The Failure of Inflation


Big government technocrats have long believed they could manage the economy through government spending and manipulation of the money supply. Their program having failed, the world now faces an unprecedented crisis.

In the classic approach to “tuning” the economy, leftist, pro-government policy analysts once were keen to argue that boosting inflation would cure unemployment. And there are those who still believe this.

The idea is based on the work of A.W. Phillips and his now famous curve describing the relationship between inflation and unemployment. The Phillips curve suggests that periods of high unemployment tend to have a negative impact on prices, lowering inflation. The reverse holds true, in this model, for periods of low unemployment that then lead to higher inflation.

Though apparently no intention of Phillips’, this model has served to provide an insidious rationale to those working with the levers of power. Having, they assume, an obligation to manage the country in such a way to ensure prosperity, they point to the Phillips curve as supporting policies that manipulate the money supply and, as a result, inflation, in order, they say, to reach employment targets.

Summarizing this tendency for the Library of Economics and Liberty, Duke University economist Kevin D. Hoover noted: “The close fit between the estimated curve and the data encouraged many economists, following the lead of Paul Samuelson and Robert Solow, to treat the Phillips curve as a sort of menu of policy options.”

In other words, if unemployment is too high, then pump some addition money into circulation to stimulate the economy and, ultimately, job creation. Writing for the St. Louis Fed in 2005, Edward Nelson summarized Samuelson and Solow’s influence based on the Phillips curve — they taught the “economics profession … that government policies that stimulated aggregate demand could buy a permanently lower unemployment rate at the cost of a higher inflation rate.”

If this sounds familiar, it’s because the world’s monetary authorities, taking their lead from the Federal Reserve, continue to plot policy, at least publicly, on this basis.

Fed Chair Ben Bernanke laid out the rationale for monetary expansion based on this framework in a speech at the National Association for Business Economics Annual Conference in Washington, D.C. on March 26, 2012.

“I will argue today that, while both cyclical and structural forces have doubtless contributed to the increase in long-term unemployment, the continued weakness in aggregate demand is likely the predominant factor,” Bernanke told conference attendees. “Consequently, the Federal Reserve’s accommodative monetary policies, by providing support for demand and for the recovery, should help, over time, to reduce long-term unemployment as well.”

In other words, the Fed will continue to expand the money supply, resulting in low rates of interest, thinking that easier access to money will spur consumer spending and, as a consequence some point down the road, spur job growth.

The trouble is, this will fail. And in failure, it will hurt Americans even more.

In the short term, expanding the money supply will help those who have first access to the newly created money. They will be able to spend these new dollars on goods and services priced in current dollars. But as these dollars enter circulation, the value of each dollar in the money supply is correspondingly reduced. Because each dollar represents less value as the money supply increases, more dollars are required to purchase goods and services. The result is the apparent price of these goods and services increases. In other words, inflation tends to increase, unless, that is, other forces intervene to counter the effect.

One of the economists to point out the folly of the money manipulator’s program was Nobel Prize winner Milton Friedman. As this is written, it is 100 years since Friedman’s birth and a proper moment to consider his contribution to setting right the economic fallacy that supports our current money manipulation regime.

In a recent column, Thomas Sowell, himself a great economist and public intellectual following in the footsteps of Friedman, his former teacher, described the latter’s critique of Phillips curve-based monetary manipulation.

Friedman, Sowell writes, “challenged this view with both facts and analysis. He showed that the relationship between inflation and unemployment held only in the short run, when the inflation was unexpected. But, after everyone got used to inflation, unemployment could be just as high with high inflation as it had been with low.”

In his Nobel Memorial lecture on December 13, 1976, Friedman himself described this phenomenon in more detail.

“Only surprises matter,” he said. “If everyone anticipated that prices would rise at, say, 20 percent a year, then this anticipation would be embodied in future wage (and other) contracts, real wages would then behave precisely as they would if everyone anticipated no price rise, and there would be no reason for the 20 percent rate of inflation to be associated with a different level of unemployment than a zero rate.”

