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Inflation: The Grand Illusion

December 23, 2003

Inflation tends not only to pressure, but to increase, the maldistribution of labour between industries, which must produce unemployment as soon as the inflation ceases. F.A. Hayek, Open or Repressed Inflation, 1969.

The failings of the Macromancers who dominate contemporary economic reasoning can be encapsulated as follows: if you can't leave the house because the trousers Granny has bought for you are too long for your legs, you can solve the lack of fit by trying them on while standing on a chair.

To explain what we mean by this, let us start by conceding that both Keynesians and Friedmanites—as well as the majority of their derivative sub-cults—realize that if there is a seeming surplus of labor, it is because it must be priced too high in relation to the value to which it will give rise.

Being politically cynical enough to presume that reducing labor rates in money terms is more problematic than making the money in which they are paid worth less, the recipe for any business setback is thus the application of a little judicious inflation. This doctrine is now so well ingrained that the Norges Bank of Norway recently stated proudly that its policy aim was "higher inflation" because the prevailing rate was "too low."

This simplistic, aggregative approach overlooks at least one critical fact: a general rise in prices carries no guarantee that a struggling firm—which, presumably, is struggling only because it has misjudged the relationship prevailing between resource costs and consumer preferences—will right itself, any more than the act of flooding a lock can be reckoned to right the capsized dinghy floundering inside it.

Aside from that particular inefficacy of the inflationary cure, we also have to contend with the other difficulties to which inflation gives rise—among them the invalidation of already faulty entrepreneurial calculation, the disruption of many entrained production processes, and the implicit frustration of contracts between lenders and borrowers, and savers and investors.

Of even more immediate concern is this: While we know a new inflation will build its usual distortions under the veneer of a temporary prosperity (mostly localized among those favored to receive the first use of the new means of payment), we remember also Hayek's point that those dependent on the artificial stimulus of inflation for their continuance will become so addicted to it that they will sicken and die if that inflation slows or is redirected.

To date in this so-called "jobless recovery," US-driven inflation has, in fact, succeeded in leading to more labor being hired. However, to the collectivists' dismay, the new labor is largely in China, where the labor distribution is better adapted to US spenders' needs and where total relative labor costs are substantially lower than they are in the US.

In this, US consumers—sustaining their lifestyles not from sufficient production of exchange value, but by using borrowed money they have not earned—have been exhausting the fruits of others' labor via the consumption of present capital and the alienation of future income. Neither of these trends can be maintained indefinitely in real terms, though they can be monetarily disguised for long enough that the damage can become severe before it is fully recognized.

When their Chinese suppliers were saving a goodly proportion of these proceeds and buying US securities with them, the secondary beneficiaries of the inflation, thanks to this act of misguided largesse, worked in the US housing market and in what Robert Higgs calls the Military-Industrial-Congressional Complex. Thus, America's homebuilders, realtors, mortgage lenders, government contractors, and its legions' sutlers and armourers all did well at home.

Further, the inflation made service providers such as banks and insurance carriers, with their less open markets, all the more lucrative, while poor old manufacturers were made simultaneously to bear increased costs at home and heightened competition from abroad.

Manufacturing real wages—which should be gauged against the industry's specific value output rather than against an arbitrary overall price index—therefore had to fall, in toto, if not for each individual worker who managed to retain his job. This was not least because nonwage costs were also being driven rapidly higher by a combination of ongoing inflation, extra regulation, legal jeopardy, and the removal of the former (inflationary) subsidy that found its expression in artificially low, float-hungry insurance premiums and the seemingly miraculous self-funding pensions enjoyed during the millennial stock bubble.

Now, however, there has been a subtle shift. China, at least, is saving much less and spending much more of the money. Hence, commodity prices are up while the dollar is down sharply.

Those businesses serving Asia's new retail clientele and its emergent yuppies—as well, some allege, as those serving China's own MICC hierarchy and its members' desire for strategic stockpiles—are now the redirected inflation's main beneficiaries, rather than the importunate US householder.

