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Sunday, September 23, 2018

Primer: Understanding The Post-Keynesian Rejection Of Mainstream Inflation Theory

From the perspective of conventional economic analysis, the post-Keynesian approach to inflation is mystifying. If we focus on the Modern Monetary Theory (MMT) school of thought in particular, it is very easy to either find claims that "MMT has no theory of inflation," or non-MMTers "explain" the MMT inflation theory is some random trivial relationship that they just made up. The key to understanding post-Keynesian approaches is that it takes a completely different approach to understanding inflation, and outcomes are seen as very difficult to forecast.

This article is based on Section 8.1.1 ("The Rejection of the Acceleratoinist Thesis") of Professor Marc Lavoie's excellent Post-Keynesian Economics: New Foundations (link to my review). From the perspective of a non-academic, a significant portion of the book would likely be found as arcane, and could easily be confusing to a non-specialist. However, Section 8.1.1 is extremely straightforward, and the most difficult part of my writing task here is staying within "fair use" copyright limitations when describing it...

(Since I raised the issue of MMT earlier, I cannot say whether there are any major disagreements between MMTers and Lavoie's description of post-Keynesian thinking on inflation. My feeling is that there is nothing that a non-academic would get too excited about, other than the importance that MMT ascribes to the Job Guarantee wage in stabilising inflation. For the analysis of a country without a Job Guarantee -- currently, all of them -- this distinction has no practical import.)

Setting up a Mainstream Straw Man

One of the problems with post-Keynesian thinking is that it largely seems to be defined in a negative fashion: it appears to be just a random set of complaints about "mainstream" economics. Although I would prefer to avoid developing the discussion this way, it seems to be the best way forward in this circumstance. I have been writing and reading economic commentary produced in the financial markets as well as the internet for a very long time, and I would argue that there is a certain "conventional" world view that is widely shared by writers and readers, even if they do not qualify as "mainstream." I think it is best to confront these conventional views directly by setting up an overly-simplified version of the thinking -- a straw man -- and then explain what parts of the straw man view are viewed as completely out-of-paradigm. (Please note that my discussion in this section is not based on Lavoie's text; I return to his logic later. Another note is that this discussion applies to inflation theories, as a practical matter, even "mainstream" economists are closer to where I am on the matter.)

When I get around to writing a text on competing inflation theories, I will then run through the various variants, and give them an honest critique. For now, I just want to re-orient the discussion in a certain direction.

A fairly typical mainstream approach is to build models around transactions between agents with an endowment of goods/resources (including labour power) at a point in time; "dynamics" are allegedly introduced by introducing forward markets. Prices are (somehow) determined for this vector of goods/resources simultaneously, and then agents act (work/consume) based on maximising utility based on that vector of prices.

The next step is to lump all non-financial goods/resources into two buckets: labour, and an aggregate good. Therefore, there are two real economy prices that matter: the wage rate, and the aggregate price level (there are financial prices as well, such as the price of Treasury bills, as well as money, which is defined to have a price of 1).

We then engage in various arguments to arrive at the conclusion that wage rates are related to the marginal productivity of labour (in terms of the aggregate good), and so we only have one real economy price that matters: the money cost of the aggregate good.

If we step away from theory, economists decide one particular price index is "the" price level of the economy, and so it is equivalent to the money price of the aggregate good in economic theory. Inflation is the rate of change of this aggregate price.

(The exception to the conventional wisdom would appear to be Austrian economists, who have an aversion to aggregating the price level. Instead, they seem to define "inflation" as the change in the money stock, which may or may not be related to changes in the measured CPI. Since Austrian economics is now largely a financial markets and internet phenomenon, it's hard to give a clean theoretical summary.)

We can now define what inflation theory is: the theory that allows us to predict the changes in some price index, which I will refer to as the consumer price index (CPI) here for simplicity. Everyone scurries off in various directions at this point, but the usual result is that there is an attempt to slap together a reduced form model (that is, computationally tractable) that allows us to forecast the change in the price level, based on a few economic time series.

