Freeman

ARTICLE

Inflationism

AUGUST 01, 1977 by WILLIAM H. PETERSON

Dr. Peterson is the Burrows T. Lundy Professor of Philosophy of Business at Campbell College, Buies Creek, North Carolina.

. . . there is no subtler, no surer means of overturning the existing basis of Society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction and does it in a manner which not one man in a million is able to diagnose.

So observed John Maynard Keynes, member of the British delegation to the Paris Peace Conference, in his book, The Economic Consequences of the Peace (1919). Within four years, a vicious hyper inflation had thoroughly debauched the mark, overturned the existing basis of German society and prepared the way for a Hitlerian Götterdämmerung.

Lord Keynes’ observation is not without irony. Later Keynes was himself to become enraptured with the idea of inflationism—to become, it would appear from the record, the most powerful if inadvertent ad­vocate of that creed in the Twen­tieth Century.

What is inflationism? I see it as a social mirage, the modern-day ver­sion of the ancient search for the philosopher’s stone that would transmute lead into gold (or "stone into bread," as Keynes put it in 1943), the hope for a social per­petual motion machine, the wish come true of King Midas for all he touched to turn into gold (only to find he could then neither eat nor drink).

Inflationism, in today’s terms, is deficit-spending, deliberate credit expansion on a national scale, a public policy fallacy of monumental proportions, of creating too much money that chases too few goods. It rests on the "money illusion," a widespread confusion between in­come as a flow of money and income as a flow of goods and services—a confusion between "money" and wealth. As Adam Smith observed in his The Wealth of Nations (1776):

That wealth consists in money, or in gold or silver, is a popular notion which naturally arises from the double func­tion of money, as the instrument of com­merce, and as the measure of value. . . . To grow rich is to get money; and wealth and money, in short, are, in common language, considered as in every respect synonymous.

Today prosperity has become but a matter of alleviating the "short­age" of money, of making money—literally. And not, primarily, of making goods and services.

For Keynes, inflationism was an idea whose time had come, coming as it did during the Great Depres­sion when people and politicians were desperate for solutions, almost any solution. Besides, the Keyne­sian solution was not clothed as in­flationism but as a means of reliev­ing inadequate aggregate demand with "temporary" or " contra-cyclical" deficit-spending, of attain­ing a balanced budget over a busi­ness cycle, over a cycle of years.

But the way things worked out, the legacy of Lord Keynes has become national deficits ad in­finitum pretty much the world over.

Economists James M. Buchanan and Richard E. Wagner of the Center for Study of Public Choice at the Virginia Polytechnic Institute decry mounting deficits in America, each one seeming to make yet another entry for the Guinness Book of World Records. In their Democracy in Deficit: The Political Legacy of Lord Keynes (Academic Press, 1976, 207 pages, $11.50), Buchanan and Wagner link Key­nesian type deficits to rising infla­tion, heavy unemployment, expand­ing government, lagging capital for­mation and generally deteriorating economic performance.

More importantly, as may be gathered from their subtitle, the Buchanan-Wagner critique of Keynesian economics is not so much on its technical structure as on its political implications, on how these implications have long im­pacted on economic policy decisions since the Great Depression—decisions adding up to the global Keynesian Revolution.

The General Thesis

In a nutshell, what are the Revolution’s technical underpin­nings all about? In his The General Theory of Employment, Interest and Money (1936), Lord Keynes ad­vanced the possibility, if not probability, of an underemployment equilibrium in a mature national economy such as Great Britain or the United States. He described a gloomy scenario of a depression long persisting without any effec­tive automatic stabilizing market forces. He saw aggregate employ­ment as a function of aggregate de­mand (total spending), which tended to contract cumulatively—unless somehow counteracted. Keynes’ approach was strictly macroeconomic, or to use the equa­tion popular with Keynesians to­day: Y = C + I + G, or total na­tional income equals total consump­tion spending, plus total invest­ment spending, plus total govern­ment spending.

