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Sunday, December 21, 2008

The Case Against Inflation

It should be noted that it is clear that Steve Chapman is a monetarist. That is someone that favors monetary policy over fiscal policy. It's further clear that he views the response to this crisis from the perception of someone that believes that monetary policy is the best approach to fixing things.

In this article, Chapman makes the case that a policy that stimulates inflation maybe the best approach to dealing with the crisis. First, he makes an argument that I agree with in arguing against the current policy.

Faced with that looming catastrophe, the federal government has been considering or doing things that were once unthinkable -- partly nationalizing banks, buying up debt, bailing out the Big Three automakers, spending hundreds of billions of dollars on infrastructure and doubling or tripling the budget deficit.

It's possible these measures can restore the economy to health. But only possible. What is certain is that they will produce a government that is bigger, more expensive, more overextended and more involved in the operations of private businesses. That result, rest assured, will live on after the crisis is over.

Chapman is, I believe, absolutely correct that the current approach will massively expand government bureaucracy, power and reach. Furthermore, I believe he is correct in pointing out that all of these things will continue long after this crisis is over.

Yet, Chapman proposes a policy that is also wraught with problems.

So some economists have concluded that expanding the money supply is the worst option except for the others. Kenneth Rogoff of Harvard writes that "a sudden burst of moderate inflation would be extremely helpful." Casey Mulligan of the University of Chicago says, "Inflation will alleviate some economic problems; prolonged deflation will aggravate them."

Gregory Mankiw, who was chairman of the Council of Economic Advisers under President Bush, urges the Federal Reserve to abandon price stability and commit itself to modest inflation. David Henderson of the Hoover Institution says that if the choice is more federal spending or rising prices, he prefers the latter.

It's not hard to see why. Most of our problems stem from the bursting of the housing bubble. That sent home prices plunging, which reduced the value of mortgages and mortgage-backed securities, which caused losses at banks, which forced a cutback in lending, which squelched consumer spending, which brought the economy to a halt. Which started the whole miserable cycle over again.

Chapman essentially calls on the Federal Reserve to turn on the money machine and simply create money. It just so happens that the Wall Street Journal had an article today that analyzed all the problems with such a plan.

Mr. Bernanke has good reason to worry about the economy. We all do. In the boom, a superabundance of mispriced debt led countless people down innumerable blind investment alleys. E-Z credit financed bubbles in real estate, commodities, mortgage-backed securities and a myriad of other assets. It punished saving and encouraged speculation. Imagine a man at the top of a stepladder. He is up on his toes reaching for something. Call that something "yield." Call the stepladder "leverage." Now kick the ladder away. The man falls, pieces of debt crashing to the floor around him. The Fed, watching this preventable accident unfold, rushes to the scene too late. Not only did Bernanke et al. not see it coming, but they actually egged the man higher. You will recall the ultra-low interest rates of the early 2000s. The Fed imposed them to speed recovery from an earlier accident, this one involving a man up on a stepladder reaching for technology stocks.

The underlying cause of these mishaps is the dollar and the central bank that manipulates it. In ages past, it was so simple. A central banker had one job only, and that was to assure that the currency under his care was exchangeable into gold at the lawfully stipulated rate. It was his office to make the public indifferent between currency or gold. In a crisis, the banker's job description expanded to permit emergency lending against good collateral at a high rate of interest. But no self-respecting central banker did much more. Certainly, none arrogated to himself the job of steering the economy by fixing an interest rate. None, I believe, had an economist on the payroll. None facilitated deficit spending by buying up his government's bonds. None cared about the average level of prices, which rose in wartime and sank in peacetime. It sank in peacetime because technological progress and the opening of new regions to agricultural production made merchandise and commodities cheaper and more abundant.

Not everyone agreed that these arrangements were heaven-sent. In comparison to the rigor of the gold standard, paper money seemed, to many, an intelligent and forgiving alternative. In 1878, a committee of the House of Representatives was formed to investigate the causes of the suffering of working people in the depression that was five years old and counting. Not a few witnesses pleaded for the creation of more greenbacks. They asked that the government not go through with its plan to return to the gold standard in 1879. But the nation did return to gold -- it had financed the Civil War with paper money -- and the depression ended in the very same year.

Gold is a hard master, and a capricious one, too, insofar as growth in the world's monetary base depends on the enterprise of mining engineers. But, as we have seen lately, there is no caprice like the caprice of sleep-deprived Mandarins improvising a monetary solution to a credit crisis (or, for that matter, of fully rested Mandarins setting interest rates by the lights of their econometric models).


Elihu Root, Republican senator from New York, thought he smelled a rat. Anticipating the credit inflations of the future and recalling the disturbances of the past, Mr. Root attacked the bill in this fashion: "Little by little, business is enlarged with easy money. With the exhaustless reservoir of the Government of the United States furnishing easy money, the sales increase, the businesses enlarge, more new enterprises are started, the spirit of optimism pervades the community.

The problem with loose money policy has several layers. The first is that it creates loose money. It allows business to borrow so easily that they take on risks they normally wouldn't. The second is that it creates prices to go up and thus limits the buying power of consumers. The third is that it weakens the currency, the Dollar.

The main problem with Chapman's analysis is that he makes an assumption he simply can't make. First, it's unclear when all of this loose money policy will actually create inflation. While this policy is clearly inflationary, the economy might be so weak that it won't necessarily cause inflation right away. Instead, prices will rise more quickly than they would have but still slowly, if at all, because the economy is so weak. Second, even if it causes inflation, that won't necessarily transfer over to housing. Just because there is generally inflation doesn't mean there will be inflation in housing specifically. It isn't as though all prices rise exactly the same during periods of inflation. The Federal Reserve created all sorts of loose monetary policy that Chapman now suggests during 2001-2003, and only housing went up. It didn't cause inflation in general just in housing. So, if it does cause inflation it won't necessarily cause inflation in housing.

Finally, causing inflation may also create the nightmare scenario. Then, we would have an economy that is still in recession at the same time we are in a period of inflation. Chapman continues to see the virtues of monetary policy but totally disregards all of its pitfalls.

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