Free market economists debate the prospects, fears, and even hopes for rising prices in post-crises America
Since the financial crisis hit the country in September 2008, the White House, Congress, and Federal Reserve have responded with a combination of bailouts, federal spending, and an expansion of the money supply. Meanwhile, many free market thinkers have been warning of a wealth-sapping malady last seen in the U.S. more than a quarter century ago: It's a word that strikes fear in the hearts of survivors of the 1970s, elicits shrugs from the young voters who helped elect Barack Obama president, and (as we'll see) provokes fierce debate among even the most libertarian economists.
After decades of relative confidence that the price of milk would be more or less the same today as it was yesterday and last year, Americans are once again wondering whether to keep what money they have in mattresses, gold bars, or banks. Has the time come to stockpile canned goods and pick up a wheelbarrow for transporting currency, or should we be afraid of the opposite—a prolonged contraction that causes prices to crash?
In mid-July, inflation seers got their first juicy slice of supporting data when June wholesale prices jumped 1.8 percent, the sharpest rise in two years and twice the increase most analysts expected. Gold prices surged on the news to nearly $940 an ounce. Just before those figures were released, reason asked eight free market economists to assess the short-, medium-, and long-term prospects for inflation and to say what, if anything, can or should be done about it.—Katherine Mangu-Ward
Inflation Is Already Here; Next Come Rising Prices
Despite economists' efforts to obscure inflation in a tangle of jargon, it is an extremely simple phenomenon. Almost every dictionary defines inflation as an expansion of the money supply, not rising prices.Although more money may not immediately translate into rising prices, over time the correlation is extremely reliable.
Inflation has always been a means for governments to raise revenues without taxation. When gold was the only accepted currency, governments inflated through debasement of coins, surreptitiously blending base metals into gold. By melting down one real coin to make two alloyed coins, money could be "created" with little effort. Nice trick. But eventually consumers caught on that their coins were bogus. Their reaction was often violent.
Paper money largely solved this problem by allowing governments to print money, or extend credit, at will. And thanks to the overly complex Rube Goldberg explanations of inflation devised by academics, such as "the wage-price spiral," "demand pull," and "cost push," governments can
inflate without admitting culpability for rising prices. The Federal Reserve's monetary base statistics show that in the last year the money in circulation has increased far faster than at any other point in American history. Thus, by the dictionary definition, we have inflation. But prices
have been relatively stable because downward recessionary pressures are currently counterbalancing the upward pressures of the expanded money supply.
The new money has been largely parked in financial institutions. Thanks to government prodding and aggressive stimuli, it will soon be showered on the economy at large.When the tide rolls in, there will be more money chasing fewer goods. (Recessions reduce the supply of things.) The result: higher prices.
The government clings to the fantasy that it will be able to "mop up" this excess liquidity before the business end of inflation kicks in, effectively taking money back out of circulation. Good luck with that. Recent history clearly shows that the authorities have no political will to dispense tough medicine."Removing liquidity"would require either much higher interest rates or a severe curtailment of credit. But politicians believe that credit is the "lifeblood" of our economy. President Barack Obama himself has said so. If the Fed was unwilling to raise interest rates substantially in the middle years of this decade, when the economy seemed healthy, how can we expect it to do so now?
Peter Schiff (firstname.lastname@example.org) is president of Euro Pacific Capital and author of Crash Proof: How to Profit From the Coming Economic Collapse (Wiley).
Why Forecasts Are All Over the Map
Jeffrey Rogers Hummel
Under normal circumstances, a massive and sudden monetary explosion—like the one initiated by the Federal Reserve after September 18, 2008, which took us from a monetary base of $850 billion to $1.7 trillion in three months—would bring skyrocketing inflation. But these are not normal circumstances. A high demand for liquidity, mostly on the part of banks, has thus far prevented inflation from taking off. In fact, almost all of that increase was concentrated in bank reserves, which during that short period mushroomed by an incredible factor of 13.
On one hand, the Fed's expansion of the base encouraged banks to make loans, thereby increasing the amount of checkbook money: an inflationary step. On the other hand, it simultaneously paid banks to hold more reserves: a deflationary step.Is it any wonder that economists' forecasts have been all over the map? Ben Bernanke, in what must stand as the most egregious example of central planning hubris on the part of any Fed chairman since the institution's founding, seems convinced that fine adjustments to these two controls will allow him to manage the price level perfectly.