The cause of depression would be private sector oversaving or under spending (underconsumption and/or underinvestment). Hence Keynes saw G as a deus ex machina in which government could simply furnish spending stimulus as needed. The stimulus, which could apparently be turned on and off like a faucet, would happily restore full employment; and it would be greatly aided by the operation of a chain-reaction effect on total in­come, a cumulative, circulatory ex­pansion of aggregate demand—Keynes’ famous "multiplier."

It is to the credit of Professors Buchanan and Wagner that they break new ground in more than four decades of Keynesian critiques, that they perhaps get to the heart of the problem in the entire Keyne­sian structure: the assumption of apolitical economic managers, of an intellectual ruling elite, of selfless men in high places dedicated solely to the public interest.

Unbalanced Budgets

As the record shows, this assumption of political altruism has proved to be most unreal in applica­tion, from Tokyo to Ottawa, from Stockholm to Buenos Aires, for the Keynesian-oriented world has long been awash in red ink, in perennially unbalanced national budgets. In the clash of pre-Keynesian economics versus post-Keynesian politics, the VPI economists observe that politics wins practically every time.

The Washington experience is a case in point. To be sure, U.S. economic managers, and their coun­terparts elsewhere, have had to assume an aura of economic omniscience so as to decipher lagging and frequently conflicting economic statistics, to "fine-tune" the economy, to produce just the right mix of fiscal and monetary policy under ever-changing economic con­ditions. Such an economic challenge is task enough; in a political en­vironment with a national election in every even-numbered year, the challenge amounts to, apparently, an impossibility.

To wit: The officially projected deficit of $64.7 billion in the 1978 fiscal year beginning Oct. 1 (the 17th deficit since 1960) comes atop an estimated inflation-generating $52.6 billion deficit this fiscal year.

Why? Why deficit upon deficit, world without end? The answer, in a word, is politics, in a letter, G.

Significantly, the VPI economists distinguish between market com­petition and political competition, a distinction Lord Keynes and his disciples did not develop. Market competition is continuous; at vir­tually every instance of purchase a buyer can choose from among dif­ferent competing sellers. Political competition, in contrast, is discon­tinuous, intermittent; the voters’ decision is binding for a fixed term—usually two, four, or six years. Market competition permits several competitors to survive at the same time; the capture by one seller of a majority of the market does not deny the ability of the minority to choose its preferred supplier. Political competition, on the other hand, has an all-or-none characteristic; the capture of a ma­jority or even a plurality of a market basically hands over the en­tire market to a single supplier.

Nor do the distinctions stop there. In market competition, as Buchanan and Wagner note, the buyer can be reasonably certain of just what he has bought for his money. Not so in political competi­tion, for there the buyer is, in a sense, obtaining the services of a rather free agent. This political agent cannot be bound in matters of specific compliance, with many a platform promise going awinging with the swearing-in ceremony.

A Bias Toward Inflation

Given such a political environ­ment, the Keynesian provision of an elastic G is almost like giving a child free rein in a candy store. Pro­fessors Buchanan and Wagner hold that "the Keynesian destruction of the balanced budget constraint" on a year-to-year basis has yielded a political bias toward budget defi­cits, monetary expansion and public-sector growth. The bias ties into the politicians’ natural proclivi­ty to spend, to avoid taxing, to ap­pear humanitarian, altruistic, munificent (with, of course, other people’s money)—in effect, to buy votes. The bias also ties into the fact that the economic managers are, in every case, political ap­pointees and, especially in the instance of the Federal Reserve Board, creatures of Congress; this means their ability to contravene their political superiors is cor­respondingly weak.

This politicalizaton of the Dismal Science in the halls of government seems to explain American fiscal and monetary experience since the Great Depression. It seems to explain how economic theory and policy have developed in recent decades to meet, if not marry, political exigencies. The marriage, if that’s what it is, has not been a hap­py one. A glance at recent decades of "managing the economy" illus­trates this marital incompatibility.

