Thursday, June 25, 2009

Inflation - The Other Side of the Story

We often hear the phrase, "moral equivalent to war." I would like to introduce a new thought, which is the "economic" equivalent of war. I will circle back to this thought momentarily.

Milton Friedman famously said that inflation is first and last a monetary phenomenon. Print more dollars and, all else equal, each dollar is worth less since there are more of them relative to whatever goods are out there. On this score, inflation could get ugly because the money supply is going berserk. While the Bush administration was no model of fiscal discipline, the Obama administration has spending plans the likes of which the world has never seen, and apparently the fact that the government doesn't have the money isn't a deterrent because, heck, they can always borrow it or print it. Borrowers need to be paid back, of course, so ultimately the only option will be to run the printing presses morning, noon, and night. Friedman is surely rolling over in his grave.*

(If you’ve never seen it, one of my favorite YouTube videos can be seen here:

(It features Friedman debating an unctuous, intellectually impaired Phil Donahue, in 1979.))

The “monetarists,” as they are known, are in Inflation Camp #1. I am a big fan of the monetarists, and history favors their view, but I think they miss half the story.

Then there are the Keynesians, who fret about people being too successful. This is Inflation Camp #2. High growth rates produce too many rich people who then presumably buy lots of things, chasing prices upwards. The only problem with this theory is that the historical evidence would suggest that, as theories go, this one is a steaming pile of poop. In the 50s, 60s, 80s, and 90s, we had high growth and low inflation. In the 70s we had the opposite: low growth and high inflation. So what gives?

So the monetarists, in my book, get it half right while the Keynesians get it half wrong. There’s another side of the story, one that I never hear anyone talk about, and one that doesn't make our current picture any prettier. Regardless of how it gets there (the economy or printing presses), monetarists and Keynesians both focus on how much money is in people's pockets, which in turn affects the demand for goods. But what about the supply of goods? Why doesn't anyone ever mention that? Prices are based on both demand and supply, after all. My thesis is that the pronounced statist direction our country is being taken will have a major negative impact on the supply of goods.

It's useful to look at a bit of history to understand this statement. In the 80s and 90s, money supply was kept under control and inflation was low, so two points for Friedman. But our wealth grew at an unprecedented rate, so how come all those rich people didn’t bid up the price of everything like the Keynesians said it would? The answer could be found in productivity gains. Simply, as demand for widgets grew (don’t groan, all ye econ majors), more widgets were delivered to the market, which kept prices in equilibrium. Supply kept pace with demand, in other words. But how? The answer lied in the ability of people and companies to marshal capital, invest it in production, and deliver goods to the marketplace in a timely fashion (something that began to be played out on a global scale). Minus 10 points for the Keynesians.

Sounds simple, but there are certain really important pre-conditions necessary to make all this possible. First, the widget makers have to be inclined towards risk taking, both in terms of time and money. Second, capital must be available for the widget maker to increase production.

Capital obviously comes from investors, and their calculus is simple. How much might one be rewarded for taking the risk? Of course, this is an after-tax calculation. Raise taxes, and investors will risk less.

Less obvious, and less recognized, is the decision matrix for the manufacturer. That taxes play a key role here as well is clear enough. But what about regulation, or legal risk? These things impose costs as well. Socialist societies aren’t just about taxes, after all, they are about control. What if our widget maker is told that he must, say:

· Provide health care benefits for all his workers, even the part time ones

· Buy Carbon credits since his plant will be emitting CO2

· Pay for a complex environmental impact study for his new plant

· Buy more insurance to cover ever-increasing class action suits

· Source a certain percentage of his energy needs from expensive alternatives like solar or bio-fuels

And then there’s the additional ongoing cost of compliance with all these initiatives. Maybe the worst thing about socialism is all the damn paperwork.

None of these measures is a direct tax, but they might as well be. Argue about the greater good all you like but unarguable is that regulation lowers the return on capital. Socialism amounts to a huge marginal tax on risk taking. Reduce the potential return from risk taking too much and manufacturers will say “screw it, I don’t need this,” and investors will buy munis and go to the beach. Initiative doesn’t happen if the rewards aren’t there, not even in America.

And so, that new widget plant never gets built. Existing widget plants can’t meet demand and widget prices therefore rise to put supply and demand back into equilibrium.

So, back to the whole “economic equivalent of war” idea. If you look back through very long periods of history, inflation is primarily a wartime phenomenon. Sidney Homer, in his groundbreaking book, A History of Interest Rates, looked at inflation all the way back to the Mesopotamians (an exercise that was on all our “to do” lists, I'm sure). What sticks out is that almost every serious inflation spike across many cultures and economies came due to war. Here are some "recent" examples:


Inflationary Period



American Revolution (1775-1783)




War of 1812 (1812-1815)




American Civil War (1861-1865)




World War I (1914-1918)




World War II (1941-1945)




1970s stagflation (1973-1982)*




But why is this so? Inflation doesn't happen just because people are shooting at each other. No, it happens because government forces a reallocation of resources away from where the natural demand is. For instance, if car factories are turned into tank factories, cars become scarce, and their prices go up.

This is why socialism is the economic equivalent of war, because both involve extensive government intrusion into the economy, and both divert resources away from where they would naturally flow. This is exactly what happened in the 1970s, our last great foray into the foul waters of a statism. Remember gas lines? They were caused not by a sudden spike in demand, but by supply bottlenecks caused by the stupid regulations and price controls of the era (in addition to supply tightening from the Middle East). Unfortunately, the regulations being contemplated right now by an unfettered Congress make the 70s pale by comparison, and they will not be easily undone.

(Side note: Congressional Democrats just introduced a twelve hundred page “Cap and trade” bill that they are forcing members to vote on Friday. Is anyone actually going to read it? This bill will be a huge tax on energy usage. As energy is baked into the price of just about everything (particularly food), the inflationary impact should be obvious. Additionally, a whole new federal bureaucracy will have to be created to police this. They will monitor energy usage of business everywhere and will dictate the need to buy carbon credits. We will come to think of these bureaucrats as “greenshirts.” I can hardly understate what a bad idea all this is. Where is the thoughtful debate?)

So, as you can see, we’re in for a double whammy: lots more money chasing fewer goods. Are you protecting yourself? Not to use this as an advertisement, but inflation is one reason Belstar has stepped up its efforts in timber. As more and more money is printed, trees – whose supply is relatively fixed – will become scarce relative to dollars and therefore will appreciate in value. It is perhaps unfortunate for our economy, but it’s going to be far more advantageous to own non-financial assets in the next few years.

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