Aviation / Economics / History / Warfare

Aggregate Demand Dominance: MIC and the Death of the Deflation Ratchet

The Utter Failure and Stupidity of the Gold and Silver Standards: Part 5

Over a series of posts, I’ve come to refer to the gold standard’s “mean reversion” tendency as the deflation ratchet; a mechanism that especially afflicted the world economy during the 1873-1890s Long Depression and the 1926-1933 run-up and descent into the Great Depression.

Over a year ago I also traced the evolution of the American Military Industrial Complex (MIC) and the Russian Voenno-promyshlennyi Kompleks (VPK)—which translates into English as…Military Industrial Complex. The rise of MIC and VPK in the 1950s corresponded with the cessation of the deflationary ratchet’s effects; this was not by accident, as I will demonstrate. But before I can dance on the grave of the deflation ratchet, I must explain what the ratchet was.

Stripped and Stuck Ratchets

If an economist were to ever read my postings (a dubious prospect indeed) he or she might question if I am confused by the ratchet effect:

In labor markets, the ratchet effect refers to a situation where workers subject to performance pay choose to restrict their output, because they rationally anticipate that firms will respond to higher output levels by raising output requirements or by cutting pay.

Well, that depends on which ratchet effect the hypothetical economist accepts. Soviet

The ratchet effect is one of earliest problems noted by modern incentive theory, being prominent in discussions of Soviet planning (Berliner, 1954; Bergson, 1976). If the factory met or exceeded its plan target, the target for subsequent years was increased, thereby reducing current effort incentives for the factory manager (Weitzman, 1980).

consumer goods

The ratchet effect can be seen in long-term trends in the production of many consumer goods. Year by year, automobiles gradually acquire more features. Competitive pressures make it hard for manufacturers to cut back on the features unless forced by a true scarcity of raw materials (e.g., an oil shortage that drives costs up radically). University textbook publishers gradually get “stuck” in producing books that have excess content and features.

Airlines initiate frequent-flyer programs that become ever harder to terminate. Successive generations of home appliances gradually acquire more features; new editions of software acquire more features; and so on. With all of these goods, there is ongoing debate as to whether the added features truly improve usability, or simply increase the tendency for people to buy the goods.

…the tendency for consumer spending to always follow a positive trend?

Ratchet Effect: the effect of the highest previous variable on the current variable, as when wage demands are based on the previous highest wage offered. This is apparent when incomes rise, but when they fall, individuals have difficulty is getting accustomed to the fall and tend to continue spending at the same level.

But I am not referring to any of these when I use the term “deflation ratchet.” I am referring directly to over-torquing risks:

preciseadjustable

Selectability defines the unique design of this instrument. This adjustable wrench provides 9 different lock-in torque settings from which to choose: 15, 20, 25, 30, 35, 40, 45, 50 and 60 Ncm. The disengaging ratchet clutch prevents over-torquing thus eliminating possible damage to various implant components and tooth structure.

 

Ratchets (and ratchet strap tie-downs) impart incredible forces with a minimum of effort on the part of the user. This can lead to the mistaken belief that the user isn’t overstressing the bolt being ratcheted—right up to the point where the head of the bolt snaps or twists off. The gold standard’s deflation ratchet had the same risks, complete with damaged implant components and tooth structure. The ratchet effect is also known for its inflationary/deflationary effects:

 

A decrease in AD will cause the level of output to decline indicating\ higher unemployment.

But what happens to the price level? Normally we would expect the price level to decline from PL to PL’ if AD decreases, but can you remember a time when the price level (the average level of ALL prices in the economy) decreased? It doesn’t happen very often. Business are more willing to raise their prices (causing more inflation) than they are to decreases their prices (causing deflation). Economists call this the ratchet effect. Like a ratchet that only works in one direction, prices more easily move in one direction (up) than in both. Sometimes it is said that prices are “stick downwards”.

The above effect is often referred to as “sticky prices/sticky wages.” I’ve written about this tendency as well, which might simply be a byproduct of population growth:

While the effects of population growth are always accounted for in monthly job growth statistics (somewhere in the 90,000 to 150,000 range required to keep up), never do I read that population growth from 2000 to 2010 has added $273 billion to current American GDP at the bare minimum (per capita GDP runs at more than four times the $10,000 I am assuming is the minimum expense to remain alive in the U.S. in 2013).

Someone with a working knowledge of economics and mathematics would immediately complain this is a drop in the bucket compared to overall American GDP.  On New Year’s Eve 2012, U.S. annual GDP was tabulated as $15,684,800,000,000; the $273 billion from the 2000s population growth represents 1.74% of that total.  Considering GDP growth was $693.5 billion more than the previous year, at first demographics appears to be a sideshow.

