Larry Kudlow's Strange Views About Inflation

This article was first published by me on Talkmarkets:

Larry Kudlow, well known economic pundit, for years on CNBC, has unusual views regarding inflation. Through a Forbes article, we see that he spoke to the Heritage Foundation and said this:

Inflation is a devastating tax on savings. But low inflation is a tax cut. By enhancing the value of financial assets, price stability rewards patient savers and investors. It is a stimulant to capital formation, new business start-ups and growth. Growth does not cause inflation, low inflation causes growth.
That does not seem quite right. After all, when there is growth, auto prices go up, and when growth is slow, there are discounts and rebates on houses. The same sort of thing works for homes. The builder throws in upgrades that normally cost extra, and if that doesn't work, the price of new homes trend lower.

Kudlow is right about inflation being a tax on savings over time. It certainly hurts those on fixed income if the COLA's do not exceed the inflation. And manipulation of cost of living indexes almost insures that COLA's do not help as much as they should.

But low inflation has not exactly driven massive growth, and Kudlow would have a hard time making that case. In discussing this issue it is necessary to define the natural rate of interest as a neutral rate, where gluts don't appear and shortages don't appear. If rates are too low, shortages of real products appear. If rates are too high, an overabundance of real products gluts the markets.

However, in credit, in the price of credit, the central banks set the rate of interest. It is hard to know if they are getting that rate right. Will credit be too abundant or too tight. Certainly the natural rate of credit being lower than the Fed 's fund rate will cause big problems.

 As I wrote on a personal blog post:

[David] Beckworth shows us a study done by MIT,  Harvard and U.C. Berkeley by economists Caballero, Farhi and Gourinchas, which shows that central banks cannot push natural rates (r*) too far negative. The article is titled Safe Assets and Aggregate Demand. The failure of central banks to push rates lower results in an interest rate gap emerging, which will cause output to fall below its potential. This impact on aggregate demand has slowed the normal business cycle. By the way, the economists say that physical assets are simply not safe assets. 
Slow growth is the by product of negative natural rates. Certainly it is causing upheaval in Europe. And an upheaval of sorts in the US with the election of POTUS Trump, is forcing the Fed to try to raise rates under conditions in which revenue is dropping for the US Treasury. This raising of rates appears to be a potential drag on growth, but so is letting the natural rate drop below zero. It seems that Fed is boxed in. 

Therefore, once you get to a natural or neutral rate that is negative, the shortages of money replacement in the money markets, such as bonds and repos actually cause fewer transactions to be done, and slower growth to manifest.

And Wicksell took the opposite position to that of Larry Kudlow:

Central banks pay implicit homage to Wicksell. Their models, for instance in this paper by Thomas Laubach and John Williams, assume the existence of an equilibrium real rate of interest that keeps the economy operating at potential. Keep the actual rate below the equilibrium rate, and the economy speeds up, eventually generating inflation. Keep it above, and it slows down, eventually tipping into recession. 
But how does this work for households? They are not as concerned with the interest rates as they are their ability to pay. If they believe their household income will not grow that much in the future they won't go into as much debt now unless they are slammed with economic distress. If they believe their household income will robustly increase they may borrow more now. But we can see that raises have not kept pace since the turn of the century.

We  cannot expect people to spend more now, regardless of how low the Fed sets interest rates. They don't see much upside for the future with regard to income growth!

So, on the supply side, we have low rates being a drag on deals and loans. And on the demand side, we have a consumer who is wary. You can't make people borrow money. For many people, it just isn't fun to borrow anymore. And it is to the bankers' peril not to understand this truth.

This is why on the supply side, we have to apply financial easing to everyone. Poor people need to be subsidized. Middle class people need to brunt of the tax breaks. Otherwise, supply side economics changes little at the household level. Ronald Reagan was quite aggressive in cutting taxes for the lower classes unlike we see in current plans which will give most tax cuts to the wealthy.

So, Larry Kudlow appears to be doing a slight of hand. His quote is dead wrong if you are bouncing around below zero for natural rates. So, truth is: 1. Inflation that is too low stunts growth. 2. Growth stimulates inflation. That is normally the way things are and Kudlow has flipped the truth on its head.

The author of the Forbes article above makes the case for Kudlow this way:
The very notion that growth causes inflation is laughable. Figure that the first laser printer cost $17,000, the first mobile phone $3,995, the first calculator over $400... What this tells us is that economic growth is the greatest enemy inflation has ever known. 
But except for new inventions and products hitting the market for the very first time, this statement by the Forbes author, John Tamney, is patently false. Most products are resold over and over. Few products are new technology, new invention. Growth causes inflation, over all. That is fact. And it is troubling that Larry Kudlow or anyone else would think otherwise.

There is much more that Tamney writes about in the Kudlow article. Most of it is too generalized. For example, yes, he is right that the housing crash alone did not cause the Great Recession.

But, I am of the view that the housing crash in subprime did cause a Fed tightening between mid 2007 and mid 2008, and that the subprime crisis was financed by a commercial paper market underwritten by the TBTF banks. When that market crashed, the Fed did nothing to save the CP market, causing the bad loans to be pushed from the SIVs back onto the balance sheets of the banks, which caused the Great Recession.

I am also of the view that the housing crash did cause the Fed to choose between saving the paper and letting main street be destroyed in order to save the banks another way, by IOR.

Growth does not have to cause massive inflation. But it can and will cause some inflation. It can cause asset inflation, if not wage inflation. Perhaps that is what Kudlow wants, an unbridled growth sans wage inflation that will not be sustainable. Don't count on the millennials to participate. They know housing bubbles cannot last forever. And bankers detest them for knowing that truth.

We should all be concerned about what is going on inside the mind of Larry Kudlow and his supporters and fans.


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