It should be underlined that practically everyone does this (including me, in my earlier life). For example, it is not hard to find physicists who opine on economics on the internet that build models that assume that there is a reduced form relationship between other economic variables and changes in the CPI; finding that reduced form model is just doing empirical work!

The post-Keynesian rejoinder is: not so fast.

Rejecting Reduced Form Models

It would be an exaggeration to say that post-Keynesians reject all reduced form models, rather they reject pretty well all the ones that the mainstream has proposed.

The first set of objections is anything based on the money supply. Marc Lavoie, on page 541:
In post-Keynesian theory, the level of the money supply does not determine the level of prices; nor does the rate of growth of the money supply determine the rate of inflation. Excess money or monetized government deficits are not a proximate cause of inflation, not even in the case of the German hyperinflation of the 1920s, as argued by Burkedin and Burkett (1992) and Wray (2012, pp. 246-57), nor in the case of the 'Great Inflation' in England in the 1500s, usually attributed to gold discoveries (Arestis and Howells, 2001-02).
We can then go after NAIRU (page 542):
... post-Keynesians reject the concept of the natural rate of interest, and they have very little faith in natural rate of unemployment or the NAIRU.
He quotes Wynne Godley (from the compilation Keynes and the Modern World, published in 1993, page 170):
Indeed if [emphasis in original] it is true that there is a unique NAIRU, that really is the end of discussion of macroeconomic policy. At present I happen not to believe it and there is no evidence of it. And I am prepared to express the value judgment* that moderately higher inflation rates are an acceptable price to pay for lower unemployment. But I do not accept that is a foregone conclusion that inflation will be higher if unemployment is lower. 
Conventional economists have an extremely wide range of variants of the notion of excess demand beyond the notion of the NAIRU, including concepts like the output gap (which can be operationally defined in many ways). From their perspective, all of these concepts are extremely different, although I am not very convinced that they are distinguishable. I am not going to put words into Lavoie's mouth and say that there is a blanket rejection of every such possibility, but I personally would argue that they are all fairly hopeless.

Within mainstream economics, there is an unorthodox school of thought known as the Fiscal Theory of the Price Level (FTPL - a primer). (The Lavoie text does not discuss the FTPL in Section 8.1.1.) As Professor John Cochrane argues, if mainstream economists actually believed the mathematics behind their Dynamic Stochastic General Equilibrium (DSGE) models, they would end up at the FTPL. The logic is sound. Unfortunately, the FTPL is an intellectual horror show: the price level is determined by the discounted value of all primary fiscal surpluses going out on an infinite horizon. The catch is that the only way to measure the value of discounted surpluses is to assume the FTPL is true, and back it out based on the observed price level. The theory is non-falsifiable, and so one could argue that it is correct (in some sense); it only has the minor drawback that we cannot make any predictions with it.

We are then left with the grab-bag of random reduced form models that analysts with access to a time series database and econometric software have churned out. Confronted that mess of internally inconsistent models is well beyond the scope of any individual. However, I would argue that it is safe to reject them based on a loose adaptation of the efficient market theory: if the models actually were reliable, we would hear about them.

What Works?

The message from Lavoie's text is rather scary from the perspective of anyone trying to build an inflation model (page 542):
What then is the basis of the post-Keynesian theory of inflation? Post-Keynesians argue that the 'economy is primarily a money-wage system' (Weintraub, 1978, p. 66). The money wage is the exogenous factor [emphasis mine] explaining the price level that the orthodox authors have sought. As Robinson (1962, p. 70) said. 'in our model, as in reality, the level of the money-wage rate obtaining at any particular moment is an historical accident.'
To anyone familiar with economist jargon, that is like a live hand grenade. I will work through the implications of that short passage for those who are less familiar with academic economist-speak.

The argument is that nominal wages are most important (a "money-wage system"). The catch is that it is an exogenous variable -- a variable that is determined outside the model. You cannot model the wage rate within a mathematical model, since it is an input to the model. 

