Monday, January 24, 2011

Expensive Potatoes, Cheap French Fries

Paul Krugman commented the other day on this article in Commodities Now by John Kemp.  The article's main thesis is:
Leading commentators such as Martin Wolf in the Financial Times and Paul Krugman in the New York Times argue the problem facing the global economy is lack of sufficient demand; the remedy is some combination of fiscal and monetary expansion. But sharply rising commodity prices suggest global growth is already hitting supply-side limits. The problem is not aggregate demand but its distribution.

Until firms significantly raise productivity, especially resource efficiency, the painful remedy is likely to involve increased competitiveness and reduced living standards across North America and Western Europe (through a combination of commodity price inflation, weaker exchange rates, higher import prices and falling real wages and incomes).

There is not much Keynesian demand management can do in the face of this sort of structural shift. Central bank policies are simply shuffling costs around (from borrowers and banks to savers and pension funds) while stoking further increases in food and energy prices.
This is the implication of the syndrome I christened misflation the other day (and since I haven't see any other term in general circulation yet, I'm going to stick with mine for now).

Anyway, Krugman responds:

The argument is that while high unemployment and low inflation may prevail in advanced economies, the rest of the world is facing accelerating inflation, together with rising commodity prices. And that is, indeed, a fair picture of what’s going on.

What’s more questionable is the assertion that “The problem is not aggregate demand but its distribution.” In fact, it’s both.
But what this says is that if global aggregate demand were redistributed, so that more of it fell on advanced countries, we could expand further without putting pressure on capacity worldwide. And there’s a simple way to get such a redistribution of demand: an appreciation of emerging-market currencies against advanced-country currencies. It’s the fact that the emerging nations aren’t willing to let this happen that is causing them to face inflationary pressures, even as it helps keep the advanced economies depressed.
I don't think this is right, and the reason is that Krugman is conflating two things that are different: A) inflation in final goods prices in emerging countries (esp China), and B) rises in global commodity prices.  These are different in their causes, and different in their implications.

It's quite true that China is having some final price inflation, and I agree that this a symptom of the fixed exchange rate they maintain to the dollar, causing them to inherit a monetary policy quite inappropriate to their economic conditions.  So this is a monetary problem and has a monetary solution.

But commodity price inflation is not a monetary problem, it's a real problem (something Krugman seemed to partially recognize a few weeks back).  The very simplified way I think about it is to consider the global economy as a three stage thing: resources (and their extraction capital), goods manufacturing capacity, and final demand.  To illustrate with a crude analogy, let's suppose we had a simplified one commodity economy.  There are potato farms that grow potatoes, restaurants that turn them into french fries, and then everyone eats french fries at the restaurants.  Historically, there were plenty of potatoes, and hence the restaurant owners were able to screw the farmers for every dime possible - potato prices were low but restaurant owners made a good profit.  As a result, two things happened: there was a boom in building more restaurants, and consumers had trouble paying for their french fries and started to pay for lunch on their credit cards, running up unsustainable debts.

Now, the situation has gone bust in two different ways at about the same time: 1) consumers have run up to their credit limit and need to cut back on their french fry consumption, but also 2) long underinvestment in the potato farms, combined with some farms having depleted their soil, has caused potato production to fall.  So now, we have french fry prices falling, but potato prices rising.

Note that here,

  • there are too many restaurants for final demand (causing the drop in french fry prices)
  • there are too many restaurants for the available potato production, but, crucially,
  • there is also too much final demand for available potato production. 

The last point is critical to understand: potato prices wouldn't be high unless this were true, and it has big implications for the correct fix, that Krugman doesn't seem have recognized.  Under this circumstance, he has essentially been saying (for the last three years over and over): consumers are overleveraged and can't buy enough french fries, the restaurant owners are laying people off, the government needs to buy more french fries, and/or print more money to help people pay down their credit card debt so that they'll be able to buy more fries.

And that would be true, but for this other problem: there aren't enough potatoes.  French fries can only be made out of potatoes, and, in the short term a certain number of french fries require a fixed number of potatoes.  If, one way or another, you induce people to eat more french fries, it requires potatoes that just aren't there, and that can only exacerbate the potato price problem.

Under this circumstance, in order to increase final consumption of french fries, steps need to be taken like buying better equipment for the farms, opening more farms, replacing inefficient old machines for making the french fries with more efficient ones that can make more fries out of a given potato (ie with less waste), restoring the soil, etc.

This is exactly Kemp's point, and something I've been saying for about five years now in the context of oil specifically - in the peak oil zone, further growth in the economy can only come from improving the efficiency with which resources are used.  Increasing final demand without doing this will just lead to exactly the situation of misflation that we are in.


Burk said...

Stuart- thanks for an acute post. I would offer, however, that your analogy is a bit misapplied. Commodities are certainly limited, but they are not the only input to economic production. So making an economy strictly limited to the number of potatoes doesn't do justice to the true economy.

One thing we have in excess rather than in limitation is labor. Much of it is unemployed. The Keynesian solution is aimed at the economy in general, not at the commodity markets. And the economy in general can grow with some of its inputs limited or rising in price. We have been doing so forever, and with respect to oil in particular, for decades.

