Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Historical Origins of the Cost-Push Fallacy

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Historical Origins of the Cost-Push Fallacy

Article excerpt

By the end of 1998, the disinflation of the 1990s had brought the U.S. price level close to absolute stability. The same disinflation witnessed a remarkable resurgence of what used to be called cost-push theories of price-level movements to explain it. Such theories, of course, attribute inflation and disinflation to a host of nonmonetary, supply-oriented influences that alter the unit cost and profit markup components of the prices of individual goods.

Cost-push theories form an integral part of the so-called new economic paradigm, or new economy thesis, which American pundits report predominantly in the popular rather than the scholarly press. Proponents of that paradigm cite such cost-reducing forces as increased global competition and rapid technological progress as the chief factors holding inflation at bay. Other frequently mentioned sources of cost disinflation-all seen as exerting downward pressure on rates of wage increase-include (1) worker job insecurity, (2) increased competition in labor markets, and (3) the declining power of labor unions in the United States.

Even these factors hardly begin to exhaust the list. Deregulation, falling computer prices, falling growth rates of health care costs: all have been proffered as cost-disinflators. Most recently, cost-push explanations of disinflation have emphasized falling import costs stemming from the Asian financial crisis, with its associated distress sale of Asian goods and plummeting foreign exchange value of Asian currencies. With such pressures holding inflation in check, cost-pushers feel free to recommend that monetary policy become expansionary in pursuit of rapid growth.

Opposed to the cost-push view is the standard monetary theory of price movements. It sees underlying monetary conditions, manifested in shifts in money supply and demand, rather than real cost-push pressure as the fundamental cause of such movements. The standard theory holds that the price level P is determined not by real cost-push but rather by the nominal stock of money relative to the real demand for it or, equivalently, by velocity-augmented money MV per unit of real output O as expressed in the celebrated equation of exchange P = MV/O. Conventional monetary theorists have always had a problem with the cost-push view. In their opinion, cost-push can at best explain relative prices. It cannot, however, explain the behavior of the aggregate, or general, price level. That is, it cannot do so unless it can show how cost pressures in specific sectors of the economy can markedly influence the money stock, its velocity, or the aggregate level of output-the three variables that jointly determine the general price level. Since there is no reason to think that sectoral cost pressures would materially affect these aggregate magnitudes for any substantial length of time, there is little reason to believe that cost-push theories offer a valid explanation of general price-level movements. i Here then is the cost-push fallacy: it confounds relative with absolute prices and sectoral real shocks with economywide nominal ones.2 It says nothing about money's role in price determination.

Seasoned scholars accept recent cost-push theories of disinflation with a sense of deja vu. They know that exactly the same theories-albeit with signs reversed-flourished in the 1950s, 1960s, and 1970s. Those decades saw cost-pushers attribute wage and price inflation to such forces as the increased monopoly power of trade unions, oil price shocks, the competitive struggle for relative income shares, crop failures, commodity shortages, and even the disappearance of anchovies (a key ingredient of livestock feed) off the coast of Peru. Indeed, economist George Perry (1987) of the Brookings Institution gives a fine account of the prevalence of such explanations 30 years ago.

Nevertheless, a historian would be remiss in tracing the roots of cost-- push theory back no farther than the middle decades of the twentieth century. …

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