However, population growth also has a stimulus effect, one much larger (and more robust) than any fiscal stimulus Congress has even permitted to be spent.  I would posit that the aggregate demand curve, which usually appears static or representing a single demand shift like so

http://webshells.com/college/grid5.jpg

…rather shifts outward continuously, perpendicular to the tangent of the aggregate demand curve (also known as slope or price elasticity of demand), eventually abutting the point where the SRAS curve begins to slope upwards noticeably (toward the vertical).  Passing the potential output point, prices rise much faster than real output…

 

…which, rather than indicating runaway inflation, far more likely is the price signal for firms to expand, resulting in an increase in capacity limits (SRAS shifts outward, to the right).  Price increases abate from the shift in AS, until AD increases restart the cycle again.  Over time, firms may also anticipate the boom generated from AD increases and expand in anticipation of the price signal rise.  Nevertheless, this makes aggregate demand the prime driver of the economy, as the continuous increase of the AD curve yield both higher real output and an increased price level simultaneously.

From here, I’ll also expand my argument that deflation is far more destructive than Paul Krugman’s two AD/one AS reasons:

There are actually three different reasons to worry about deflation, two on the demand side and one on the supply side.

So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield – Japanese bank deposits are a really good deal compared with those in America — and anyone considering borrowing, even for a productive investment, has to take account of the fact that the loan will have to repaid in dollars that are worth more than the dollars you borrowed. If the economy is doing well, all this can be offset by just keeping interest rates low; but if the economy isn’t doing well, even a zero rate may not be low enough to achieve full employment.

And when that happens, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. That’s the deflationary trap we keep worrying about.

A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum affair, since creditors experience a corresponding gain. But as Irving Fisher pointed out long ago (pdf), debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. So deflation exerts a depressing effect on spending by raising debt burdens – which, as Fisher also points out, can lead to another kind of vicious circle, in which depressed spending because of rising real debt leads to further deflation.

Finally, in a deflationary economy, wages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages — there’s downward nominal wage rigidity. What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines. See Estonia and Latvia, cases of.

These are all indicative of a fairly static AD/AS model. Under such a model…

http://graphics8.nytimes.com/images/2013/08/02/opinion/080213krugman1/080213krugman1-blog480.png

…a deflationary expansion only occurs, temporarily, after a massive GDP contraction. In a dynamic model, however, deflation almost by definition must accompany a reduction of real GDP…continuously.

Maintaining price decreases in a dynamic model absent highly distortive price controls is almost impossible, as incessant population-derived AD increases would otherwise cancel out the disinflation and eventually overwhelm the system and revert to reinflation. Sustained deflation, such as the Long Depression, Depression of 1921 and Great Depression indicate a policy preference towards price-control-mandated decreases—i.e., the gold standard’s “mean reverting” deflation ratchet. So, when did the head of the economic bolt shear off?

The Gold Standard Meets MIC

The First World War expended over a billion shells on the Western Front, but still the world economy was ratcheted back to £4.25/oz gold in the 1920s. The weapons expended during the Second World War killed more than 60 million people but gold remained at the $35/oz level it had been set at in 1933; the massive postwar demobilization and recession of 1948-49 locking in the deflation ratchet at the end of the decade:

Historical Data Chart

The same was not true for after Korea:

(The table below gives yearly expenditures in millions of inflation-adjusted dollars (2008 $)):

Year Defense
1940 24,387
1941 93,311
1942 337,851
1943 808,672
1944 932,470
1945 957,356
1946 480,358
1947 123,888
1948 80,227
1949 111,983
1950 118,969
1951 192,500
1952 360,008
1953 406,515
1954 376,119
1955 327,838
1956 324,740
1957 337,321
1958 336,548
1959 347,497
1960 336,287
1961 342,294
1962 357,524
1963 360,335
1964 364,500
1965 332,735
1966 373,895
1967 445,432
1968 494,574
1969 474,866
1970 443,987
1971 407,619
1972 395,010
1973 367,752

Historical Data Chart

Deflation did reoccur briefly after the 1953 armistice, but MIC would not tolerate another epic postwar (World War II) demobilization:

Eisenhower was played to a T by the MIC.  Western observers during a 1955 Soviet air show were duped (as in stupid enough to not question whether a group of large airplanes could fly over the same location more than once) into thinking ten M-4 bombers overflying the stands repeatedly numbered at least sixty. These observers apparently reported to the CIA, because the Agency projected the Soviets would have 600-800 M-4s in service by decade’s end (again, the Russians would build 93 in total).  Eisenhower and his advisors, instead of questioning the methodology the CIA used, set forward a policy to build an ever-growing nuclear deterrent force.  This set the bomber gap hysteria into hyperdrive, to the Boeing Company’s immense benefit.