Additionally, high inflation, rather than cure unemployment, may actually cause it. Debasement of the the currency reduces the value of dollars held in savings, stimulating erstwhile savers to spend their hard-won dollars. But this spending is ephemeral, and when the savings are depleted, further spending slows as consumers have less financial ability to make purchases. Some may become highly leveraged, finding inflation an incentive once their savings are depleted to make purchases on credit. If this sounds like the beginning of a credit bubble, it is. And if it sounds like what happened in the decade before the Great Recession struck, it is. Ultimately, a credit crisis is reached, the bubble bursts, and more inflation, as a policy measure, becomes increasingly ineffective.

Why, then, the pressure to inflate the money supply? There is really only one reason and that is to reduce the budget pressure from government liabilities.

Governments around the world, including the United States, have pursued since at least the Great Depression and World War II the building of social welfare regimes promising increasing benefits to ever larger numbers of recipients. The unique demographics of the post-war era, with very large numbers of Baby Boomers progressing through the work force and now heading into retirement, has meant that there are ever fewer productive workers to support wealth transfer payments to the beneficiaries of these programs. This has, along with costly foreign interventionism and enormous post-9/11 national security budgets, caused governments increasingly to turn to deficit financing leading to skyrocketing public debt.

As a result, Western nations face incredible debt. The United States, for decades the motive force for the world’s economy, now has a debt to GDP ratio of approximately 102.94 percent. This is approaching that of the most heavily debt-ridden of European nations. Ireland and Portugal, by comparison, are at 104.95 percent and 106.79 percent. Italy is at 120.11 percent and headline maker Greece is at 160.81 percent, all according to IMF data.

Much of this stems from wealth transfer programs that require heavy taxes on the productive sector in order to fund social programs. A case in point is Social Security. Counted on by many millions of Americans who pay into it, the poorly designed program is unsustainable due to demographics. Paul Krugman, a leading liberal economist, described the problem with the Social Security more than a decade ago in the Boston Review.

“Social Security is structured from the point of view of the recipients as if it were an ordinary retirement plan: what you get out depends on what you put in,” Krugman wrote. “So it does not look like a redistributionist scheme. In practice it has turned out to be strongly redistributionist, but only because of its Ponzi game aspect, in which each generation takes more out than it put in. Well, the Ponzi game will soon be over, thanks to changing demographics, so that the typical recipient henceforth will get only about as much as he or she put in (and today’s young may well get less than they put in).”

Social Security is not alone in paying out more than it takes in. The same is true of Medicare. In their most recent summary of the annual reports for their agencies, the Social Security and Medicare Boards of Trustees warned of major deficits facing the programs.

“Social Security and Medicare are the two largest federal programs, accounting for 36 percent of federal expenditures in fiscal year 2011,” the Trustees pointed out. “Both programs will experience cost growth substantially in excess of GDP growth in the coming decades due to aging of the population and, in the case of Medicare, growth in expenditures per beneficiary exceeding growth in per capita GDP. Through the mid-2030s, population aging caused by the large baby-boom generation entering retirement and lower-birth-rate generations entering employment will be the largest single factor causing costs to grow more rapidly than GDP.”

Absent deficit spending, programs like this, and the ever larger appropriations approved by Congress for other federal programs, are unsustainable. But deficit spending means more debt.

There is only one way for countries facing this debt crisis to react, and that is to monetize the debt, paying off the old burdens with new money. Thus we have Bernanke promising to keep interest rates low and European Central Bank President Mario Draghi promising “to do whatever it takes” to save the euro.

All of this amounts to a great deal of gambling. And as in gambling, a few will win big.

The rest of us will likely lose, and lose a great deal at that.

The Moral Liberal Associate Editor, Dennis Behreandt, is the Founder and Editor In Chief of the American Daily Herald. Mr. Behreandt has written hundreds of articles on subjects ranging from natural theology to history and from science and technology to philosophy. His research interests include the period of late antiquity in European history as well as Medieval and Renaissance history.