Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

   John Maynard Keynes, The Economic Consequences of the Peace (1919)

According to a front page article in today’s (October 27, 2013) New York Times, economists have begun to clamor for more inflation.  Arguably the most important economist of them all (if not today, then shortly into the future), Janet Yellen, President Obama’s pick to chair the Federal Reserve Board of Governors after Ben Bernanke’s retirement, is flirting with the notion that a bit more inflation would be a good think to lift the aggregate economy from its doldrums.   It sounds radical—the future head of the very body charged with managing the value of the currency thinks that debauching the currency might grease the economic gears such that the economic engine, gasping and wheezing and unable to generate enough jobs to even keep pace with population growth (the percentage of Americans working remains mired in levels not seen in forty years), will sputter to robust, energetic life.   But is it a valid idea?

The first thing to understand is that inflation of a rate around 2% is the stated preference for Federal Reserve policy makers, a preference that goes back to at least Greenspan’s tenure.  Federal Reserve Chairmen specifically, and most economists generally, have come to believe that gradually rising prices are the best path to stable, predictable economic growth.  Their belief is a derivative of Milton Friedman’s belief that a gradually increasing money supply offers the best hope for smoothing out the business cycle, which before Friedman could be characterized as euphoria following panic following euphoria, etc.  If the money supply declined because of panic, the best way to alleviate the panic and set things on a less psychotic course would be, in the face of panic, to simply increase the money supply to its pre-panic levels through whatever means would accomplish the end of replacing the money destroyed in the panic. 

In a panic, prices decline (the flip side of which is that money becomes more valuable), fueling losses, particularly for debtors who find their obligations commensurately becoming more onerous.  Money supply decreases as it is withdrawn from circulation, or sometimes simply evaporates, particularly from the ledgers of banks that find it impossible to pay their short-term debts (i.e., deposits) by selling or calling in their long-term assets (loans), describing what happens in a bank run.  Friedman pointed out that the way out of the negative feedback loop would be simply to increase the supply of money, at least to a level sufficient to replace that lost to evaporation and reduced velocity.  Friedman believed that the huge decline in the money supply during the first stages of the Great Depression greatly amplified the duration and extent that demand contracted, and that a looser money supply policy would have ameliorated the carnage.  There is evidence Friedman was right about money supply and the Great Depression in the marked economic rebound that ensued soon after Roosevelt abandoned the gold standard, which had been draining the country of gold reserves and pushing prices inexorably downward. 

But this describes how to recover from a panic—a loss of confidence that paralyzes economic activity for all except the most basic and necessary transactions.  It depends upon inflating prices, i.e., devaluing a currency that, with its declining supply and decreasing velocity has become ever more valuable.  The deflation that ensues in a panic overshoots on the down side, just as the hyperactivity of inflationary conditions overshoots prices on the high side, so infusing the economic system with money in a panic helps to keep the currency functioning as a medium of exchange and truer measure of value.  Practically all economists believe this sort of inflation to be unremittingly valuable.

Panic induced deflation works a special sort of misery on labor markets.  Wages are sticky, particularly on the downside.  No matter what is happening to the prices of goods purchased with their labor, workers do not like seeing nominal declines in their wage rates.  In a deflationary panic, firms, especially those in a heavily-unionized economic system where wage rates are contractually sticky, have no choice but to lay off workers to bring their costs in line with their reduced revenues, exacerbating the decline in demand that precipitated the initial contraction.  A death spiral of declining demand fueling decreasing employment fueling even greater declines in demand can ensue.  The inflationary monetarism Friedman espoused, mainly to alleviate the financial system’s problems resulting from declining money stocks, also serves to decrease the prices paid to labor.  Wage rates are sticky on the upside as well (though perhaps not to the extent they are sticky on the downside), and as prices rise with inflation but wages don’t, the firm’s revenues recover while its labor costs remain relatively static. 

Thus, increasing the money supply in a measure sufficient to reverse deflationary forces has the effect of decreasing real wage rates, allowing the demand for labor to gradually recover.  It is this strategy—one that Keynes himself embraced—that neo-Keynesians today pursue through their expansive monetary regimes.  Keynes had this to say, in arguing against laissez faire economic adjustment of wages in the face of decreased demand (from The General Theory of Employment, Interest, and Money [1936]):

In fact, a movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices.