For China's booming industrial concerns—and, by extension, for their Asian suppliers and investors—a triple threat may emerge from this transformation:

  • a policy of deliberate central bank restrictionism, instituted in addition to the likely slower acquisition of those dollar foreign exchange reserves that have so boosted domestic money supply this far;
  • the burden of higher import costs due to the renminbi's link to the sagging dollar (though a partial subsidy is being granted by the currency interventions of such players as the Bank of Japan);
  • greater competition for labor and capital resources from domestic consumer industries whose customers' requirements may, furthermore, be widely misaligned with the tastes of their international counterparts who have been so well served until now.

The corollary to all this is that, as the dollar falls, there will be an initial boost to some—though not all—US industries. The greenback's decline should be particularly beneficial to those firms that are relatively sparing of energy use and that do not include a high degree of import content (whether raw materials or components) into their own final products.

Whichever industries best represent the various categories, certainly there would now be scope for the creation of a marginal extra incentive for employing capital and/or labor in the US, as opposed to sending it all to the coastal entrepots of the South China Sea.

So, with the effects of US inflation having the potential no longer to be so disguised and indirect as when it formerly underwent an interim Asian transformation, housing and finance may both suffer—at least, in the absence of a more concerted effort on the part of the Fed to take up the slack (not to be ruled out, of course!). Conversely, makers and sellers of manufactured goods might find the cost-price balance tilted a little less heavily against them from here onward. Indeed, manufacturing has shown tentative signs of stabilization of late; sales, hours, and head count have begun a slow ascent, and even inventory registered an uptick last month.

What would be notable, as a corroboration of this development, would be to see an increase in short-term borrowing to fund greater working capital needs. Even more heartening would be evidence of a continuation of the 8-9% year on year gain in aggregate operating profits reported by Commerce last quarter, especially were these to be accompanied by more than the anemic 3.5% sales increase also registered, since such a paucity of sales growth speaks more of a successful adjustment to straitened circumstances than of the onset of a genuine expansion.

Still, if we know what to look for in manufacturing, if present trends continue, what then of the wider economy?

Here we need to step back a little first.

In the classical model of a cyclical recession, there is little extension of consumer credit, but the inflation of the prior boom works, through producer-directed funding instead, to induce a top-heavy and ultimately unsupportable productive structure. The increased worker incomes earned here, as a result of this false investment, soon begin to be used to bid for consumer goods—goods whose supply no one has had the foresight to increase and thus whose prices inevitably rise.

Such higher prices for end goods then induce those who can to shift to the business of making them, leaving the hypertrophic higher-order goods firms stranded between the rock of underestimated costs and timings and the hard place of overestimated resource availability and end demand for their products.

Incomes now fall as profits and payrolls in these firms dwindle again. Prices and wages adjust to the new mix. It should be recognized, though, that if some firms are forced into liquidation as a result, others find they can still make a handsome return satisfying the needs of their customers. The wily investor will remember that the manifestation of mass entrepreneurial error that constitutes a bust cycle does not preclude occasional individual entrepreneurial success.

Any emergence of an excess of consumer goods will hence signal both the means and the opportunity to defer immediate production of yet more of these goods in favor of employing the monetary savings made possible by the fall in their prices to make new, more rational investments. At the same time, these surplus goods' existence conveniently provides the means necessary for the entrepreneurial object of this investment to feed and clothe his newly-hired workers until the workers' own output matures, in turn, as a batch of future consumption items.

Instead of this archetypal scenario—and ignoring all harmful impediments cast in the way of this healing process by the ever interfering State—we currently have the bizarre modern phenomenon of the further discoordination caused by the wild orgy of debt-financed consumption, which has been officially promoted to keep aggregate spending and arbitrary price levels unconscionably high throughout the recession. This is analogous to expecting that wrapping a corpse in an electric blanket to delay rigor mortis will also bring about a resurrection.

For now, instead of higher prices making a recalcitrant labor force cheap enough to re-employ, a la Keynes, these prices will instead decrease the incomes out of which people already are struggling to service and pay down their towering debts. Additionally, this bind will be made all the more constraining if nominal interest rates—at least those set by the market, rather than the ones suppressed by the Fed—also rise in response to the signs of renewed activity and higher prices.