So imagine that your boss tells you to come up with "an inflation model" for some country (which is a pretty common demand for employees of central banks or investment firms). According to post-Keynesian theory, the "correct" answer is to respond that inflation is an historical accident**. However, I must point out that the theoretically correct answer is also an extremely career-limiting one, so any employee stuck in that particular situation needs to figure out what their superiors want to see, and give them exactly that (even if the model stinks).

Future articles will delve further into the post-Keynesian description of how wages relate to the measured aggregate price level. However, the key takeaways are:
  1. The relationship between wages and the CPI is complicated.
  2. Wage inflation is dependent upon economic institutions and convention.
In other words, do not expect a cute little regression model (or whatever) between three or four economic time series and CPI inflation to work.

Aggregation Aggravation

I will conclude with another attack on reduced form inflation models, which is based on my own personal experience as an analyst than what I have seen in the post-Keynesian literature. I have no idea how what I am writing fits in with the existing academic theory. (To what extent it might fit in with existing theory, it might be more Austrian theory, which might cause some of my regular readers to faint.)

I see very little value in assuming that aggregate price levels have useful theoretical content. To be clear, aggregate price levels obviously exist, and can be measured. (If one rejects that they can be measured, one will have a very short career as an index-linked bond analyst.) Rather, my point is that since we are lumping together unrelated things, we should not expect the aggregate to follow any reduced form model in the first place. If we are going to apply reduced form models to inflation, we would need to apply them to the components of the CPI index separately.

Although such an assertion would give some academic economists the vapours, it would not be a surprise to inflation-linked market practitioners: that is exactly what they are already doing. Moreover, central bank analysts will do such decompositions when they are preparing detailed inflation forecasts, and such central bankers are mainstream almost by definition. The issue is that this approach coexists uneasily with mainstream theory.

We need to forecast CPI inflation component by component.
  • What will cause the price of oil to move? If a cartel of oil producers decide to jack up the global price of oil, the domestic price of oil will move with it (translated to local currency).
  • Food commodities are also flex-price markets, driven by varying factors. If those prices were easy to forecast, grain trading would be an easy way to millionaire-hood.
  • Imported goods are sensitive to the exchange rate, which is similarly hard to forecast.
  • Some prices are administered, such as the ever-rising cost of tuition.
  • Other goods and services have varying input costs associated with them -- labour, rent, energy, etc.

For each of these components, the reduced form model will vary greatly. For example, even if you think inflation expectations are really important for the determination of inflation, the expected CPI inflation rate in Australia is going to mean diddly squat for the global price of oil.

Concluding Remarks

Beware reduced form inflation models.


* "Judgment" is (or at least was) the preferred British spelling, and is used in Canada in legal contexts. So it should be fine to write the sentence "In my judgement, the judgment in the case was incorrect," in a Canadian spelling test.

** North Americans would probably prefer "a historical accident."

(c) Brian Romanchuk 2018


  1. These are what I understand to be some of the mainstream causes of inflation. Many overlap. Unemployment falling below 'their' continually revised estimated NAIRU level. Too loose monetary policy. Too expansionary fiscal policy. Government deficits in general. Expectations of future inflation based on previous inflation. Money creation by the government or central bank. Falling exchange rates in forex markets. Sales tax increases. Import restrictions and tariffs. Unions, increased minimum wages, labor regulations, or really anything that might allow workers to increase their nominal and real wages except for productivity growth.

    It is hard to believe that anyone would criticize MMT inflation theory as opposed to this assortment of ideas. I guess I am continuing the 'random set of complaints about mainstream economics'.

    1. Some of those - sales tax increases - are related to my comments on decomposing inflation into components. As I noted, this is already the standard in the financial markets, hence they show up in news reports when bank economists are interviewed by the financial press. So I do not see too much of an issue with the fact that news stories have a whole bunch of different factors popping up; they should.

      And to be fair, central banks also work with decomposing CPI in practice, even though that is somewhat in conflict with their theory wing.

      My “mainstream straw man” is more the academic theory side of things, which snorts at decomposing CPI in this way.

