The Inflation Fallacy Refuses to Die

In a progressing economy, prices should fall, not remain 'stable' or rise

By Pater Tenebrarum

Seemingly every week another supposedly reputable economist comes out reviving the fallacy that the economy can be 'fixed' by more inflation. There was for instance an article by Paul Krugman in early May, once again extolling the alleged virtues of inflation and deficit spending. There's simply not enough inflation, Krugman assures us. 

It is true that monetary inflation initially creates an illusion that things are 'getting better'. After all, the early receivers of new money will spend it. It is only when this new money has percolated fully though the economy and exerted its effect on prices that the losers become evident (namely all those who either received the new money late or not at all). Moreover, workers can be cheated for a while, as their real incomes tend to decline as a result of inflation.

The problem is that neither inflation nor government spending can create any real wealth. The 'stimulation' that a bout of inflation initially imparts leaves things not merely back at square one when the inflationary policy is stopped, it leaves them in worse shape than before – as scarce capital has been  misdirected and consumed.

So-called 'idle resources' are usually idle for a good reason. In the case of specific capital, there may no longer be the complementary capital goods available to profitably employ it. Many of the remnants of the preceding boom are idle because they were revealed as malinvestments – investment in lines for which the expected consumer demand never materialized. Even if we grant that some non-specific idle resources may be 'activated' again by monetary stimulation, why should that remain to be the case once it ends? In Krugman's world, the economy is like a stalled engine that requires a 'jump-start' – thereafter it is assumed to just continue merrily on its way by itself. As far as we can tell, the Fed's current policies are based on the very same deliberations.  The question is: Why should it?

The reality is that an economy stimulated by inflationary policy needs ever more and greater doses of inflation to keep going. This process is however not without ill effects, in fact, with every additional dose of stimulation, the negative effects tend to become both larger and more obvious relative to perceived short term positive ones.

Better Interest Rate Manipulation Desired

This week yet another economist, one Lawrence Ball,  has come out advocating more inflation on the grounds that if a higher 'inflation target' were pursued by central banks, this would allow for more effective manipulation of interest rates during the inevitable slumps. Note here that the question why there was an economic slump in the first place is not even addressed in passing. These busts just 'happen', sort of like inclement weather. Here is an excerpt that represents the core of his argument: 

“In five of the eight recessions since 1960, inflation began above 4%. With high inflation, nominal-interest rates were also high, so the Fed could cut them sharply without approaching zero. But what would have happened if inflation had started at 2%?

We can get an idea by examining real interest rates. If the nominal-interest rate, i, cannot fall below zero, then the real rate, r=i-π , cannot fall below -π . One way to interpret the danger of low inflation is that it raises the lower bound on the real interest rate.

If inflation is 2% when a recession begins, the bound on the real rate is -2% at that point. However, the recession is likely to push inflation down somewhat. In the three recessions that actually started with 2-3% inflation, the inflation rate fell to about 1% before the economy recovered. History suggests, therefore, that initial inflation of 2% will produce a bound of -1% on the real interest rate.

For the recessions that started with inflation above 4%, we can gauge the relevance of a real-interest-rate bound by examining the lowest value reached by the real rate during the recession and subsequent recovery. In two of the five cases – the recessions of 1973-75 and 1980 – the real rate fell below -4%. In these episodes, a lower bound of -1% would have severely distorted monetary policy. For the recession of 1969-70, the real rate fell to a minimum of -2.3%. For the recession of 1990-91, the minimum was -0.6%; this episode would have been a near-miss with a lower bound of -1%. Only in one case, the recession of 1981-82, was the minimum real rate above zero.

To summarise, history suggests that, with a 2% inflation target, the lower bound on interest rates is likely to bind in a large fraction of recessions.” 

In other words, by devaluing money even faster than they already do, central banks will be all the better able to manipulate real interest rates into negative territory during recessions, which is held without qualification to 'help the economy'. The 'zero bound' and the mythical 'liquidity trap' are regarded as evils that must be avoided at all costs.

Central planning by central banks is accepted without question: that it could have negative effects on the economy's ability to create wealth is passed over in silence. The author briefly discusses objections against overly inflationary policies and dismisses all of them by arguing that the negative effects allegedly could not be 'measured' to be very large (such as e.g. the distortion of relative prices). He invokes Paul Krugman's authoritative judgment on that point.

If that is so, we might well ask, what was the 2007-2008 crash then? A visitation from Mordor? To use the diction preferred by Mr. Krugman, did the 'Bust Fairy' visit us because we were bad?

As Joseph Salerno pointed out last year (discussing a column by Caroline Baum published at Bloomberg), the entire chain of reasoning employed by the inflationists is based on the illusion that 'spending' somehow produces wealth – and it is essentially not one iota different from the reasoning employed by John Law and all the inflationists who followed in his wake: 

“How many eminent macroeconomists is one clear-thinking and literate economic journalist worth? Well if the journalist is Caroline Baum of Bloomberg.com, the answer is at least five. In a column this week, Ms. Baum, channeling Henry Hazlitt, demolishes the argument put forth by the IMF’s Olivier Blanchard, Ivy League Professors Ken Rogoff, Greg Mankiw, and Paul Krugman and Fed Chairman Bernanke that an acceleration of the inflation rate is the panacea for the still ailing U.S. Economy. The gist of the argument of these luminaries of modern macroeconomics is that an increase in the inflation rate, say to 3 to 4 percent, will stimulate the economy in two ways. First, higher inflation will “help the process of deleveraging” by eroding the real value of debt, thereby reducing the burden of debt payments and encouraging spending. And second, an increase in the inflation rate will arouse expectations of future depreciation of the dollar and thus panic businesses and households into spending their hoarded cash.