The ineffectiveness of the strategy to thus far move the employment needle in any significant way is why more and more economists are thinking it might be time to double down on the inflationary push that was initially (and correctly) pursued at the onset of the latest panic, the Great Recession (whose occurrence, incidentally and obviously, happened anyway, no matter the steady, predictable growth regime the Fed thought it had engineered during the so-called Great Moderation).  Though the New York Times article acknowledged the thrust of the strategy only in passing, the implication should be clear—economists who believe that the time is nigh for more inflation are seeking to engineer a real decline in wage rates in order to help the labor markets clear.  Paul Krugman, the erstwhile champion of left-leaning economists, who fancies himself something of populist, forever railing at sinister capitalists and their Republican backers, is one of many proponents of this strategy.  Krugman, like his predecessor Keynes, who is quoted in the post’s preamble as claiming that Marx was correct in observing there is no better way of overturning the existing basis of society than debauching the currency, wishes to debauch the currency in order to reduce wage rates.  Who knew the neo-Keynesian Krugman was such a revolutionary? 

But is pursuit of an inflationary strategy appropriate even after the deflationary panic has been subdued?  Pursuing a policy of inflation of roughly 2% per year is to the economic organism what birth control pills are to the female body—it is an attempt to create in the organism the illusion that it is pregnant with growth.  When growth seems always on the horizon, as prices relentlessly climb, economic activity ensues at a more feverish pace than might otherwise obtain.  Or, that is its intended effect.  But while inflation is a monetary phenomenon, economic activity is not, and it has been proved that even massive amounts of so-called “stimulus” will not work to alleviate aggregate economic doldrums when the individuals in the system aren’t inclined to feverish activity.  Japan, an economic system with an aging population (median age is roughly 45—the oldest in the world), an ultra-low birth rate, and an outright declining population, is a case in point.  Japan has kept interest rates at near zero for over two decades and has pushed massive amounts of fiscal stimulus (i.e., deficit spending by its central government) in the service of infusing life into its economic organism, and still, even after the latest round of hyper-stimulating, Japan can’t conceive.  It refuses to yield to growth-impregnating stimulus.  So it is not even clear that growth-impregnating inflation is possible to engineer.  Yet it is quite possible that this impulse to maintain the of growth through regularized inflation was the direct cause of the stock market boom and bust of the late nineties/turn of the century, that it caused the real estate boom and bust of the mid-aughts, and that it is causing the stock, bond and real estate markets to simultaneously boom, with the commensurate bust sure to come soon.

The ineffectiveness of the stimulation strategy to create inflation is apparent in the US as well, where massive stimulus efforts, including a Federal Reserve binge of dollar creation, tripling its balance sheet since the panic, and $5 trillion or so in fiscal stimulus (i.e., deficits) have not done much more than ameliorate the panic.  With every passing month, the more money is added to the system, the less and less frequently each dollar changes hands (i.e., money velocity has declined to levels not seen since records began in the early sixties).  Very little in the way of price increases in consumer goods have been engineered.  At some point, as money velocity approaches the singularity of zero, prices will presumably begin rising, and perhaps quite quickly, because at that stage, there will be so much money sloshing around chasing so few goods, that hyperinflation might result. 

But will all this stimulus still help labor markets to clear?  Perhaps.  Labor markets will clear when labor demand equals labor supply at a market-allowable price.  It might get there by devaluing the currency paid to labor in an amount sufficient to decrease prices to a labor-clearing value.  Or, it might get there by expanded demand pushing up the real price for labor.   Or, it might get there by declining real wage rates of another sort, such as reduced protections for the unemployed.  The truth is that nature abhors allowing valuable resources to lie idle.  Something or another will eventually come along to make it profitable to both the employer and the employed to enter the employment relationship.  The problem for proponents of engineering inflation now is impatience.  They don’t want to wait for prices to align supply and demand.  It was the same problem that so frustrated Keynes:  Why wait for markets to calibrate labor supply and demand through the pricing mechanism when it can readily and easily be done through currency devaluation?

In closing, one last Keynesianism:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

        From The General Theory of Employment, Interest and Money (1936)

Keynes is the defunct economist to whom we are enslaved.  And Keynes’ prescription for unemployed labor is to lower wages rates through debauching the currency.  At least now you know exactly what your Central Bankers are really aiming for if they pursue a strategy of inflation.  They are trying to reduce, on a real basis, the wages you are paid for your work.

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