Buried within the bailout bill of October 3, 2008, that set up the Troubled Asset Relief Program (TARP) was a provision permitting the Fed to pay interest on bank reserves. This seemingly technical change not only gives banks an incentive to hold reserves rather than make loans; it also essentially converts reserves into more government debt. Fiat money traditionally pays no interest and therefore allows the government to purchase real resources without incurring any future tax liability. Economists refer to this revenue from creating money as seigniorage. Federal Reserve notes will continue to earn no interest. But now the seigniorage that government gains from creating bank reserves will be much reduced, if not entirely eliminated.
Outside of America's two hyperinflations (during the American Revolution and under the Confederacy during the Civil War), seigniorage peaked during World War II, to nearly a quarter of the war's cost,or about 12 percent of GDP. By the Great Inflation of the 1970s, financial innovations and market sophistication had managed to reduce seigniorage to only 2 percent of federal revenue, which translates into less than half a percent of GDP. Now with the Fed having to divert potential government revenue to pay interest on base money held by banks, seigniorage has virtually been eliminated as a source of future funding. And this constraint will become tighter as people replace the use of currency with bank debit cards and other forms of electronic fund transfers.
This is not to say that monetary increases cannot still generate high inflation rates. But if the U.S. does get high inflation,even inflation exceeding double digits,the government is still confined to essentially two sources of revenue: 1) current taxes and 2) borrowing, which represents future taxes.
Interest-earning bank reserves also blur the distinction between monetary policy and fiscal policy. To see how, imagine the extreme case:Assume the interest the Fed pays on reserves is exactly the same as the interest the Treasury pays on its outstanding debt. Then Fed open-market operations are no longer exchanging government debt for created money; they are exchanging one form of government debt for another form. Monetary policy becomes entirely neutral and impotent, in a self-fulfilling Keynesian prophecy.
Jeffrey Rogers Hummel is an associate professor of economics at San Jose State University.
Inflation? We Should Be So Lucky
This crisis has been poorly understood by economists from the very beginning. The original subprime crisis of 2007 had a relatively modest impact on both financial markets and the broader economy. The much more severe crash of late 2008 resulted from monetary policy (unintentionally) becoming far too contractionary for the economy's needs. Most economists missed this problem, as they are used to looking at faulty indicators such as nominal interest rates and the monetary base (which is the money actually produced by the Fed-cash plus bank reserves). Milton Friedman and Anna Schwartz showed that these two indicators gave highly misleading signals during the Great Contraction of 1929-33. They are no more reliable in the current crisis.
It is discouraging to see so many free market economists now warning of an inflationary time bomb. I'm afraid that New York Times columnist and recent Nobel Prize winner Paul Krugman is right: The real problem is that inflation is likely to remain too low.
In a fiat money world the only sensible indicator of monetary policy is market expectations of growth in the variable actually being targeted by the central bank. That variable might be the Consumer Price Index, but I believe the economy would be more stable if the Fed targeted nominalGDPat a roughly 5 percent annual growth rate.We know from various asset markets that nominal growth expectations turned quite bearish after mid-2008. This severely depressed aggregate demand and dramatically worsened the debt crisis.
Almost everyone has reversed the causation, assuming that the intensification of the financial crisis caused the big drop in nominal income,whereas the reverse is closer to the truth. Nine months later the markets continue to signal that inflation and nominal growth will remain below the Fed's
implicit target for years to come. Monetary policy remains too contractionary, which has led to a very costly reliance on fiscal stimulus.
Most economists have a deeply ingrained instinct that printing money inevitably leads to inflation. Although our gut might tell us that the recent explosion of the monetary base is reminiscent of Germany circa 1923, it is actually more like Japan after 1998. Yet Japan has seen almost no growth in nominal incomes since 1993. This isn't to say that Japan was "stuck"in a liquidity trap; although nominal interest rates cannot fall below zero, monetary policy could have sprung the trap if the Bank of Japan had been willing to devalue the yen or commit to a policy of mild inflation. Zero interest rates reflected deflationary expectations, not "easy money."
Once the Fed began paying interest on reserves in October 2008, banks hoarded massive amounts of excess reserves, and monetary policy became much less effective. This deflationary policy was analogous to the Fed's 1936-37 decision to double reserve requirements, but it was even more costly. Both policies encouraged banks to hold on to reserves, which prevented monetary injections from stimulating the economy.
It may be hard for free market economists to admit they were wrong about inflation, but I'm afraid that is exactly what the markets are telling us. If we don't pay attention, then monetarist, supply-side, and Austrian ideas may be discredited for all the wrong reasons.