  2. Economics as tireless production of proto-scientific toilet paper: inflation theory as an example
    Comment on Brian Romanchuk on ‘Primer: Understanding The Post-Keynesian Rejection Of Mainstream Inflation Theory’

    Economics is a failed/fake science or what Feynman called a cargo cult science. The four main approaches ― Walrasianism, Keynesianism, Marxianism, Austrianism ― are mutually contradictory, axiomatically false, materially/formally inconsistent, and all got profit ― the pivotal concept of the subject matter ― wrong. The pluralism of provably false theories is evidence for the representative economist’s scientific incompetence.

    After 200+ years, there is still no such thing as a valid profit-, employment-, or inflation they, there is always a whole bunch of theories/models and everyone is free to pick the one that suits him politically. This guarantees that economics remains what it is since the founding fathers: a brain-dead talk-show.

    Brian Romanchuk gives a vivid description of how economists produce their proto-scientific junk: “So imagine that your boss tells you to come up with ‘an inflation model’ for some country (which is a pretty common demand for employees of central banks or investment firms). According to post-Keynesian theory, the ‘correct’ answer is to respond that inflation is an historical accident. However, I must point out that the theoretically correct answer is also an extremely career-limiting one, so any employee stuck in that particular situation needs to figure out what their superiors want to see, and give them exactly that (even if the model stinks).”

    This characterization of the representative economist fits the definition of a pseudo-inquirer: “A genuine inquirer aims to find out the truth of some question, whatever the color of that truth. ... A pseudo-inquirer seeks to make a case for the truth of some proposition(s) determined in advance. There are two kinds of pseudo-inquirer, the sham and the fake. A sham reasoner is concerned, not to find out how things really are, but to make a case for some immovably-held preconceived conviction. A fake reasoner is concerned, not to find out how things really are, but to advance himself by making a case for some proposition to the truth-value of which he is indifferent.” (Haack)

    There is no use to untangle the multiple idiocies in Brian Romanchuk’s treatment of inflation theory. What has to be done is to replace his blather by the scientifically correct approach.

    In order to go back to the basics, the elementary production-consumption economy is for a start clearly defined by three macroeconomic axioms (Yw=WL, O=RL, C=PX), two conditions (X=O, C=Yw) and two definitions (profit/loss Qm≡C−Yw, saving/dissaving Sm≡Yw−C).

    Money is needed by the business sector to pay the workers who receive the wage income Yw per period. The workers spend C per period. Given the two conditions, the market clearing price is derived for a start as P=W/R (i). So, the macroeconomic price P is determined by the wage rate W, which has to be fixed as a numéraire, and the productivity R.

    The average stock of transaction money follows for a start as M=kYw, with k determined by the payment pattern. In other words, the quantity of money M is determined by the AUTONOMOUS transactions of the household and business sector and created out of nothing by the central bank. This, to begin with, kills the commonplace Quantity Theory of inflation.#1, #2

    The market clearing price is given in the general case with the macroeconomic Law of Supply and Demand P = (rhoE)*(W/R) (ii), with rhoE≡C/Yw.#3 An expenditure ratio rhoE greater than 1 indicates credit expansion = dissaving, a ratio rhoE less than 1 the opposite. In the initial period rhoE=1, i.e. the household sector’s budget is balanced. The ratio rhoE establishes the link between the product market and the money/capital market.

    See part 2

    1. Re: your pseudo-enquirer comments. I take it that you’ve never held a job in the real world. I don’t want some young idealist fool having their career ruined because I told them how to act in a perfect world.

