Tuesday, May 3, 2011
Krugman on Grantham's Resources Piece
In Resources, Inflation, and Monetary Policy, Paul Krugman argues that because commodities don’t make up a large percentage of our consumption basket, commodity inflation is unlikely to have a big impact on total inflation. Thus, he argues that the Fed is justified in keeping interest rates low.
I will let you read the piece below first and then make a short comment after on the problems with his argument (as usual, the original article taken from Krugman's blog published today in the NYT contains more links and sources):
“I’ve been getting a number of requests that I say something about the implications of the widely publicized Jeremy Grantham piece arguing that we’ve entered a new era of resource scarcity.
“I’m broadly sympathetic to this view — in fact, I’ve expressed quite similar views. I am, however, much more optimistic than Grantham seems to be that we can combine a shift toward conservation with continuing economic growth.
“The immediate question I’m being asked, however, is what all this says about macroeconomic policy in the near term, especially with regard to monetary policy. And the answer is, not much — or to the extent there is a moral here, it is to keep interest rates low and focus on employment.
“Why? Well, even a long-term trend toward higher commodity prices will have surprisingly little effect on overall inflation. Suppose that we believe that commodity prices will double over the next decade — which is a lot. And that’s a rise of 7 percent a year (compounding!)
“Well, the San Francisco Fed tells us that commodities account for only about 5 percent of personal consumption:
“So that adds 7 x 0.05 = 0.35 percentage points to the inflation rate; not trivial, but not huge either. To get really big effects on inflation, you have to have big swings in commodity prices, not just an upward trend.
“Now, it’s true that we’ve just had such a big swing — and as I argued last year, that swing suggests that resource scarcity is in fact a growing concern. But it also suggests that the rise in commodity prices is driven by underlying real forces, and is not the result of Fed policy. So if anything it reinforces the case for not using commodity prices as a reason to tighten.
“Oh, by the way: for those who think that it all has something to do with the decline of the dollar, the chart I used here also gives prices in SDRs, a basket of major currencies; no big difference.
“So: over the next decade or two I do think that resource scarcity will have major effects on the economy. But it’s an issue for the Department of Energy and such to worry about — not the Fed.”
Should we believe this narrative? There is nothing untrue about the explanation except that it is misleading. Even if commodities only make up 5% of our average consumption expenditures, for the average worker this percentage is likely to be much higher. This in turns means that workers are more likely to demand higher wages to be compensated for their higher costs of living. Granted, the labour markets are weak now and will probably remain weak for a while.
However, in a few years from now, these pressures will start to rise. These pressures on wages will likely coincide with the increase in the percentage of commodity expenses in our total consumption expenditures. Why? Because if the price of food and energy rise at 7% a year while the prices of other goods remain relatively stable like Krugman assumes in his example, it is only normal that the percentage of commodity expenses in our total expenses becomes larger and larger as times passes.
Moreover, the price of commodities is also imbedded in the price of intermediate goods. For instance, gas is not only used by consumers when they are driving their car but also by companies using gas to deliver goods and to produce manufacturing products. The same goes for other commodities, like metals, used in the production of final goods. Large and rapid price increases in intermediate goods will unavoidably be passed to consumers and eventually contribute to inflation.
Now let's assume that these intermediate goods (energy, metals and food) also represent today 5% of the other 95% of non-commodity goods we spend money on. In total, this gives our consumption basket a direct and indirect exposure to oil/gas and crops of 10%; rather than only the 5% asusmed by M. Krugman. And as these prices rise relatively to other prices, it is only logicial that this percentage will grow over time to represent a higher proportion of our consumption basket. To be very conservative, I'll assume that this proportion grows to 14% over the next five years.
Using the same calculation as M. Krugman, we get 7% annual inflation x 14% commodity exposure which yields 1% extra inflation; triple the amount of extra inflation which Krugman generated with his simple back of the envelop simulation. In sum, although in theory we might only get less than 0.5% extra annual inflation at first, this number is likely to grow as the years pass by and surpass 1% within just a few years.
And remember that this extra inflation only represents an average. If you are at the bottom of the pay scale, it may be much higher. After a few years, you may have endured a severe deterioration of your purchasing power which will only worsen exponentially every year after that. In other words, a sustain increase in commodity prices is a reciepe for disaster in the making. And unfortunately, trusting M. Krugman's soothing stories is only going to make it worse.
Update: I realised today that I should have given you the link to my blog entry about Grantham's resources piece, entitled "Jeremy Grantham on Resources" referred to in the title on this entry. Sorry about the inconveniance.