All Commentary
Wednesday, November 10, 2010

Inflating Our Way to Prosperity?

Say what?

According to Paul Krugman, getting out of this depression is as easy as cranking up the printing presses at the U.S. Department of the Treasury. However, I believe, as a card-carrying member of the “Pain Caucus” (foolishly, or maybe my motives are darker), that the government’s current economic policies of borrowing and spending might not do anything but dig our economic hole even deeper.

Krugman and many other economists believe that the government is much too stingy and that what it needs to do is not cut back on spending and borrowing but rather throw the spending levers full forward. I present their views (as fairly as possible) and then look at them from another perspective.

The Keynesians – including Krugman – hold that the key to recovery is spending, increasing “aggregate demand” to move our economy out of an alleged “liquidity trap.” (A “liquidity trap” is a special situation, according to Keynesians, in which interest rates are near zero and people are holding money and not spending it. The way to bust out, say Keynesians, is for governments to borrow and spend in order to give the economy “traction.”)

Furthermore, with Ben Bernanke at the Federal Reserve System claiming that the Fed needs to find creative ways to ratchet up the rate of inflation to at least match “target” rate of 2 percent, we have the supposed experts claiming that inflation is the magic carpet to prosperity and full employment.

The thinking behind such policy prescriptions is this: Inflation will lead individuals and businesses to spend now, which supposedly will clear the inventories and convince producers to make more goods to put on the shelves. Further inflation will encourage people to continue spending, and the process will go on indefinitely. According to Krugman and others, this will give the economy traction, and from there the spend-produce-spend machine will grind along.

No Perpetual Motion

Excuse me if I differ with this assessment. First and most important, a surge of new money, while encouraging people to spend now, will not result in the economic perpetual motion that inflation advocates predict. What is more likely is that producers will gladly sell their current inventories, but they also would recognize the rush of spending as temporary at best.

The problem is that the new money injected into the system will not encourage longer-term capital investment, and why should it? Unlike the producers in economists’ mathematical models, which assume that firms automatically invest in new capital when spending increases, people in the real world are living, breathing, and thinking entities who actually observe economic conditions.

Second, with the hostile rhetoric against businesses coming from the Usual Suspects in Washington and in the media, the climate amenable to long-term investment simply is near nonexistent. Economist Robert Higgs writes that the current political environment is fraught with “regime uncertainty”: Entrepreneurs and capitalists are unwilling to commit resources long-term if the government is likely to confiscate them or create an economic climate so hostile that profitability is impossible.

As Henry Hazlitt wrote, with inflation the “good effects” come first and the bad effects follow. In the beginning people have more money in their pockets, and they purchase things at prices that existed before the surge of new money. It looks as though prosperity has returned.

However, as more and more money is pumped into the economy, not only do prices go up but so do inflationary expectations. Long-term capital investment is jettisoned for assets that will increase in value relative to money during inflation, and in the end the economy is mired in both higher prices and higher unemployment.

Hazlitt likened inflation to the “Dead Sea Fruit,” which “turns to ashes” in one’s mouth. Unfortunately, the most “brilliant” minds are demanding we harvest and eat this fruit, and when it turns to ashes they will blame businesses and free markets. They always do.

  • 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.