Wednesday, July 16, 2008

Whip Inflation Now (WIN)

Yes, this is another economics post, but you don't have to be particularly interested in economics to be angry about what's going on across the country right now. Today the labor department announced that the consumer price index shot up 1.1% just this past month, and yesterday it was announced that the producer price index rose at the fastest rate in a quarter-century. In other words, prices everywhere are increasing at a rapid pace. Granted, things aren't as bad today as they were during the 70's, but we could well be headed in that direction unless monetary policy changes course.

To fully grasp this issue, one must understand what causes inflation. Politicians and liberals in the media will usually blame evil companies, sinister speculators, greedy oil CEO's, and Kevin Barry's bartenders for the general rise in prices we're seeing. Others will resort to the traditional Keynsian explanation and blame "rising demand" among consumers (recall WIN lapel pins with Gerald Ford and Jimmy Carter telling people to stop buying so much stuff and to turn off their thermostats). This is to be expected, because government officials and their experts are always going to attack private business and citizens instead of placing the blame where it truly belongs: on themselves.

It is crucial to understand that the true definition of inflation is not a general rise in prices, but instead an increase in the money supply. Rising prices are thus the effect of inflation, not the cause. Once we see things this way, it is much easier to understand the inflation problem and why our anger should be aimed at Washington and the Federal Reserve, not at the private sector.

How Inflation Happens

So just how and why does our government increase the money supply? Well, first think of all of the savings accounts across the country. All of the deposits people make out of their paychecks that they don't intend to immediately spend. Banks, of course, lend these deposits out to borrowers. So let's call this entire pool of savings the loanable funds market.

Now loans, just like any good or service, have a price, which is determined by the supply and demand for these loanable funds. We call this price the interest rate. When savings are low and demand for loans is high, interest rates are high. By the same token, when savings are high and there is less demand among borrowers, interest rates are low.

What the Federal Reserve does, in the name of "stimulating" economic activity, is print new money out of thin air and use it to buy treasury bonds from the banks, artificially increasing the supply of loanable funds. This, of course, decreases the interest rate. The Fed has a "target" rate that it shoots for (currently it's at a paltry 2%), and so long as the target rate is exceeded by the true rate that represents the relationship between savers and borrowers, the Fed must continue printing money and injecting it into the banks to keep the target rate from rising to what it would otherwise be under normal conditions. Since September of last year, the Fed has pumped an exorbitant amount of new money into the system to in order reduce the target rate from 5% to its current 2% target today.

You don't have to be an MIT grad to understand that this process erodes the value of the dollars in our wallets. It is a corrosive charade that eats at our savings, promotes prodigality, penalizes thrift, and distorts economic decision-making. By pumping more paper money into the system, the paper money becomes more and more worthless. This is what is meant by the idea that inflation is "always and everywhere a monetary phenomenon." To better help illustrate, imagine you and some friends are playing monopoly, buying and selling properties between one another, when, all of a sudden, every player is given an additional $1,000 out of nowhere. What happens? Obviously, the price of each property traded is going to rise because people are going to be willing and able to pay more.

How to Cure Inflation

The only way to stop prices from rising is to stop printing money and extending "fake" credit to the banks, allowing the interest rate to return to its real, natural level. In the short term, this reckoning will be painful: as rates rise, many of the projects previously undertaken will become unprofitable. Some workers may lose their jobs, borrowers will have to pay higher interest rates on their credit cards, and a sharp recession will take place. But in the long term, everyone will benefit. All of the malinvestment will be cleansed out and liquidated and people will have more incentive to save instead of spend. True, sound economic growth can resume and the dollars in our pockets will retain and even gain in value.

For a real-life example of this, look no further than the early 80's. After a decade of easy and loose money, with the printing presses running at full speed to keep interest rates low and annual inflation near 20%, Reagan came into office and gave Fed Chairman Paul Volcker the green light to finally stop money creation and allow interest rates to float. This led to devastatingly high double-digit interest rates, which induced a sharp, deep recession in 1981-1982. Farmers, mortgage brokers, and basically anyone dependent on credit or employed in the finance industry took a hard hit. But by 1983, the dragon of inflation had been slain and the economy was back on sound footing. Interest rates began to naturally decline as people began to save more and as prices stabilized.

The question is, does the Fed and our government have the same courage today as Messrs. Reagan and Volcker did 30 years ago? Do they have the guts to end the party era of cheap credit and let the inevitable hangover start to run its course? Let's hope so, unless we want to see a nightmarish repeat of the dreaded 1970's, an era when Keynsian fallacy dominated economic thinking and the only thing good was BC Football.


Joan said...

Great explanation for the layman - right on target. History doesn't have to repeat itself when we remember past mistakes. Thanks for a thought-provoking blog.

HANK said...

Hey joan,

I heard your mom has inflation.