Wednesday, December 26, 2012

Can someone help me understand this?

In Microfoundations and Macroeconomics, Steve Horwitz writes: "Inflation... also leads to a capital structure that is not sustainable. This unsustainability appears in two ways. The first, as we have just discussed, is that the heightened instability in prices caused by inflation leads to a greater amount of (ex post) mistaken plan revision by entrepreneurs. Inflation embeds more errors into the capital structure at any one point in time precisely because entrepreneurs have more difficulty making use of monetary calculation and making wise decisions about capital and labor usage."

So earlier he discusses (and maybe this isn't the "we have just discussed" he is referring to, but I'm not sure) the fact that even if an entrepreneur knows the inflation rate, he does not necessarily know what's happening in his "corner" of the market, and so the exercise is more complicated than simply accounting for a headline inflation number (it's true, BLS produces geographic and industrial disaggregated price level figures, but the point still stands).

This is fine.

What I don't understand is why this is more likely with inflation than without inflation. If we take this "corner of the market" viewpoint, even at zero inflation you're going to have health, education, and certain other sectors growing a lot faster and heavy manufacturing, agriculture, etc. growing a lot slower. Plus different parts of the country will be performing differently. That variability is there even if inflation is consistently zero percent. I could imagine the variance of prices might increase with inflation, but at sub-hyperinflationary levels I wouldn't think that's really the case. He specifically cites the signal extraction literature elsewhere, and that usually preserves this constant variance assumption which I think is a pretty safe one at most inflation rates.

What am I missing here? Why does inflation embed "more errors into the capital structure at any one point in time". I get why price instability would do that. I don't get why price inflation would do that.

I do not think this one has anything to do with standard ABCT roundaboutness stories because that is the second point that he goes into after this point.


  1. Unless he means inflation is unstable, but so is deflation and even price stability, so unless his comparison is a stationary economy, he could as well replace inflation with growth having the same effect.

  2. He is confusing sub-optimal and unsustainable. Even in the face of uncertain inflation, the capital markets carry on under a wide range of expectations and outcomes. Inflation generally and uncertain inflation in particular will lead to portfolio choices which will not generally be optimal.

    It is conceivable that under some labor market conditions and tax regimes a known fixed inflation rate of, say, 2% per annum will lead to optimal capital allocations given the other constraints on the system.

  3. The counterfactual is productivity norm, not zero price-level inflation. Under that circumstance, higher prices observed really do reflect differences in scarcities. The deflation that takes places under the productivity norm even reflects differences in relative scarcities. Once you have price level inflation greater than what is demanded of the productivity norm, changes in prices may or may not reflect the underlying changes in relative scarcities that are important for entrepreneurs' plans.

    The higher the rate of price level inflation, the worse these issues get (unless the economy is contracting, in which case the productivity norm probably demands positive price-level inflation).

    This can be mapped to the Hayekian triangle and the capital structure, but I don't think that's what you are asking.

    And yes we are assuming away the money illusion for the most part.

    1. re: "Once you have price level inflation greater than what is demanded of the productivity norm, changes in prices may or may not reflect the underlying changes in relative scarcities that are important for entrepreneurs' plans."

      But all you need is a price level statistic and a productivity statistic (presumably the same things you'd need for entrepreneurs to know they're at the productivity norm!). I'm not sure this makes sense. He seems to be referencing both price stability and price inflation, and even if our target was the productivity norm, I don't see why we should expect prices to be more stable with that target.

    2. Think of it this way Daniel: entrepreneurs in an economy without monetary inflation have to deal with all of the price changes coming from all of the real factors. That's one challenge - what, if anything, do changes in my input prices or the price for my output mean, and what, if anything, should I do about them. Now assume some monetary inflation. It also causes prices to change in ways that challenge entrepreneurs - now they have to not only interpret if there are any real changes that require action, they also have to separate the real factors from the inflationary ones.

      Given the Cantillon effects story (you should revisit that post of mine that you agree with), just looking at aggregate statistics will not be enough. Entrepreneurs face a much more challenging epistemic environment and there are, therefore, more likely to make errors, and those errors cannot in all cases be costlessly reversed, causing them to be "embedded" in the capital structure as malinvestment.

    3. Right but as you point out earlier in the book, even with a given level of monetary inflation (say, zero - no monetary inflation) that does not mean that different things aren't happening in different "corners" of the market. So I'm not understanding how they escape dealing with those worries.

      Your whole point, earlier in the book, was that one single headline inflation number conceals variable nominal fluctuations in different corners of the market.

      Surely if one percent headline inflation can come with two percent in one corner and zero percent in another then we can expect zero percent headline inflation to come with one percent in one corner and negative one percent in another.

      I guess to make this simple, are you saying that the variance of nominal changes is a function of the level of nominal changes and it is zero when nominal changes is zero? That seems to be what you have to be arguing but I don't understand why that has to be true.


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