  3. Part 2

    Now we have: deficit spending, i.e. rhoE greater 1, yields a price hike. If deficit spending is repeated period after period the price remains on the elevated level but there is NO inflation. No matter how long the household sector’s debt increases, there is NO accelerated price increase. The same holds for the government sector.#4

    The macroeconomic Law of Supply and Demand makes it clear that inflation only occurs if the wage rate W increases in successive periods faster than productivity R. This can happen at ANY employment level. It is NOT a precondition that employment is close to the capacity limit. This is merely a false interpretation of the Phillips curve.#5

    The explanation for the fact that inflation in the USA is since some time below the FED’s target value of 2 percent is that the rate of change of the average wage rate has been lower than the rate of change of average productivity. Things become a bit more complex, of course, when foreign trade, investment etcetera is taken into account. This does not change the fact that the core of inflation theory is given with eq. (ii). This tiny equation fully replaces Brian Romanchuk’s gigantic roll of proto-scientific toilet paper.

    Egmont Kakarot-Handtke

    #1 Inflation: back to basics

    #2 Attention: there are THREE types of inflation

    #3 Wikimedia, Macroeconomic Law of Supply and Demand

    #4 MMT was right all along: Gov-Deficits do NOT cause inflation

    #5 NAIRU, wage-led growth, and Samuelson's Dyscalculia

  4. Hi thanks.
    Can I ask how commodity market prices such as oil and many others affect the perspective/understanding about *price* (I’m not saying it must—nominal means nominal no matter what else can be said?) when prices appear to come from diverse speculative/hedged markets. My sense is that the appearance of ‘natural’ in economics means nothing much at all, tho price still may come across as real (like use value) in some way. I’m not an economist so I’m trying to make sense of this as an alien.

    1. I’m not sure I grasp the some aspects of the question, but I will try to answer it. Feel free to ask follow up questions if I missed the mark.

      There is a split in economics in how prices are thought about.

      For mainstream” economics, the ways in which prices are determined in commodities/financial markets is the ideal case, and the idea is that other prices ought to be set in the same way.

      The post-Keynesian view is that financial/commodity markets are an exception (called “flexprice markets”), most prices are administered. As an example that hits close to home, I set my book prices based on my guess of what best accomplishes my goals. Unfortunately, my books are not high volume sellers, but even if for higher volume retailers, pricing decisions are heavily determined by the decision of the seller, not an intersection of supply and demand curves.

      As for use value determining prices, that seems to be more associated with older schools of thought. I came into economics as an applied mathematician who worked in finance, and no formal training. I am familiar with modern schools of thought, but not the person to discuss older theories.

    2. Thank you. That is very helpful.

  5. Buffer Stock Schemes

    The supply and demand curves are a mathematical model which attempts to describe how prices shift based on changing perceptions of shortage or surplus. The government would have to intervene in markets to limit the swing in prices to keep them from fluctuating when natural and market events would cause wide fluctuations.

    1. Interesting video but I think it would not really apply to the MMT Jobs Guarantee proposal when implemented by a currency issuing government. I mean its not really like the government would be putting people in warehouses until someone wanted to purchase their labor. Commodities in warehouses impose only costs (at least storage costs) and are otherwise completely useless until they are actually used. JG labor would be doing something for someone, I mean someone would have to be benefiting even if it was really only the person who signed up for it.

    2. Here is a link to a 15 page paper by PK authors discussing the economic and political problems of buffer stock employment (BSE) and employer of last resort (ELR) models:

      Hyman Minsky uses a similar analysis based on Kalecki's profit model to propose automatic fiscal stabilizers in his book Stablizing an Unstable Economy. I am aware that he proposed ELR programs but do not recall a discussion of BSE or ELR models in that book. No one seems to discuss his model of inflation there which argues, in addition to other claims, that a shift in the aggregate wage bill from consumption goods to investment goods production will drive inflation in consumer goods prices. Minsky argues that the government must be ready to force a surplus via automatic tax policy to curb inflation although MMT does not seem to agree with this analysis.

    3. I really did not need to read these guys to know that 'the capitalist class' would be opposed to the Job Guarantee. Kalecki was not discussing a JG in any event- I think he was talking about more typical government stimulus that increases demand for the already employed just as much or more than for the unemployed. That is not hiring off the bottom as a JG would do.

      The paper is more a statement of what is politically possible in the opinions of the authors than what the economic effects would be. I am pretty sure such opinions were stated about ending slavery, Social Security, Medicare, Obamacare and a variety of other issues as they were being considered.

