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Wednesday, October 20, 2010

The U.S. Economy Needs Inflation?

Who set that liquidity trap?


So it now is official. Officials at the Federal Reserve System claim the United States is mired in a “liquidity trap,” so the government must engage in inflationary policies to end the recession and bring the U.S. economy into recovery. The Financial Times (registration required) reported:

Charles Evans, president of the Chicago Fed, said that “in my opinion, much more policy accommodation is appropriate today” because “the US economy is best described as being in a bona fide liquidity trap”, a point where ultra-low interest rates and high savings rates conspire to make monetary policy ineffective.

It gets even worse:

…[H]e said the Fed should consider using a temporary target for the level of prices instead of the rate of inflation in order to drag the economy out the trap by convincing businesses and consumers to stop saving and start investing and spending.

When combined with Fed Chairman Ben Bernanke’s recent pledge to raise the rate of inflation, these statements are a declaration of war on sound money, and they also appeal to an utter ignorance of money, interest, and the nature of inflation itself. It is hard to know where to begin in such a short space, for economic fallacies seem to rule with U.S. policymakers. I will begin with the “liquidity trap” claim itself.

The Mark of Keynes

John Maynard Keynes claimed that people will develop an irrational “liquidity preference,” hoarding money while waiting for interest rates to rise. The modern apostle of the liquidity trap is Paul Krugman, who says the only way out is for the government to spend and inflate, which then will dislodge the hoarded cash, as people spend in anticipation of rising prices.

One would hope that the supposed “great minds” at the Fed and in academic economics would better understand inflation and its destructiveness, but that is not to be. First and most important, the lack of inflation is not the enemy of the economy. The economy does not remain in recession because government is not debasing money quickly enough, no matter what they say at the Fed.

Instead, the economy is in a downturn because government and Fed policies recklessly created two financial bubbles within a decade. Those bubbles led to massive malinvestments that ultimately proved unsustainable, yet the federal government the past few years has tried to stimulate the economy into recovery via tax rebates, public works, and bank and auto industry bailouts, not to mention massive intervention in the mortgage markets, thus preventing the needed economic liquidation and realignment needed for the economy to recover.

People forget the lessons of history. Three decades ago, the economy stumbled through both a recession and double-digit inflation. When the Fed tightened its policies and interest rates went above 10 percent, the pundits proclaimed that a recovery was impossible, yet by 1984 the economy was well into recovery and was growing despite the high interest rates.

While the Reagan administration was not fiscally responsible, at least it did not try to “reflate” the economy, nor did it claim a liquidity trap was at fault. Instead, necessary liquidation of malinvested assets occurred and promising lines of production were launched in their place.

Contrast that with today’s events. The Fed has purchased billions of dollars of private assets and boosted bank reserves, while the federal government has propped up favored businesses. The government’s current end game is to force up inflation in hopes that people and businesses will spend now, which supposedly will give the economy “traction” to move on its own.

This is nonsense. While a burst of inflation might bring more short-term consumer spending, in the longer run it will lead to more malinvestments and, yes, more economic depression. Austrians have an answer: Let the liquidations proceed and allow entrepreneurs to find those profitable lines of production that will lead us out of this morass. Unfortunately, few people are listening.


  • 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.