Scott Sumner (email@example.com), a professor of economics at Bentley University, focuses on monetary economics, particularly the role of the gold standard in the Great Depression. He blogs at blogsandwikis.bentley.edu/themoneyillusion.
The Choice: Great Depression or Great Inflation?
Now that it appears the threat of a worldwide financial market meltdown has subsided, the public is assessing the threat of future inflation.Many commentators are speaking as if massive 1970s-style inflation is a foregone conclusion and claiming the Fed has done a great wrong.
Hardly. How about a recap of Federal Reserve actions with some historical perspective?
Beginning in August 2007, the Fed had a choice: either increase the monetary base dramatically and stop financial markets from unraveling, or let the market take its course and eliminate the threat we currently face of potential inflation. In other words, would you rather have a Great Depression or the threat of a Great Inflation? I know which one I'm
picking, and you should not doubt what side Ben Bernanke picked either.
The Great Depression happened as it did because the Fed of the 1930s was always worried about the next inflation in a world economy that was dead from deflation. Ben Bernanke knows this history and its lessons better than anyone else walking around this big blue marble. We may yet have a depression, but it won't be because the Fed abdicated its responsibilities and let the money supply fall by 33 percent like it did in the 1930s.
The Fed has blown up its balance sheet from $902 billion on August 8, 2007, to more than $2.3 trillion today, mostly in new lending facilities created to earmark credit for specific areas of our financial markets. The danger is that the Fed's independence has been compromised in the process. Yet the money supply has increased only by about 15 percent. That is big, to be sure, but increasing the monetary base is not the same as increasing the money supply dollar for dollar.
The threat of inflation is real, but the Fed has two ways out. First is the new policy of paying interest on bank reserves. It can increase that rate as high as it wishes and thereby stop banks from loaning excess reserves and creating money. Second, there is talk of permitting the Fed to issue its own debt. This too would drain the monetary base and prevent money creation. Of course, the Treasury could take the assets off the Fed's balance sheet in a new Treasury-Fed Accord like the one reached in 1951. Don't hold your breath.
Inflation is a threat. But I would not be too ready to cash that ticket as a sure thing.
Randall Parker, a professor of economics at East Carolina University, is working on a book titled Interwar Historical Antecedents of Modern Inflation Targeting. He blogs at randallparker.blogspot.com.
Greenspan's Fear of Deflation Is What Got Us Here
By the standards of any other moment in history, the world today is a cornucopia. Prices fell steadily in the last quarter of the 19th century, another time of bounding human progress. What has been holding them up in the 21st century? Why, our central bankers have. In 2002-03, soggy consumer prices alarmed Alan Greenspan, then chairman of the Federal Reserve, and Ben Bernanke, then
a member of the Fed's Board of Governors. "Deflation!" they cried.
Inflation is too much money. Rising prices are a symptom of that excess. Deflation is too much debt. Falling prices are a symptom of that excess. But Greenspan and Bernanke defined deflation, if they defined it at all, as "falling prices." They said nothing about debt.They made no attempt to distinguish between the Wal-Mart business model (i.e., everyday low and lower prices) and a collapse in prices brought about by desperate debts. So the Bank of Alan Greenspan pressed interest rates to the floor. It was the ensuing derangement of credit- the crackup in subprime mortgages, in the debts of sub-prime corporations, and in the banks that trafficked in those items-that led us to the present pass. To forestall an imagined deflation, the Fed instituted a real one.
Now comes the money printing. The Federal Reserve has set out to debase the dollar. It makes no bones about it. "Excess reserves" is one marker of Fed policy. You may think of these balances as monetary dry tinder.At the end of 2007, excess reserves totaled $1.8 billion.Today, they stand at $744 billion.
The Fed will surely haul away this underbrush before it can catch fire, many on Wall Street insist. Perhaps. But in the wake of the previous two recessions, ending in 1991 and 2001, the Fed was slow to extinguish the extra dollars it had printed in an attempt to hasten economic recovery. And in neither one of those episodes was the nation's financial system as close to collapse as it came last year. I predict that the Fed will indeed vanquish deflation. It will vanquish deflation by creating a new inflation. You may wish it had never tried.
James Grant (firstname.lastname@example.org) is the editor of Grant's Interest Rate Observer.
A Little Inflation Can Be Good for You
Steven Gjerstad and Vernon L. Smith
Long considered the bane of modern economies, moderate inflation-around 6 percent per year for several years—may be the only way out of our current dilemma.