Presiding over a massive increase in American nuclear armament and strike delivery systems, Eisenhower supposedly became “suspicious” of the purported bomber gap at some point.  Rather than forcing intelligence agencies to actually gather useful information on the subject, in November 1954 Eisenhower authorizes the CIA to procure and operate a fleet of U-2 spy planes for reasons that include determining the veracity of the CIA’s own projections.  Not a Boeing project, but the province of proud MIC member Lockheed.  As no one in the Eisenhower Administration apparently understood what confirmation bias is, the initial conclusion from a U-2 photographing 20 M-4s at Engels-2 Air Base outside Saratov on July 5, 1956 was that hundreds more were deployed at other air bases (in reality, the U-2 had photographed the entire M-4 fleet).  The Supreme Allied Commander must have never had experience with deception and misdirection during the Second World War….

It’s rich that Eisenhower railed against MIC…in his 1961 farewell address. How had MIC and Boeing outmaneuvered the president?

February 15, 1954.  Aviation Week runs an article speculating the Myasishchev M-4, a Soviet four-engine swept-wing turbojet bomber, can reach the United States with nuclear payload from the U.S.S.R.  No one bothers to ask whether the M-4 has the range to be able to fly back, or if the Russians have the capability to build more than 93 of these fairly defenseless bombers.

July 1955.  Soviet air show tricks the West into projecting the M-4 bomber fleet will soon numbers in the hundreds.

Following the article and air show stunt, SAC commander General Curtis LeMay takes advantage, even going as far as testifying before Senator Symington’s 1956 hearings: “The only thing I can say is that from 1958 on, he [the USSR] is stronger than we are, and it naturally follows that if he is stronger, he may feel that he should attack,” a tactic later termed “policy by press release.”  Over the next eight years the bomber mafia will trick the Eisenhower Administration and the U.S. Congress into purchasing 3,579 Boeing swept-wing turbojet aircraft: 2,032 B-47s, 744 B-52s, 803 KC-135s and the massive infrastructure and support apparatus required for at least half of the force to fly deterrence missions continuously.

Boeing would benefit from the nuclear hysteria for decades…

On October 27, 1962, the first two Minuteman IA LGM-30 ICBMs went on alert at Malmstrom AFB amidst the Cuban Missile Crisis.  Manufactured by MIC founder Boeing, the almost-terminal overreaction of the Kennedy Administration in the Caribbean leads JFK to authorize SAC’s favorite manufacturer to put 1,800 Minutemen into the USAF ICBM arsenal (controlled by SAC, naturally) over the course of 15 years.  Neither the first deployed American ICBM nor the first solid-fueled American strategic missile, nevertheless the first deployment of American monopropellant ICBMs (neither Polaris nor Poseidon had intercontinental range) marks the beginning of the missile gap President Kennedy had railed against during the 1960 election.  Oddly enough, the missile gap would favor the Soviets in reality this time.

…and the concurrent rise of MIC’s counterpart VPK was almost comical:

VPK’s [(the Soviet Politburo Military Industrial Commission)] first chairman, Dmitri Ustinov, ran the Kommissia from 1957 to 1963 before being tapped by Khrushchev to run the entire civilian economy.  Ustinov returned to his military industrial roots the following year, exerting enormous influence as the powerful Secretary of the Central Committee for Defense Industry after the rise to power of Brezhnev in October 1964.  Understandably, after becoming Minister of Defense after the death of his predecessor Marshal Andrei Grechko in 1976, Ustinov intensified the grip of MIC:

Soviet arms production became even more supply-driven after Ustinov was promoted to Defense Minister.  Prior to 1976, the General Staff Directorate for Armaments Orders (Upravlenie zakazov) played a central role in shaping of weapons programs.  It made recommendations on the basis of which the General Staff allocated funding to the services and placed orders for weapons.  In 1976, with Ustinov’s approval, the directorate was taken out of the General Staff and reconstituted as an independent directorate of the Ministry of Defense.  The VPK was allocated funds directly, and the services thereafter appealed to the MoD or directly to the VPK for funding.  Disagreements between the VPK and General Staff were constant, but the VPK almost always won the decision.

Senior General Staff officers complained bitterly of Ustinov’s tendency as Defense Minister to side with the military-industrial complex against the Armed Forces.  Danilevich recounted that Grechko resisted pressure from the defense-industrial sector to procure certain weapon systems before they were fully developed, or if they failed to meet specifications.  Ustinov, in contrast, would scold industrialists but in the end would give in to them.  During Ustinov’s tenure as Defense Minister, Danilevich asserted, strategic objectives were often subordinated to, and built around, weapons systems.