Oil does not function as an absolute limit to economic activity, but as it rises in price, as a brake, and an encouragement towards more energy efficiency- an economy that ends up employing the same number or more people on less fossil energy. Perhaps more people will telecommute to new jobs!

kjmclark said...

"steps need to be taken like buying better equipment for the farms, opening more farms, replacing inefficient old machines for making the french fries with more efficient ones that can make more fries out of a given potato (ie with less waste)"

Wait a minute - where did this farm equipment industry come from? That wasn't in your example. And more efficient french fry equipment? But your simple model doesn't have any of this complex manufacturing. Where did that come from?

That is Krugman's point. We don't only have industries that consume raw commodities, we also have industries that allow you to consume less of those commodities to produce goods. But those manufacturers laid people off too and aren't rehiring because demand for their products is off.

Krugman's solution is to inject money back into the system (through demand, where it will get used, not just through increased money supply, where it will sit in bank reserves), and let the market decide how it gets spent after that. He'd be completely in favor of organic demand from corporations to improve their efficiency (see his comments on "competitiveness"), but they're just sitting on their money right now too.

As you put it, "further growth in the economy can only come from improving the efficiency with which resources are used" - yes, and that requires a great deal of spending, which isn't going to happen without some increase in demand. As it is, there isn't much spending on anything, and corporations are hoarding cash because their sales are down.

kjmclark said...

One related point. I do agree with you that Prof. Krugman seems to be thinking of this as something of a repeat of the Depression, so the solution is to increase demand. However, I think you're right that if the production doesn't go into increased energy efficiency, it will largely be wasted.

But we don't have a command and control economy. If the people with jobs want to use their money to buy Escalades, there's not much we can do about that. It might not be in the long-term interest, but it's their money.

If you want people to make more efficient choices freely, in a free-market economy, you just let the prices rise and let people decide for themselves to buy more efficient goods. From that perspective, rising commodity prices are a good thing. That's what's going to encourage people to buy more efficient goods. But if they have no money, they're not going to buy much of anything. In an ideal world (right now) everyone would have lots of money and fossil fuel prices would be through the roof.

rks said...

Hi Burk. Liebig's Law applies. Only the thing in short supply is important. That has been skilled labour for so long that we are confused by the emerging situation where fuel for transport is in short supply. This means that we can't use all the available labour with our current infrastructure. We need to use mor of the available production to change infrastructure while keeping a lid on total production.

Stuart Staniford said...

Kjm: Of course, you are technically right in your first comment and I'd need to clutter up my model some to make it better. However, it seems pretty clear to me that I could do so without breaking my main point (which is essentially captured in your second comment).

Burk: What RKS said.

Stuart Staniford said...


Wrt "don't have a command and control economy". No, but we have a mixed economy in which government policy has a fair bit of influence. So we can (and are, to a point) do things like fuel economy standards, energy efficiency incentives, etc.

Also, this basic argument was why I thought Cash-for-Clunkers was a great stimulus policy (albeit that it got just about zero support in the blogosphere).

Burk said...

Hi, rks-

It escapes me how Liebig's law applies here. As kjm said, the price mechanism allows flexible response to scarce inputs. Oil is hardly even scarce- it is everywhere. Only its price is going up by a few dollars.

I take it that you mean on a macro scale, given that we are at peak oil, the US economy is overall limited by oil- that input will not be going up in amount. But how does that relate to the economy at large or any particular product? The french fry analogy is faulty, since there is a 1:1 relationship between potatoes and french fries. No such relationship applies between oil and other goods on a macro scale. Even gasoline can be made from corn, from coal, etc. if needed. But the point of Keynesianism is not to increase the consumption of gasoline, but to raise economic activity generally and employment specifically.

There are plenty of economic goods available with very low oil inputs. Pedicures, economic instruction, writing. The whole point of having an economic system is to have mechanisms that send (price) signals of scarcity, redirecting activities. The fact that we have not to date used price signals (taxes) in advance of true oil peak price rises doesn't mean the sky is falling. It doesn't even mean that economic growth has to slow down very much.. only a little.

I think in econ-speak, it all boils down to the elasticity of oil demand with respect to price. It tends to be inelastic in the short term, but somewhat elastic in the long term (i.e price increase of 2X results in demand decrease of 1X). Thus calling oil a "limiting" component is not correct in any but an extremely short-term view, and even then is not limiting to a great many economic activities that employ people. A hundred years ago or so we had a whole economy with no fossil oil at all.

Stuart Staniford said...


The short term issue is that the income elasticity of oil demand is pretty much 1, while the price elasticity was about -0.05 in the last oil shock. It's in that sense that it's a limiting factor, and the potato/fry analogy is fair.

Of course, I agree that in the long run, we can/will transition away from it. But, as a great man once said, in the long run we're all dead.

Anonymous said...

Entertaining seeing the physicist taking on the nobel prize-winning economist, on the economist's home ground.

And imo hitting a few homers. My simple take on it is that excess (and debt-fueled) consumption is largely responsible for getting the developed world into this mess, and thus it is difficult to see how consuming more can get us out of it. Pretty much exactly this situation: