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Suddenly it seems as if everyone is talking about inflation. Stern opinion pieces warn that hyperinflation is just around the corner. And markets may be heeding these warnings: Interest rates on long-term government bonds are up, with fear of future inflation one possible reason for the interest-rate spike.
But does the big inflation scare make any sense? Basically, no — with one caveat I’ll get to later. And I suspect that the scare is at least partly about politics rather than economics.
First things first. It’s important to realize that there’s no hint of inflationary pressures in the economy right now. Consumer prices are lower now than they were a year ago, and wage increases have stalled in the face of high unemployment. Deflation, not inflation, is the clear and present danger.
So if prices aren’t rising, why the inflation worries? Some claim that the Federal Reserve is printing lots of money, which must be inflationary, while others claim that budget deficits will eventually force the U.S. government to inflate away its debt.
The first story is just wrong. The second could be right, but isn’t.
Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices.
But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all.
Still, don’t such actions have to be inflationary sooner or later? No. The Bank of Japan, faced with economic difficulties not too different from those we face today, purchased debt on a huge scale between 1997 and 2003. What happened to consumer prices? They fell.
All in all, much of the current inflation discussion calls to mind what happened during the early years of the Great Depression when many influential people were warning about inflation even as prices plunged. As the British economist Ralph Hawtrey wrote, “Fantastic fears of inflation were expressed. That was to cry, Fire, Fire in Noah’s Flood.” And he went on, “It is after depression and unemployment have subsided that inflation becomes dangerous.”
Is there a risk that we’ll have inflation after the economy recovers? That’s the claim of those who look at projections that federal debt may rise to more than 100 percent of G.D.P. and say that America will eventually have to inflate away that debt — that is, drive up prices so that the real value of the debt is reduced.
Such things have happened in the past. For example, France ultimately inflated away much of the debt it incurred while fighting World War I.
But more modern examples are lacking. Over the past two decades, Belgium, Canada and, of course, Japan have all gone through episodes when debt exceeded 100 percent of G.D.P. And the United States itself emerged from World War II with debt exceeding 120 percent of G.D.P. In none of these cases did governments resort to inflation to resolve their problems.
So is there any reason to think that inflation is coming? Some economists have argued for moderate inflation as a deliberate policy, as a way to encourage lending and reduce private debt burdens. I’m sympathetic to these arguments and made a similar case for Japan in the 1990s. But the case for inflation never made headway with Japanese policy makers then, and there’s no sign it’s getting traction with U.S. policy makers now.
All of this raises the question: If inflation isn’t a real risk, why all the claims that it is?
Well, as you may have noticed, economists sometimes disagree. And big disagreements are especially likely in weird times like the present, when many of the normal rules no longer apply.
But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.
Needless to say, the president should not let himself be bullied. The economy is still in deep trouble and needs continuing help.
Yes, we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself.
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Indeed
Posted June 3rd, 2009 by Robb SmithHi Brent, this is accurate, IMO. The history of economic cycles teaches us that we often can't accurately predict the cliffs we run off, whether the deflationary cliff of 1933, the inflationary one of the 1970s or the collapse of 2008. If our economic gurus were infallible then we would not have shocks. We can't know the future, but we can know that long-dated Treasuries remain at reasonably low yields and that the unprecedented supply of bonds flooding the market to pay for our deficits and other liquidity emergencies will only be bought up if prices warrant it, meaning downward price pressure and upwards yield pressure.
As the author of the article points out the long-term insolvency of the United States is, perhaps, nearly a fait accompli at this point, and the only way out of it is through inflating the value of the debt away (something which has proven irresistible to political classes throughout economic history) or drastically changing the social contract that the Democrats have made with their constituency by reining in deficit spending in the intermediate to long term. Higher long-term interest rates are almost a given and the dollar is toast, IMO. Russia, China and Brazil will push to get off the dollar as the reserve currency and we've given them what they need to do so.
Worse, I expect economic stagnation as our overcapacity does not get soaked up for several years and American consumers shift to a savings-mentality. I think stagflation is a real and present possibility, which is an extremely difficult environment in which to preserve capital. It is also possible that next to commodity inflation (oil, gold) we get financial asset deflation (real estate, dollars). It's a tough environment ahead, I don't think people have any idea what might be coming or what the political class is doing to the long-term viability of this country.
Disclosure: I am long gold, oil, real estate and healthcare equity, and short the 30 year Treasury and S&P. (I'm also long Integral!)
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Robb Smith