labor to foreign investors.
Yet the potential for expansion in China (and India) makes clear that there is no effective labor supply constraint on world production. What about skilled labor? Maybe. But education in developing countries is made cheap by the low cost of its primary input, which is the time of the learner. If you ask the question whether higher relative prices would be necessary to induce more production of educated or trained workers, it does not seem likely.
More likely the constraint is absorptive capacity. That used to be another word for effective aggregate demand. Now it has more to do with what the ability to adopt modern methods profitably. The main problem is not that labor is so cheap that labor-saving technology doesn’t pay. Outside of subsistence agriculture, nothing could be further from the actual situation. Rather, the situation is that today’s technology-intensive methods can move into any fast growing market and use a quality edge to cream off all the high end demand. This is not labor-saving technology in the sense of automating or mechanizing so much as saving on the variations and errors that creep in with straightforward mass production. As a result of this pre-emption effect of global capital, manufacturing employment is likely to grow slower than income, rather than providing positive feedback to growth. Automation of production was the engine of growth in today’s industrialized countries. Outside Mexico and China, there may be no place left in the world where this can happen again.
I conclude that the absorption of advanced economy methods is limited by the pace of opportunities for low-salaried local producers to put together income for buying modern stuff. And thus the creation of skilled labor is limited more by demand than by supply.
The other main constraint in the world today is environmental. What China is doing to its environment is criminal, even by the laws of China. We don’t really need carbon dioxide to be pouring into the atmosphere any faster. But as in the 60s, the problem is not so much overproduction as under-regulation. The environmental industry in industrialized countries is calling for pricing methods on effluents, to give manufacturers an incentive to adopt the pollution control technology that already exists. The shortage of hybrid vehicles is another example of how proper pricing could move demand quickly toward taking advantage of the technology we have. The damage to the environment should be paid for by polluters, period.
The kinship between development economics and Keynesianism is closer than even most economists realize. Much mischief has been done in the name of both, but behind this abuse is the genuine analysis of market failure. Today the world is reaching a stage where the linkage has come full circle, from closed economy macroeconomics, to development planning policy and back to world economy macroeconomics. The Keynesian insights that made their home in inward-looking development policy, mistakenly, now make sense in a world that has been globalized by the rejection of inward-oriented growth policies. By rejecting these policies, nations have forged a world labor market and a world capital market capable of the kind of rapid expansion that probably needs a government push to bring it to fruition.
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