A Country in Denial

Watch Bernanke’s ‘Little’ Inflation Capsize U.S.

By Amity Shlaes

A little is all right. That’s the message Federal Reserve Chairman Ben S. Bernanke has been giving out recently when asked about the evidence of inflation in the U.S. recovery.

Sometimes Bernanke doesn’t even go that far. He simply says he doesn’t see inflation. The Fed chairman recently described the prospects for price increases across the board as“subdued.”

 “Sudden” is more like it. The thing about inflation is that it comes out of nowhere and hits you. Monetary policy is like sailing. You’re gliding along, passing the peninsula, and you come about. Nothing. Then the wind fills the sail so fast it knocks you into the sea. Right now, the U.S. is a sailboat that has just made open water, and has already come about. That wind is coming. The sailor just doesn’t know it.

“Sudden” has happened to us before. In World War I, an early version of what we would call the CPI-U, the consumer price index for urban areas, went from 1 percent for 1915 to 7 percent in 1916 to 17 percent in 1917. To returning vets, that felt awful sudden.

How did it happen? The Treasury spent like crazy on the war, creating money to pay for it, then pretended that its spending was offset by complex Liberty Bond sales and admonishments to citizens that they save more.

In other words, the Woodrow Wilson administration was in denial, inflating in all but name. Commenting on one complex plan to make more money available, Representative L.T. McFadden, a Pennsylvania Republican, said, “I would suggest that if the administration believes that inflation of this character is necessary to finance the war the more direct way would be to issue the notes direct.”

Or, to return to sailing terms, the Treasury and Fed had tilted the U.S. monetary craft so far one way that it needed to lean back the other way before it could right. That leaning was the true tight money policy of subsequent years, including deflation of 10 percent and wrenching unemployment.

History has other examples. In 1945, all seemed well: Inflation was 2 percent, at least officially. Within two years that level hit 14 percent.

All appeared calm in 1972, too, before inflation jumped to 11 percent by 1974, and stayed high for the rest of the decade, diminishing the quality of life for whole cohorts. They paid thehigher interest rates needed to reduce the inflation, and got a house with one less bedroom. Or no pool.

The thing about inflation is that it accelerates. The acceleration hit storybook levels in the most sudden case of all, that of Germany in 1922. Many financial analysts thought the Weimar authorities weren’t producing enough money.

“Tight Money in German Market: Causes of the Abnormally Rapid Currency Deflation at Year-End,” read a New York Times headline. The Germans didn’t know it, but they had already turned their money into wallpaper; the next year would see hyperinflation, when inflation races ahead at more than 50 percent a month. It moved so fast that prices changed in a single hour. Yet even as it did so, the country’s financial authorities failed to see inflation. They thought they were witnessing increased demand for money.

The greater the denial before, the faster the inflation accelerates after. Author Daniel Yergintells the story of a student in Freiburg who ordered a cup of coffee in a cafe; the price was 5,000 marks. Then he had another. When the bill came, it was 14,000. “If you want to save money and you want two cups of coffee, you should order them both at the same time,” he was told.

Extreme Example

Germany in the 1920s is always the extreme example. But one form of denial then warrants comparison to the U.S. today.

Bernanke talks about prices in one area - energy, for example -- as different from those in the rest of the economy. The Germans, in their denial, thought their problem was limited to exchange rates, and that their domestic economy had hope. Risibly, Chancellor Joseph Wirthtried to tie down prices by regulating foreign currency. The equivalent, and equivalently risible, move today is the Ralph Nader effort to get the administration to push down oil prices.

The reason a little inflation is not all right, and the reason inflation comes suddenly, is expectations.

The phrase “perception is reality” is overused generally. But perception can be reality in monetary policy. The bond market doesn’t act merely on what it sees. It acts on what it expects of the Fed or the government. And our own Fed has let us know it’s capable of just about everything, which includes inflationary monetary policy. Disillusionment can come as fast as a gust, but building faith that the government won’t inflate again is like building a new sailboat, a project of years. Another way to put this is how the central banker Henry Wallichdid. Inflation is like a banana, Jerry Jordan of the Cleveland Fed quoted him as saying. Once you see one brown spot, it’s too late.

The reason that markets haven’t jumped yet is that the last great inflation and correction happened in the late 1970s and early 1980s, just long enough ago that most adults in the financial markets don’t remember it.

We can debate whether today’s challenge resembles that faced in the early 1980s, or something worse. But one thing is clear: pretty soon, we’ll all be in deep water.