This argument is rooted in what might be called the “spending illusion,” the simplistic and deeply fallacious doctrine that the spending of money drives the economy.  This doctrine originated in the writings of John Law, the notorious early eighteenth century gambler, financial schemer–and central banker. Law’s doctrine inspired the monetary cranks of the nineteenth century as well as the founders of modern macroeconomics in the twentieth century, Irving Fisher and John Maynard Keynes. It remains deeply entrenched in the macroeconomic thought of the twenty-first century.” 

(emphasis added)

In fact, we would argue that this fallacy is now more entrenched than it has been in at least 30 years. After the disastrous experience of the 1970s run-away inflation, the hoary and crude inflationism of Keynesian provenance was at least discredited for a while. That central banks have adopted the relatively low 2% inflation target that is now under fire is the last remnant of the experience of that era. Of course in adopting this low target they have revived another fallacy, namely that of Fisherian 'price stability' policy, the dangers of which we have previously discussed.

In a progressing economy, prices should fall, not remain 'stable' or rise. After all, the object of economic activity is doing more with less, i.e., increasing productivity.  Keeping prices 'stable' in an economy that experiences a large jump in productivity and an expansion in trade (such as e.g. happened in the 1920s and 1990s) thus requires enormous monetary inflation.

The resulting distortions as a rule produce gigantic bubbles in debt and asset prices and large scale consumption of capital that eventually lead to a secular bust – which is precisely where we find ourselves today.

Now we have 'economists' (we use the term loosely) like Krugman, Blanchard, and Laurence Ball arguing for even more monetary pumping. Let us not forget, the Fed has expanded the US economy's true money supply by about 80% since early 2008 alone and by 225% since the year 2000 when the current secular bust period (or depression if you will) began. To what end? If this policy actually 'works' as the inflation promoters claim, in what way has the economy improved since 2000?

Mind, we do not need empirical evidence to prove that their claims are bogus. Sound economic reasoning should suffice. They are the ones who always point to empirical data to buttress their case. However, not even by their own standards can it be confirmed that their policy recommendations even remotely 'work' – the exact opposite is the case.

Short term sugar highs for the economy like the housing bubble or the current echo bubble in junk bonds and stocks do not represent proof that inflationary policy works. It is precisely in these boom periods that scarce capital is unwittingly consumed and the economy is severely weakened on a structural level. The inevitable bust is merely the time when these facts are revealed and the economy attempts to adjust to reality.

US money supply TMS-2 since 2000 – an increase of 225% (from $2.9 trillion to $9.4 trillion). Where are the positive results?

Frank Shostak on the 'Liquidity Trap'

Frank Shostak discusses the 'liquidity trap' ideain a recent article. As he points out, the 'spending fallacy' is based on the idea that it is money that actually funds production and consumption. That is however not the case. Money is merely a medium of exchange. Money is of course indispensable in a market economy based on the division of labor, because without money prices, there can be no economic calculation. A complex market economy with increased levels of specialization is not thinkable without economic calculation (this is also why socialism is fated to fail: its economic managers cannot calculate).

However, money funds neither production nor consumption. As Shostak points out, if the baker wants to buy shoes from the shoemaker, he must first produce bread. That he sells his bread for money and then uses the money he receives to pay for the shoes does not alter the basic fact that it was his bread that actually funded the purchase of the shoes.

When an entrepreneur pays his workers, he forwards to them the ability to acquire present goods from the economy's pool of real funding before the product of their labor is finished. However, once again, what funds production is not 'money', but the fact that this money can be used to pay for goods and services the workers need for their own survival and well-being. If those goods and services did not exist, it wouldn't matter how much money they receive. It would be worthless paper.

Introducing additional money from thin air into the economy first and foremost leads to a diversion of resources into the hands of the early receivers of the new money. It does not create wealth, on the contrary, it makes the job of wealth creators more difficult (as Shostak points out, it enables exchanges of 'something' – namely real resources – for 'nothing' – namely money from thin air).

Every credit boom leads to economic imbalances due to a shift in relative prices. Factors of production are drawn toward lines that would not be regarded as profitable if the additional money and credit had not pushed interest rates down. Artificially low rates create the illusion that more real savings exist than are actually available and that the production structure can be profitably lengthened. It later turns out that many investment projects have simply wasted capital; many cannot even be finished (see the ghost towns of Spain as a pertinent recent example).

Moreover, the distortion of prices falsifies economic calculation. Sales in money that has been devalued are contrasted with input costs incurred when its value was still higher; a part of the profits so obtained is an illusion. Write-offs and depreciation are similarly falsified. The end result is that a part of what appears to be profit actually consists of the capital employed. Whether these illusory profits are spent on consumption, paid out to shareholders or used to increase wages, at the end of the process there is impoverishment.

As Shostak points out, it is a good bet that the economy's pool of real savings has been severely damaged by the series of credit booms preceding the current period. If so, then there is literally 'nothing left to lend' – as ultimately, what borrowers really require is capital, not money. If banks were to increase their lending under such circumstances, they would only succeed in adding to their non-performing assets.

Conclusion:

The inflation policy only 'works' by dint of an illusion: the wasting of scarce capital for a brief time appears as a revival of the economy in aggregate type statistics. Spending as such and 'activity' alone however do not create wealth. It has to be activity that is purposefully aimed at serving future consumer wants.

They could, if they wanted to, build yet another giant shopping mall in China. That would boost GDP for sure; however, if later the mall stands empty, then obviously all the resources  – labor, cement, steel, and so forth – expended in building it will have been wasted. It is precisely such waste that is engendered by an inflationary policy. And yet there are economists demanding even more inflation. We cannot say how long it will take before this policy is once again thoroughly discredited (at least for a while – if history is any guide, it will never be discredited for good), but it is inevitable that it will happen. Getting to that point is unfortunately not likely to be pleasant.