In the early stages of the Great Depression (itself largely the prod­uct of credit expansion in the Twen­ties followed by credit contraction in the early Thirties), Franklin Roosevelt, as a Presidential suitor in 1932, ran on a balanced-budget plank and publicly decried GOP deficits ("continuation of that habit means the poorhouse"). Once in of­fice, however, President Roosevelt soon found "pump-priming" expan­sion of spending programs political­ly popular, while tax increases were not. The balanced budget goal seemed more and more elusive.

Political Attributes

Moreover, along came Keynes’ General Theory. Though addressed to academics and incomprehensible to almost all but professional economists, it was promptly perceived by politicians for its political value. Deficits became respectable. Spending programs and tax mea­sures could be politically manipu­lated this way and that. A "flexi­ble" budget, after all, has to play the main role in stabilizing the economy and sustaining "full em­ployment." Baldly, inflationism was in.

The "full employment" concept was enacted into law in the Employ­ment Act of 1946. The Act, which formally married economics to politics, directs the federal govern­ment to "use all practical means consistent with its needs and obligations . . . for the purpose of creating and maintaining . . . condi­tions . . . to promote maximum employment, production, and pur­chasing power." The Act leaves Professors Buchanan and Wagner cold. They protest its political im­plications and believe that the Act "may come to be regarded as one of the more destructive pieces of legislation in our national history."

They see, for example, how the Eisenhower Administration played a reluctant spouse in the Keynesian marriage between political practice and economic theory. The GOP came into office to do something about inflation and the growth of Federal spending, only to come under Democratic fire for "fiscal drag." The Republicans lost the White House in 1960, after losing the Congress in 1954 (which hasn’t been regained since).

Initially President Kennedy was also something of a reluctant spouse, but, note the VPI econ­omists, his economic counselors were, to a man, solidly Keynesian.

The counselors, who included Walter Heller of the University of Minnesota and John Kenneth Gal­braith of Harvard, apparently won a complete convert in JFK after the 1962 steel pricing confrontation and consequent stock market slump. In 1963 President Kennedy called for a dramatic tax cut, without any corresponding spend­ing cut, in order to accelerate economic growth and bring actual GNP in line with potential GNP, given the productive capacities of the nation. With the tax cut, enacted in 1964, the New Eco­nomics had really arrived, but hard-nosed politics had long preceded it.

In this new dawn it seemed that "the enlightened would rule the world, or at least the economic aspects of it," to quote Buchanan and Wagner. Then they add: "But such dreams of Camelot, in eco­nomic policy as in other areas, were dashed against the hard realities of democratic politics."

Redistribution Schemes, Open-Ended Spending

The hard realities included the redistributionist zeal of Lyndon Johnson’s "Great Society" aug­mented by his Vietnam guns-and­butter strategy, and Richard Nix­on’s New Economic Policy of wage/price controls (which quickly became a cover for the fastest monetary growth since World War II-12.1 per cent in election-year 1972).1 The realities also included the open-ended spending proclivi­ties of the Welfare State and the no-growth implications of Ralph Nader, the Sierra Club, Common Cause, and Senator Edmund Muskie’s Environmental Protection Agency.

The Keynesians also overlooked some economic as well as political realities. Probably the most devas­tating reality has been the unprece­dented worldwide experience of "stagflation"—heavy inflation cum heavy unemployment. In the U.S., inflation was 12.2 per cent in 1974; in 1975 unemployment was 8.5 per cent. How did this happen? The VPI authors cite some economic reasons.

For apart from its political naïveté, the New Economics can be faulted on at least three technical grounds. First, the Keynesians have relied on the money illusion—the notion that fiscal-monetary stimulus would yield a beneficial "automatic lowering of real wages as a result of rising prices" (General Theory, p. 264). But in a world in which inflation is widely antici­pated by market participants through escalator clauses, in­creased wage demands and infla­tion-hedged price boosts, the money illusion breaks down. Indeed, Buchanan and Wagner note that "the generation of inflation that has been predicted will do nothing towards stimulating employment and output."

