August 3, 2010
Inflation: The Last Gasp of the Obama Economic CrisisBy Monty Pelerin
Inflation is the inevitable ending of this awful economic crisis. The only questions are how much and when.
A rising number of supports champion inflation as a salvation strategy. Richard Russell in a recent newsletter provides the rationale (emboldening by Mr. Russell):
Mr. Russell lived during the Great Depression and has been involved in the financial world ever since. His experience and observations are valuable. The desperation of our current economic situation should be apparent when default is presumed the only option. The idea is hardly unique to Mr. Russell. Anyone who has studied the numbers knows the mathematical impossibility of paying off the debt.
I differ with Mr. Russell -- not on the government's intent, but on their ability to execute such a strategy. They do not possess the knowledge to manage it. Nor is the government likely to have the luxury of time to succeed, given the rate at which we are adding new debt.
I expect inflation because it is based on a universal political characteristic: cowardice. Politicians are not going to stop welfare, social security, unemployment, and Medicare, at least not willingly. Furthermore, the Federal Reserve is not going to force the government into insolvency. The Fed, while de jure independent, is de facto not. It was created by legislation and can be disposed via legislation. The Fed must be a willing slave of the government.
Bernanke will "print" so long as the federal government is unable to support itself via tax revenues and market-based bond sales. Government as presently constituted will never regain this stasis of self-sufficiency. The Fed has been forced into an accelerating Quantitative Easing spiral which will not stop until market or political forces intervene. The timing of the end and its ultimate form are not yet knowable.
Former Fed Chair Paul Volcker understood the dangers of inflation in the early 1980s and took forceful action at a critical time. It is likely his actions prevented hyperinflation from destroying the economy. His was a personal act of courage, aided by at least two factors not present today. First, the economy was much more resilient and not overburdened with debt. Second, Mr. Volcker had President Reagan backing him. Reagan took the political heat because he considered inflation an evil: "Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man."
Today, we have no Volcker, Reagan, or functioning economy. To argue that our economic salvation depends on default is to admit the intractability of our problems. To believe that we can manage an inflationary default strategy is the height of folly. It represents more of the Keynesian arrogance that an economy can be run from the top. Friedrich Hayek aptly phrased an inflationary strategy as akin to having "a tiger by the tail." His analogy captured a situation that is neither enviable nor manageable.
Not all economists agree on the definition of inflation, how to measure it, or its causes. Yet many believe inflation is a cure that can be applied in proper doses to resolve insolvency. The economy, akin to a cooking recipe, can be improved by adding the right dosages of this or that at just the right temperature and at the proper time. What ignorance and hubris!
At this point, Bernanke's rather simple goal of avoiding deflation appears to be failing. If he is unable to create inflation under the insane spending and QE of the last couple of years, why would anyone believe he can manage inflation to save the economy?
Inflation, once begun, is difficult to stop from a political standpoint. Reducing inflation always produces a slowdown in economic activity: the higher the inflation, the greater the slowdown. The recession Volcker triggered was severe and produced the usual painful effects.
An economy with extreme levels of debt would be especially vulnerable to massive bankruptcies and defaults. Such a debacle would bring debt back to sustainable levels, but at enormous social and economic costs. The term "Great Depression II" is something no politician wants associated with his legacy.
At some point, the political costs of accelerating inflation must be dealt with. Public unrest then becomes a bigger fear for politicians than making difficult spending cuts. Political action will then occur, but not because of "courage." Fear of peasants with pitchforks marching toward the Capitol has immeasurable motivational value.
When inflation is finally addressed, action will likely come too late. The problem with higher levels of inflation is that a new dynamic is encountered. Inflation is a function of both the supply and demand for money. While the Fed has substantial, but not total, control over supply, it has virtually no control over demand. As inflation accelerates, individual and business demand for money decreases. It does so because the cost of holding money goes up as its purchasing power declines.
Under these conditions, money is spent faster to get in front of expected price increases. This behavior appeared during the latter stages of the Carter administration, before the Volcker-Reagan clamps were applied. Under extreme conditions, people refuse to hold money (think Weimar Germany or Zimbabwe). They spend it as soon as they receive it.
Monetarists use the term "velocity" to describe the behavior of the demand for money. Velocity is a measure of the rate at which money turns over. In all hyperinflations, demand for money turns down and velocity turns up. This is a sign that the Fed has lost control of monetary policy and inflationary expectations. As an aside, the rather unexpected turndown in velocity in this recession has offset much of the Fed's easy money efforts.
The economy collapses in a hyperinflation when money ceases to be an acceptable medium of exchange. Barter replaces money. Trade is drastically curtailed, plunging the economy into a hyperinflationary depression.
While it is true that a hyperinflation will wipe out debts, it will also wipe out the value of savings, loans, and fixed income. The wealth of the middle class of a country is generally wiped out. Society is reduced to two classes -- the haves and the have-nots.
Inflation is not an economic strategy. It is the worst thing that can happen to a country. It is not manageable! Economists have less chance of managing inflation than they do of controlling a tiger by the tail. Great harm will come to both the tail-holder and the economy.
Inflation is a political strategy, and a damn poor and dangerous one to boot. It represents a desperate attempt to kick the can down the road one more time. It is the last hope for scoundrels. It will destroy the economy and society. As a political strategy, inflation has only two purposes:
The reader should make his own judgment as to whether either or both intentions might be applicable.
Monty Pelerin is a recovering economist who blogs at www.economicnoise.com.