It would be worthwhile to carefully consider the benefits of and alternatives to inflation before taking measures to curb it. Moderate inflation, if it can be achieved, will gradually reduce the debt burden of households and stimulate household spending, generating a decentralized, market-driven recovery.
Two questions arise. First: How does inflation affect long-term creditors? Second, and perhaps more difficult: How do we induce inflation when private demand for credit is suppressed? Credit is a crucial element of the money supply. If households and firms are determined to reduce debt loads, their declining demand for credit will undermine efforts to increase the money supply.
Inflation involves a tradeoff for long-term creditors in mortgage and corporate bond markets. The values of earlier loans or bond issues depreciate, but delinquencies and foreclosures fall as asset values and consumer spending recover. The real value of U.S. Treasury debt also declines with inflation, but other assets will appreciate as consumer spending recovers. Most debt holders should benefit from moderate inflation, except those whose only investments are U.S.Treasury debt.
Although inflation may be the best way out of a deflationary spiral, the Japanese experience suggests we may not be so fortunate. In 2005, after 15 years of a debt-deflation spiral in Japan, private firms finally became net borrowers (and hence investors) again. Throughout this terribly long and arduous recovery, Japan relied on public spending and an export-driven industrial sector to maintain production and employment and to work off the stultifying debt loads of households and firms from prior asset bubbles. Political consensus for public sector spending over a 15-year period will be difficult to maintain in the United States. Strong exports that helped sustain Japan through the "lost decade" depended on the rapid growth of worldwide demand.Long-standing American trade deficits and the slowing worldwide economy make export-driven growth an unlikely way out of the U.S. downturn.
Declining demand for private credit reduces the money supply, which in turn reinforces the deflationary spiral. Even the large increase in the Federal Reserve balance sheet in September 2008 may not presage inflation. In usual circumstances, the Fed's asset purchases increase bank reserves and lead to more lending, but its recent purchases have not had the usual effects. Banks are reluctant to lend to any but the best credit risks, while many households and firms are reluctant to buy assets in a declining market.Japan has faced this dilemma for almost 20 years now.
If inflation does arise, the excess reserves of banks provide a simple means to contain it.The enormous increase in the Fed balance sheet from about $800 billion to $1,800 billion creates an unprecedented surge in the monetary base, but the Fed could limit the impact of this increase by placing a lower limit on excess reserves and thereby control credit creation by banks. Consequently, it appears now that deflation could pose a more serious risk than inflation.
Steven Gjerstad (email@example.com) is a research associate at Chapman University. Vernon L. Smith (firstname.lastname@example.org) is a professor of economics at Chapman University and the 2002 Nobel laureate in economics.
The Fed Fears Unemployment More Than Rising Prices
Donald L. Luskin
Inflation is inevitable in the intermediate and long term. Short-term inflation, however, is unlikely, because the recent financial crisis had the deflationary effect of creating enormous global demand for money balances.
The Federal Reserve responded to that demand with an enormous increase in the money supply. Politics and economics conspire to make it unlikely that the Fed will contract that supply rapidly enough to prevent inflation as the crisis ebbs and recovery ensues.
First, the economics. The Fed makes its policy decisions under extreme uncertainty and therefore must err on the side of avoiding unacceptable risks even if that means deliberately taking on acceptable risks. To the Fed, deflation is an unacceptable risk. Most economic historians, including Ben Bernanke, believe that deflation was the greatest single cause of the Great Depression; averting a repetition of that was uppermost in Bernanke's mind as he expanded the money supply so copiously during the last three quarters.
Inflation, on the other hand, is an acceptable risk. While it leads to the diminution of the real value of savings and induces all manner of economic distortions, the Fed feels confident that it is not catastrophic. Thus the Fed will surely keep the money supply extremely generous even as the economy recovers, preferring to accept the near certainty of inflation rather than any risk at all of deflation.
Second, the politics. The Fed is tasked by statute not only with ensuring "price stability"-that is, no inflation -but also with achieving "full employment." As the economy slowly recovers from an unprecedented global recession, the Fed's employment mission may have to take priority over its inflation mission. Unless inflation becomes extreme, employment is a much more potent political concern.
The Fed is likely at some point to judge that the risk of deflation has passed; yet it will not dare to take the restrictive policy actions required to quell inflation for fear of disrupting recovery in the labor market. If Ben Bernanke signals to the Obama White House that he will not support the labor market at the price of inflation, I have no doubt he will be replaced by someone else who will.
Donald L. Luskin (email@example.com) is chief investment officer of Trend Macrolytics.