Opportunities in smallcaps header image 2

Why inflation is not a problem, even when the economy finally recovers

January 13th, 2009 · 3 Comments

Some critics of stiumulus plans on the drawing board argue that all this extra money creation will drive inflation to unprecedented highs in the future, and will sink the dollar. This is misguided, especially on the first count. Inflation isn’t a problem, at all.

Here are the reasons why:

1) With demand running way below supply, most (if not all) industries have significant overcapacity. These create incentives to lower prices, especially in those industries in which fixed cost play an important role. As long as selling prices are above variable cost, part of the fixed cost that have been incurred already will be recouped, and don’t forget, fixed cost are, well, fixed. Companies incur those fixed cost whether they sell zero or ten million products.

2) Other potential drivers of inflation, like labour cost and commodity prices have gone into reverse. Rapidly increasing unemployment is not the right environment to ask for wage hikes, quite the contrary.

3) In fact, deflation (falling prices) is much more of a danger than rising prices.

4) But what of all this extra money creation? The balance sheet of the Fed increased sixteen fault, testifying to it’s intense program of injecting liquidity into the financial system by buying up whatever (dud) assets the banks wanted to get rid of.

5) Indeed, that’s increasing bank reserves (exactly as intended), which is enabling them to increase their lending, which is the main way new money is created in an economy. (For the non-initiated, in essence, this process is very simple, bank lending creates new or enlarged deposits for the borrowers, money that wasn’t there before, that is, new money).

However, bank reserves have taken a large hit by the write downs of assets, and banks have become way more conservative, so they’re not putting these new reserves to work (in economic terms, the money multiplier is falling rapidly).

6) When the dust settles and the economy stabilizes, they might start to put some of it to work, but it’s a safe bet that won’t be anytime soon. And inflationary risks are further away, with the gap between what the economy can supply, and the demand for it’s output (the so called output gap) growing ever larger.

In Argentina, the currency collapsed from one to the dollar to three to the dollar in the crisis early this century, but there, the output gap was so large that even such a huge inflationary boost (as import prices three-folded almost overnight) did not set off any serious inflation.

7) Yes, the government is likely to embark on a huge spending spree, and much of that will be monetary financed (that is, bonds issued to pay for the expenses will be bought by the Fed, either directly or indirectly), but even this new money creation won’t set off any serious inflation threat.

8) The inflationary alarmist don’t realize that when the economy recovers, all this extra money can be taken out of circulation again. The Fed will just sell these government bonds (it might even sell some of the more exotic assets it acquired in the crisis) on the open market, mopping up the extra liquidity. No problem.

9) Only if the Fed would be forced to chose between conflicting policy ends does inflation have any real chance. This summer was such a situation. As commodity prices spiraled out of control, Inflation seriously threatened, but the hands of the Fed were tied by the financial crisis and looming economic crisis.

But deflationary forces turned out to be much stronger, and they will be for some time to come. When they finally reside, the Fed will assume normal duty and mop up extra liquidity that might threaten to set of inflation.

Tags: The World according to Economics

3 responses so far ↓

  • 1 Darcy Patten // Jan 13, 2009 at 6:59 am

    Hey STP,

    First off I am no economist, not even remotely close, so I apologize if this is a dumb question, but why in the recession in 81/82 did inflation get out of control?

    From what I understand it was similar to the situation we are in today, major stimulus required and then as a result a second part to the recession which was a over inflationary period.

    Was the situation different then compared to today or were the decisions makers making bad decision then which allowed the inflationary period to come to fruition?

  • 2 admin // Jan 13, 2009 at 1:46 pm

    Thanks for the reaction, Darcy, but we have to disagree. The recession of 81/2 was actually caused by central banks. They jacked up interest rates drastically (Volcker is still famous for that) against inflation that had already reached double digit rates, to slay it once and for all.

    In any case, the situation then is much more comparable to that which we experienced this summer, a supply shock (then the second oil crisis as a result of the Iran-Irak war), but the recession was mostly a result of policy, decisions, especially in the US and UK. In the latter, under the recently elected Margaret Thatcher, they actually produced a very restrictive budget with high interest rates, a combination which increased the value of the pound and wiped out 25% of British industry, some would say a pretty high price to pay, but a subsequent chancellor of the exchequer once famously argued that it was a price well worth paying.

    And even critics have to admit that inflation, a big problem in the 1970s (largely because labour productivity almost came to a halt, but unions hadn’t come to grip with that), never really returned.

    Paul Volcker, 27 years later, is still known as the man who slayed inflation once and for all..

  • 3 Darcy Patten // Jan 13, 2009 at 9:37 pm

    Good info. I was only 10 when the 81/82 recession hit and given my junior understanding of the vortices of economics it is no surprise that I don’t comprehend the details.

    Thanx for the high level education!