Secondly, the Keynesians over­looked the impact of inflationism on economic calculation and resource allocation—a possible general disruption of the market economy, perhaps a full-fledged business cy­cle. Relative prices, including in­terest rates, are distorted, uneven­ly, by rapid increases of the money supply entering the economy at different times and in different ways and places. Market par­ticipants receive false signals. For example, corporate income state­ments reflect "phantom profits" which do not incorporate true in­ventory valuations and especially plant and equipment replacement costs; moreover, reported "record profits" are expressed in current, inflated dollars and not in constant dollars.

Thirdly, Keynes and the Keyne­sians overstress macroeconomics to the detriment of vital microeco­nomic considerations. This leads to a one-dimensional, depthless per­ception of the forest but not of the widely different individual trees. G is perforce a heavy-handed eco­nomic policy instrument—taking such diverse, discrete forms as dams, defense projects, welfare pro­grams and so on. Financially, G poses quite a drain on capital markets—and private capital formation—a "crowding-out" of private borrowers through higher interest rates.

Unemployment Realities

This strictly macroeconomic view of things leads to the glossing over of still other problems, including the microeconomics of unemploy­ment. In the case of structural unemployment, for example, the authors observe in a footnote that government spending may act to cement pockets of unemployment "into quasipermanence." Or con­sider the problem of properly defin­ing full employment, traditionally set at 4 per cent. Now it turns out that 4 per cent is much too low, and may have been so for almost the last 30 years.

Economist Robert Hall of the Massachusetts Institute of Tech­nology, for example, says that the sustainable rate of unemployment, below which inflation begins to escalate, was around 5 per cent in 1948 and has slowly risen to be­tween 5½ per cent and 6 per cent in recent years. This rise, reflecting in part the influx of women and teen­agers into the labor force, seems to mean that economic managers have long been working with a fallacious policy goal. Nonetheless, the Humphrey-Hawkins national eco­nomic planning bill, the Full Employment and Balanced Growth Act of 1976, went beyond the 4 per cent goal and mandated a quixotic unemployment target of 3 per cent, to be attained within four years.

Balance the Budget

Well, what is the solution to stagflation and related ills? James Buchanan and Richard Wagner believe the heart of the problem lies in "the political legacy of Lord Keynes." They believe the solution lies in virtually banishing peacetime deficit-spending. They call for, as do Senator Carl Curtis of Nebraska and Congressman Bill Archer of Texas, a Constitutional amendment requiring an annually balanced budget, except in a national emer­gency (as declared by two-thirds of both Houses of Congress and ap­proved by the President). Their solution merits serious considera­tion.

In any event, the timely Buchanan-Wagner book focuses at­tention on the overriding economic paradigm of our age: government intervention to "improve" free market performance. This is a paradox, for government is more often the problem than the answer. In the case of Keynesian theory and policy, maybe Prime Minister James Callaghan of Great Britain, the land of Lord Keynes, has the last word on inflationism in his ad­dress to his own Labor Party last fall:

We must ask ourselves unflinchingly, what is the cause of high unemploy­ment? Quite simply and unequivocably, it is caused by paying ourselves more than the value of what we produce. This . . . is an absolute fact of life, which no government, be it left or right, can alter. . . . We used to think you could just spend your way out of a recession and increase employment by cutting taxes and boosting government spend­ing. I tell you in all candor that that op­tion no longer exists, and that insofar as it ever did exist, it worked by injecting inflation into the economy. And each time that happened the average level of unemployment has risen. Higher infla­tion, followed by higher unemployment. That is the history of the last 20 years.


1 From Ludwig von Mises, Planning for Freedom (Libertarian Press), page 81: "The superstition that it is possible for the govern­ment to eschew the inexorable consequences of inflation by price control is the main peril. For this doctrine diverts the public’s attention from the core of the problem. While the authorities are engaged in a useless fight against the attendant phenomena, only few people are attacking the source of the evil, the Treasury’s methods of providing for enormous expenditures. While the bureaus make head­lines with their activities, the statistical figures concerning the increase in the nation’s currency are relegated to an inconspicuous place in the newspapers’ financial pages."  

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August 1977

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