Price Level Shocks, uhm, Screwed Up Relative Prices, and Organization
2 March 2010 at 2:29 pm cpirrong 3 comments
| Craig Pirrong |
Peter’s post on the relation between inflation, vertical integration, and markets brings a couple of other thoughts to mind.
First, and most importantly, the number and characteristics of markets are endogenous too, and respond to changes in the amount of uncertainty in the environment, including the amount of uncertainty resulting from monetary shocks that (in Sherwin Rosen’s unforgettable in-class phrase) “f*ck up relative prices.” In particular, the number and variety of futures markets depends on the amount of uncertainty. The big boom in the creation of futures markets in the 1970s corresponds with, and was arguably caused by, the coincident inflation of that period, and the associated volatility in relative prices.
Second, although Peter’s point, and previous research, focuses on the implications of inflation on organizational choices and market vs. firm choices, in the current environment it is worthwhile pondering the implications of deflation. Certainly we have more research on the effect of inflation on the variability of relative prices due to our more recent inflationary experiences, and this was a major source of concern about inflation among Austrians, but the current situation makes it worthwhile to consider the effects of deflation on the pricing system, and firms’ responses to that.
Perhaps an examination of Japanese experience since 1990 would be worth some in-depth analysis.
Personally I am torn as to whether inflation or deflation is the greater risk in the near to medium term. The huge monetary overhang in the US and around the world (resulting from quantitative easing and other extraordinary monetary policies), and the inability of the Fed to commit credibly to drain reserves from the system when money demand picks up make me believe that it will be hard to avoid a burst of inflation. But all current indicators point to flat or declining prices.
It is hard to see things ending in a Goldilocks moment — just right. Thus, it is likely that that there will be a shock to prices generally, arguably a large one, and that this will disrupt relative prices for a variety of reasons. (Including, notably, the very likely case where these price level shocks lead to government policy interventions that distort relative prices.)
Thus, Peter’s research program may be rejuvenated, courtesy of the Fed, ECB, the Chinese Central Bank, etc. It is indeed an ill wind that blows nobody any good.
Entry filed under: Austrian Economics, Bailout / Financial Crisis, Financial Markets, Former Guest Bloggers, New Institutional Economics, Theory of the Firm.
Organizations and Markets 
1.
srp | 2 March 2010 at 9:03 pm
The peculiar thing from a policy point of view is that a monetary expansion pursued in a guaranteed-to-be-neutral-on-relative-prices way would have no effect on output and hence would be pointless. If the Fed just renumbered everything (say $1 is now called $2) all relative prices would be constant but I don’t think there would be much if any behavioral impact. It is precisely the non-transparent relative price signals that give conventional monetary policy its demand-increasing kick.
2.
David | 3 March 2010 at 1:04 am
“The big boom in the creation of futures markets in the 1970s corresponds with, and was arguably caused by, the coincident inflation of that period, and the associated volatility in relative prices.”
The technology shock of the BSM pricing model may have had greater impact than inflation.
3.
Pietro M. | 3 March 2010 at 4:18 am
The reason why present expectations of deflation and inflation seem to be volatile (mid 2007 – mid 2008: inflation; mid 2008 start 2009: deflation; start 2009 – now: inflation, albeit more moderate than two years ago) may have something to do with Austrian capital theory and the state of financial markets.
If aggregate demand is expanded in the present of binding production constraints (at the end of the boom), prices must go up. In standard ABCT accounts, if the policy keeps on, hyperinflation will sooner or later occur.
On the other hand, if a negative shock hits the monetary transmission mechanism, i.e., the banking and shadow banking sectors, credit must be destroyed and prices must fall, which is often called a secondary depression.
In the last two years, we have both had binding production constraints and financial malaise. The two things are not independent: if aggregate demand policies succeed the former will bid up prices; if they fail, deleveraging will accelerate.
I would give a 50% chance to the two outcomes.
As far as I can tell, Japan has failed to experience a stagflation only because it didn’t avoid a contraction in the credit pyramid. There is some literature on the fact that the BOJ was not serious in reinflating, despite the zero policy rate. Policies can always turn a deflationary crisis into an inflationary one, as long as banks are not totally broke. What they can’t do is avoid binding production constraints forever.
PS PPI is skyrocketing again (although less than +15% yearly like two years ago). CPI is on the rise, although the last data has been flat. If CPI/PPI is a proxy for returns on investments, the recovery is already losing steam.