Inflation vs. Deflation
This is a guest post from Mike Kurth, Professor of Economics at McNeese, and an old friend of mine from grad school at VPI (aka known as Virginia Tech). When he sent this along to me and others, he attached this article that makes a similar point by Peter Cohan.
-MC
They say generals always fight the last war. I think the same is true of many economists; we are always fighting the last depression. In the Keynesian economic model, recessions are associated will falling prices due to insufficient demand. Ergo, the solution is to pump money into the economy to keep people spending. But recessions do not always lead to deflation. For example, in the seventies we saw “stagflation” with double-digit unemployment and double-digit inflation.
Basically, an economic depression occurs when markets collapse. Not just the stock market, but markets in general. In the nineteen-thirties this happened when the Fed raised reserve requirements in an effort to restore public confidence in the banks, but it had the unintended consequence of contracting the money supply and forcing banks to call in good loans. Faced with deflation, people began hoarding their money-burying it in cans in their backyards or stuffing it in their mattresses-rather than it saving and investing.
The Roosevelt administration then implemented a series of reforms to fix the economy, but each “fix” only made things worse. Somehow, for the next ten years the Democrats managed to convince the American public that all our economic woes were caused by Herbert Hoover and the failure of capitalism, and that government intervention was the solution rather than a large part of the problem. The point is that in the nineteen-thirties the causation was from a currency collapsed, followed by ill-advised government intervention which caused markets to collapse, rather than the other way around.
The problem today is not insufficient money, but too much money. The world is afloat in debt. Governments and their economic advisors in the post-war era have confused prosperity with the ability to spend. As long as we can buy big homes, new cars, fancy appliances, and the latest electronics, we are prosperous. Thus, at the first sign of a slowdown they have pumped more money into the economy, primarily by expanding consumer debt, to keep consumers spending and the nation “prosperous.” For over two decades now, US consumers have spent more than they earned. Clearly, this is not sustainable, and I fear we have now hit the credit wall.
The sub-prime crisis did not come about because the market system failed or because Democrats wanted to qualify low-income persons for home loans. The problem developed as money fled the stock market after the high-tech bubble burst, much of it going into real-estate, causing home prices to rise. Wanting to expand debt to maintain the appearance of prosperity, the government relaxed regulations were so that sub-prince lenders such as Countrywide and DiTech could encourage people with poor credit due to high credit card balances to consolidate their debt into one low payment by tapping into their home equity.
Thinking they had discovered manna from heaven, many of these high-risk borrowers then re-maxed their credit cards in the belief that in the future they could simply roll this new debt into their mortgages as home prices continued to rise. But, alas, the housing market also proved to be a bubble too, and when home prices fell these people were trapped with huge credit card debt, mortgage payments they could not afford, and negative equity in their homes.
The long-term solution this economic crisis is not to pump more money into the economy and further expand debt. Our government is acting like someone who has just maxed out all their credit cards and is feverishly filling out applications for new cards so they can keep spending to maintain their style of living. Somehow we have to get back to fundamentals: real prosperity depends on our wealth and not simply our ability to spend.
The consumer price index fell this month because oil prices have fallen sharply, but core inflation rose. In other words, lower oil prices are currently masking the underlying inflation taking place in our economy. We are now witnessing bail out mania in Washington: Congress is passing out hundreds of billions-no, make that trillions–of dollars to special interests, and no one is asking from whence the money will come. It cannot come from taxes; the American people-even the rich ones-don’t make enough money to pay that tax bill! If the government cannot get it from taxes, there are only two other possible sources: either borrow it or print it.
Will the Chinese lend us more money? I’m hoping they just hang on to the trillion plus dollars of our debt they now hold and don’t try to cash it in to stimulate their own economy. How about the Europeans or Japan? Their economies are in recession, too. We could ask our friends in OPEC, but with falling oil prices I doubt they are going to line up to loan us money. So that leaves only one option-we print it.
I don’t want to sound like some alarmist nut-case, and I don’t want to scare anyone. But I am concerned that we could possibly see hyper-inflation, similar to what the Germans experienced after WWI. If that happens, the entire global financial structure-which is built on the US dollar-will collapse. Many economists are predicting deflation as consumers cut back on spending and industrial output slows down. We probably will see some falling prices in the initial phases of this recession, but I think the eventual impact of these massive government bailouts will be more money chasing fewer goods, which means inflation and probably the end of the US dollar as the de facto global currency.
Mike Kurth