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Wednesday, September 15, 2010

Are We Headed for Deflation – or Inflation?

Keynesians versus Austrians.

For the past few years economic debate has fallen into two general camps. The first, which features Paul Krugman as its chief spokesman, says that the government must be bold in spending money for a “stimulus” — the more the better.

The second camp has people like Peter Schiff and the Austrians claiming that “stimulus” spending by government will only make things worse and that the government risks creating conditions that can bring about massive inflation and runaway gold prices.

So which is it? Is the stimulus a disaster because it does not involve enough spending, or has the government gone too far and created dangerous economic conditions that will explode later?

Krugman clearly believes his argument has won the debate. Pointing to the fact that interest rates currently are low and that the possibility of deflation exists, he writes:

[T]hat framework [of the “liquidity trap”] has held up very well. That basic framework led me to conclude that the Obama stimulus was much too small; that the huge increase in the monetary base wouldn’t be inflationary; that interest rates would stay low as long as the economy remained depressed, despite huge government borrowing. All this has turned out to be true.

Now, there’s no virtue in sticking with a model if it fails the reality test; but in this case the model — unlike the economy — has performed well.

In other words, we should look at results. Where is the hyperinflation? Where are the sky-high interest rates? Haven’t the so-called bond vigilantes been wrong?

I am in the second camp, but the current Austrian claim that “hyperinflation is just around the corner” is not an acceptable answer. The inflation wolf may well be at the door, but we need to do a better job of explaining not only why the stimulus is not working – and actually making things worse – but also why the current situation exists. Furthermore, we need to better elucidate why we believe inflation is a real danger in our economic future.

The short Keynesian answer to why the current situation exists is that “aggregate demand” is weak, which is why we supposedly need more “stimulus” spending through government. According to Krugman, if the government spends enough, then the economy will gain “traction” and the economy will operate as though on automatic pilot. However, Keynesians argue, if government spending does not fill the gap left by the drop in consumer spending, the economy will implode into the black hole of depression. Krugman argues we are well on the way to that point unless government spending picks up rapidly.

What Next?

How, then, can this current scenario suddenly morph into hyperinflation? Some economists point to the huge increase in the monetary base created by the Federal Reserve System, but unless that base (which is found in bank reserves) turns into a blizzard of loans, it remains out of circulation and has little effect on prices.

There is a way, however, for this current situation to turn into an inflationary mess, and it is related to the stimulus. Most countries where we have seen outright hyperinflation have had large government-owned sectors of the economy, and governments simply printed the money to pay the workers, who then quickly spent the new money.

While new money in our economy comes through bank loans, if in the future the Fed and the banks aggressively purchase U.S. short-term bonds to finance current spending increases, that effectively would be like printing money and certainly would quickly force up prices. Furthermore, such a scenario would not be far-fetched should Washington become desperate enough with an imploding economy.

There is a way out, however. In my column next week I will show the way to an economic recovery and explain why increased government spending has not worked. While it is doubtful that Washington is in a mood to listen, nonetheless the Austrians really do have the answers. No. they don’t involve yet another “stimulus” and the accompanying threat of inflation.

  • Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Economics from Auburn University. He is a member of the FEE Faculty Network.