[Note on March 1: A day after I published this article, warning that inflation is back, CBS News reports that the regular cost of living in America is showing disturbing signs of inflation. Their report is based on a crude index called “Everyday Price Index”, developed by a small, ad-hoc outfit in Massachusetts, but the statistics conveyed by the CBS are correct. In short: inflation is back.]
When the Bureau of Economic Analysis (BEA) released its preliminary data for the U.S. economy and GDP, I explained that the numbers were:
…scathing evidence that Obama’s and the Democrats’ big-government spending policies, including the ARRA “Stimulus bill”, have been a complete disaster and a reckless waste of money. Year-to-year growth, from 2010 to 2011, was a minuscule 1.7 percent, adjusted for inflation. This number alone shows that the enormous deficit-driven government spending since 2009 has done absolutely nothing to put the economy back on track. The private sector is in as big a mess as it could be. Business investments, which according to established theory and historic evidence should be recovering by now, are almost in a state of depression. The echoes of the stimulus bill are bouncing off the walls of empty office buildings and closed-down factories across America.
The BEA has now updated its numbers for the fourth quarter of 2011. Before we get to the dire inflation warning, let us first note that the depressing growth picture that the BEA painted in their January press release has not changed:
Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 3.0 percent in the fourth quarter of 2011 (that is, from the third quarter to the fourth quarter), according to the “second” estimate released by the Bureau of Economic Analysis. In the third quarter, real GDP increased 1.8 percent. The GDP estimate released today is based on more complete source data than were available for the “advance” estimate issued last month. In the advance estimate, the increase in real GDP was 2.8 percent.
This is a marginal adjustment that affects neither the annual growth rate nor the troubling pattern exhibited by the variables that constitute GDP. The U.S. economy is suffering from weak business investments – American businesses are investing close to half-a-trillion dollars less per year than they would if the economy was operating at full gear. Furthermore, the BEA’s revisions of 2011 GDP data does not change the fact that the increase in business investments we saw in 2010 is almost gone.
Time now for the news on inflation. The BEA’s adjustment of a key price index for domestic spending indicates that we are in for a ride we have not been on since Carter was in the White House (emphasis added):
The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 1.1 percent in the fourth quarter, 0.3 percentage point more than in the advance estimate; this index increased 2.0 percent in the third quarter. Excluding food and energy prices, the price index for gross domestic purchases increased 1.2 percent in the fourth quarter, compared with an increase of 1.8 percent in the third.
For a price index, this is a fairly significant adjustment. It’s been a long time coming – there have been signs in the economy of pending inflation for quite some time now, but it has not quite broken out yet. However, this is the time to take the inflation threat seriously. We need a new fiscal policy, and we need it yesterday.
Yes, fiscal policy. Contrary to what simplistic economic theoreticians would have you believe, inflation is not a monetary phenomenon (other than accounting-wise). It is caused in good part by reckless deficit spending on behalf of the federal government.
To see what we can do to prevent inflation from once again engulfing the U.S. economy, we need to understand what causes inflation. As a start, let us dispel the myth that simple money-printing generates inflation. Those who believe so – those who equate money supply increases with inflation through the utterly misused “quantity theory of money”, or MV=PQ – have been proven wrong for years. The bulk of the expansion of the U.S. money supply took place 3-4 years ago, and it is not until now that we are beginning to see an emerging inflation trend.
Inflation has much more complex causes than is claimed by the quantity theorists (including Austrian economists). For money supply to cause inflation, there has to be a system of transmission mechanisms from the money supply to the point in the economy where prices are adjusted upward. Austrian economics is completely void of any analysis of such mechanisms. To learn about those, we turn instead to mainstream macroeconomic theory (represented by the IS-LM model, for those of you who took economics in college). For money supply to affect prices and cause inflation, the money has to enter the real sector, where consumers and businesses spend the money. It can do so in the following ways:
1. Currency devaluation and imported inflation. This is not the same as price increases. A currency such as the U.S. dollar is constantly being re-evaluated by the international money markets: its exchange rate goes up when there is relatively high demand for the dollar, and down when there is relatively low demand for the dollar. On any given day there is a certain demand for the dollar. The more money the Fed prints given that demand, the lower the exchange rate will be. The rapid expansion of the U.S. money supply 2-3 years ago has devalued the dollar vs. other currencies. This has led to a rise in the cost of imported goods and services. As the BEA explains, imports have been on the rise all 2011. The combination of a weaker dollar and increased imports is beginning to show as inflation.
2. Credit expansion. In some countries with hyper-inflation problems, the out-of-control prices can be traced back to an expansion of cheap credit by the banks. They, in turn, expanded their credit because they could borrow cheaply from the central bank. Cheap central bank credit is one effect of rapid money supply expansion. China has inflation problems that are in part caused by abundant access to cheap credit, which in turn is the result of currency sterilization (a money-supply expanding technique used by some central banks operating with fixed exchange rates). However, the U.S. economy does not have an abundance of cheap credit; our credit rating system and low level of confidence among businesses and households put behavioral bars in the way of credit-driven inflation.
3. Government borrowing. This is a major culprit in the U.S. economy. When government borrows money to spend on regular programs, it increases demand for goods and services without there being a corresponding supply available. Crude Keynesians mistake this for a “multiplier” effect and tout it as something to pursue in recessions. They are correct in a very limited sense, but the same transmission mechanisms mentioned earlier must work here as well: there must be confidence in the economy for people to respond to occasional government spending increases. The problem here is instead that government is spending more and more of its borrowed, and newly printed, money on entitlements.
This last mechanism is perhaps the most dangerous of them all. It means that govenment prints money, then hands it out to people through entitlement programs so they get work-free spending. As a result, demand increases without their having been a corresponding increase in productive capacity. But the spending that comes from entitlements is typically not of a quality and quantity that will lead to expanded production: unless you put the entire population on entitlements, all it does is drive up consumer prices.
When people spend money they get from entitlements they tend to spend a larger portion of it on goods than is the case for income-driven consumption. As a result, the push on consumer prices is stronger. Since there is a relatively high import content in consumer goods, this price push is reinforced by the aforementioned increase in import prices.
Venezuela is a tragic example of how entitlements can conspire with import prices to create high inflation. Their consumer prices have gone up 25-30 percent for several years. We are nowhere near that situation and we probably will never get there. But the same fundamental mechanisms that have virtually destroyed the Venezuelan economy are at work here as well.
We need to end the embarrassingly high dependency on entitlements among the American people. We need to bring back self determination as a norm for all Americans. If not, our children will pay a very, very high price for our welfare state.