Gen. Makhmut Gareev described in the wake of Ustinov’s elevation to Defense Minister the MoD “had been taken over by the enemy.” What came next should surprise no one:

The defense-industrial sector used its political clout to deliver more weapons than the armed services asked for and even build new weapon systems the operational military did not want.  Efim Liuboshits, an analyst with more than 30 years’ experience with the Strategic Rocket Forces’ main institute [NII-4], wrote in Krasnaia zvezda that studies conducted in 1979 showed that the large number of missiles in storage exceeded by tenfold the number required for alert duty.  Stocks of missiles reached surplus levels, he continued, because additional missiles were delivered at the initiative of the industry even through the Ministry of Defense had not placed orders for them.

In some instances, Kataev recounted, the directors of production facilities approached Defense Minister Ustinov directly in an effort to sell their weapons.  The Director of IuzhnoMash, Aleksandr Maksimovich Makarov, once visited Ustinov to ask him to take a few dozen more missiles.  Ustinov replied “What will we do with them, Aleksandr Maksimovich?” to whick Makarov answered “But if you don’t, how will we feed the workers?”

A quick note from 2013—here’s strong evidence that the Soviet Union was not economically communist during the missile build-up.  Why should it matter to IuzhnoMash’s employees that the design firm continues to pump out missiles?  Shouldn’t they be fed by the state anyway?  The behavior of defense sector industrialists indicates that the USSR transitioned from state socialism long before the collapse of 1991:

In the end, Ustinov took the [IuzhnoMash] missiles, even though the army did not really need them.  Kataev asserted that the ongoing efforts of defense plants to expand production generated large stockpiles of [excess] military equipment.  There were at different times, for instance, up to 4, 5, and, in the case of particular systems, 8 nuclear basic loads (boekomplekty) of naval strategic missiles.

The military tried unsuccessfully to reduce the number of different types of missiles.  The Soviet Union had a much greater variety of missiles than it needed.  Kravets complained that the internal competition among various chief designers and industrialists, each designer and industrialist ultimately had his own way.  After development and testing, all competing missile systems, usually two but sometimes more, were put into production and then deployed.  As a consequence, the USSR fielded up to 12 types of ICBMs simultaneously.

The SRF at one time had 10 different missiles serving the same mission.  Kataev characterized this process as a kind of internal arms race carried out inside the defense sector.  Kalashnikov repeatedly proposed a reduction of different types of missiles to two or three, but his proposal was rejected by Ustinov, who was concerned about the unemployment such a measure would generate.

I still believe the facts support an argument that the Soviets had transitioned from a command economy to crony capitalism at the latest during the Brezhnev era (perhaps calling this the Ustinov or Missile Gap era would be more appropriate). The crazed Soviet missile buildup continued for 20 years, until Ustinov’s death on 20 December 1984.

For the U.S. and its military post-Korea, permitting the effects of the deflationary ratchet to continue was out of the question. Throwing the country into a long, deep depression to defend $35/oz gold was suicidal when Boeing had orders to manufacture 3,600 jet bombers and tankers for SAC and the rest of MIC the Century series fighters and nuclear air-to-air missiles to incinerate the M-4s and TU-95s that were supposedly itching to cross the North Pole and rain nuclear hellfire on North America.

The Russian bomber threat wasn’t real but the massive Soviet missile buildup was—besides SAC’s 1,800 Minutemen ICBMs, MIC had 41 SSBNs (ballistic missile submarines) and hundreds of Polaris and Poseidon SLBMs (submarine-launched ballistic missiles) to fill the “41 for Freedom’s” 656 missile tubes…which were all in U.S. Navy service by the end of 1967. The gold standard came crashing down three months later.

The New Ratchet

MIC thoroughly stripped the teeth out of the deflation ratchet before smashing it and melting it down, needing the metal for SSBN hull construction. MIC, along with the millions of tons of conventional ordnance delivered with “South-East Asia” on the destination invoice, had previously constructed a massive new ratchet in the 1950s. With MER engraved on the side (the USAF had insisted MIC use an acronym for Military Expenditure Ratchet), the gold standard’s own bolt was subjected to inordinate forces starting in 1965 which sheared the bolt’s head off on 15 March 1968.

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3 thoughts on “Aggregate Demand Dominance: MIC and the Death of the Deflation Ratchet

  1. Announcing the proposed of nuclear dominance laws, Royal was keen to stress that nuclear would continue to play an important part in the energy mix, but that it was important to advance other sources of power generation. She said: “We are not exiting nuclear, but its part must fall. It is thanks to nuclear that we can make a secure energy transition.”

  2. Pingback: Aggregate Demand Dominance: False Foundations | In The Corner, Mumbling and Drooling

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