    4. As I recall the political argument is not the only argument in the paper. Buffer stock models are part of the PK school of thought. I find them helpful to understand inflation in the rich context of component by component inflation where excess capacity, excess inventory, and lack of finance should generate deflation whereas low capacity, low inventory, and easy finance should generate inflation either on a micro level or a macro level. Warren Mosler as advocate of MMT uses buffer stock models to describe how the government can set a price floor under anything in the economy such as labor with a Job Guarantee. To my knowledge he does not say exactly how the government should uses taxes as an automatic stabilizer to curb inflation when buffer stocks are in shortage rather than surplus in the whole economy which was a research project of Hyman Minsky.

  6. Joe Leote, Jerry Brown

    You are obviously deep in the woods. The issue is inflation theory, but now you are at employment theory. The former has already been treated above, for the later see

    Keynes’ Employment Function and the Gratuitous Phillips Curve Disaster

    Essentials of Constructive Heterodoxy: Employment

    It would be a good thing if economists could get economic theory right before they pester the world with their brain-dead policy proposals: “In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum) … or senseless blather.

    Egmont Kakarot-Handtke

  7. This comment has been removed by the author.

  8. There is also the "structuralist" approach to inflation. I have yet to figure out whether the "Structuralists" of this approach are the same "Structuralists" as those mentioned as such in the PK monetary debate of "Structuralists vs Horizontalists". I am talking about scholars like Lance Taylor and Celso Furtado.

    There seems to be a significant overlap (as long as these Structuralists are not the same as the PK ones) with PK in their explanation of inflation. They argue that (especially in developing economies) most prices are administered/mark-up and can therefore be decomposed into factor cost + markup. In this setting the starting point for inflation is a change in an "important price" e.g exchange rate, the price of a key input or the wages, which feeds into the cost component of a markup price and being "important" is transmitted to most prices in the economy.

    Inflation is then the result of distributional conflict between workers and capitalists who in an attempt to increase/maintain their share in output propagate the price increases in a continuous fashion. The money supply growth is seen as endogenous in this setting which is also a point made by other PK's.

    1. Hyman Minsky includes finance in the structural model and uses the Kalecki-Levy profit identity. Capitalist output in a closed economy with no government consists of spending for consumption goods C and investment goods I. The wage bill paid is WC + WI to pay workers in the two categories. Profit is the markup over technical costs and wages to support overhead and profit. Kalecki and Minsky make the heroic assumption that workers spend all their income on consumption goods except for saving out of wages. In this system debt finance must be available to capitalists and workers or all the output could not be sold at a markup to support overhead and profits.

    2. Crossover

      You say: “There is also the ‘structuralist’ approach to inflation.” Indeed, almost everybody has an opinion about inflation. The problem is that the goal of science is NOT to have many contradicting opinions but the one materially/formally consistent theory: “That the settlement of opinion is the sole end of inquiry is a very important proposition.” (Peirce)

      Post-Keynesianism has been refuted long ago,#1 hence there is no use to try to reanimate post-Keynesian inflation theory or to produce one more roll of proto-scientific toilet paper.

      Egmont Kakarot-Handtke

      #1 Why Post Keynesianism Is Not Yet a Science

  9. Brian, thanks for writing this. I had always operated under the assumption that wages as cause of inflation was a neoliberal concept designed to keep wages stagnant.

    I'm interested in Crossover's comments regarding Structuralist conceptions of inflation. He says "In this setting the starting point for inflation is a change in an "important price" e.g exchange rate, the price of a key input or the wages..."

    This jives with my conceptual starting point of inflation being a rise by the central bank of the overnight rate. Many small businesses and producers use short term financing as a "key input" and a rise in this rate would lead to a need to increase pricing.

    I'd be more interested in EKH's comments if he were more engaged in productive criticism and less inclined to shit all over everyone else's ideas. At least he seems to have plenty of toilet paper.

    Please continue exploration along these lines.


    Dave Gerlitz


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