Thus, the Fed may well find itself faced with the dilemma that it must yield to the relapse at last, or else it must fully monetize every price increase in order to ensure that either incomes themselves, or the sum of income-plus-new-credit, keep pace with the heightened drain on family budgets.  In the instance of monetizing every price increase, real wages would be prevented from falling and so would usher in a period of stagflation—i.e., of joblessness amid rising prices and of fewer lucky businesses thriving in the hotspots and more languishing in the relative chill of their continued sub-marginal efficiency as enterprises.

If this occurs, the possible shifts we have listed mean that the hosepipe of inflation might play more fully on different pastures than before. Among those water-softened plants that require an ever more plentiful supply of fluid and that will therefore wilt if the abundance is merely lessened, there could well be some of today's winners. Examples might be those involved in real estate, the importers of consumer discretionary items, and even today's near-zombies such as the credit junkies in the auto business.

More profoundly, the ongoing erosion of middle class wealth and middle class values that inflation tends to hasten will mean that in economics, as in politics, the decaying Empire will polarize further into two classes. The first will be of inwardly competing but outwardly self-preserving oligarchs. The second will be of a proletariat baying in the Cities for its dole, or toiling in peonism amid the latifundia estates of the nation's Corporatist Dons and Dictators. Worryingly, given the tenor of recent earnings results, this is exactly the sort of environment where a Wal-Mart might flourish alongside a Saks, but where the market for the middle ground becomes a charnel house for capital.

It is also a society in which the Opera might thrive (albeit on its patrons' largesse and on their command of the public purse) and where the modern day charioteers of Nascar might also draw ratings, but where the more modest aesthetic and edifying pursuits which comprise the cultural heart of a free nation are carved out and cast aside.

If the Fed thus leans again on consumer borrowing to plug any gaps in the nation's cashflow, for all the general harm it may occasion, the banks will be pleased enough, as they are the only important creditors with both a scanty capital-asset ratio and greatly more monetary than real forms of entry piled on each side of the balance sheet.

These, the Fed's precious cartel members, are therefore characteristically sanguine about seeing the actual worth of their assets erode, as long as their liabilities are likewise degraded. The banks are thereby largely indifferent to whether the achievement of accounting success in conducting their business translates into real, rather than simply numerical, gains.

In preventing consumers themselves from defaulting (and the vast pools of "securitized assets', which such loans ultimately underpin, from going sour), bankers will benefit from inflation's help in supporting their hapless customers in a state which heaps technical insolvency upon reckless profligacy, one in which they are borrowing more in order to support the service of old debts alongside the making of new, wholly unproductive outlays.

If the Fed is to seek a stay of execution for the crimes of its past on these latter grounds, it would be greatly assisted if it could spark off another mass asset-credit spiral such as we have had in financial securities and residential real estate in recent times.

Though we should not rule it out, reliance on consumer credit/debt presently looks prone to something of an exhaustion, which means the equity-bubble strategy must take its place once more. Unfortunately, the propagation of another leg to the equity bubble, however rapid the money pumping, will still require that earnings show at least the occasional desultory promise of improvement.

But if real wages are being prevented from adjusting downwards, higher profits—however synthetically inflated by a falling currency and windfall numerical gains in successive rounds of production—will not co-exist with increased levels of employment. Thus, we would be back to the sorry old game of increased indebtedness and ongoing capital consumption as a means to the maintenance of the economics of illusion which so haunt us Moderns.

Sadly, with the secret of the magic having been revealed to the foreign dupes who have long been avid buyers of so many tickets to the show, the Grand Illusionist himself is no longer regarded as an initiate of Hermes Trismegistus, a guardian of the eternal mysteries, but rather as a mere fairground conjurer. So, not only is his prestidigitation less able to hold his audience's attention and to prevent its members from wandering off to sample some of the other acts and exhibits at the carnival, but such a house as he can still command will be drawn only by conceding a drastically lowered price of admission.

Less metaphorically, a renewed resort by Western central banks to their same old shell game may well prove less and less successful at distracting attention from the hole at the heart of the Western (above all the US) economies. The descent of both the internal and external value of the dollar might begin to accelerate, threatening more upheaval and potentially triggering inherently unpredictable cascades of loss in the murky and highly nonlinear world of international financial speculation.

Above, we have pencilled in some general investment conclusions arising from such a scenario, but for an exposition of the much more profound consequences we might expect, let's turn once more to Hayek, writing in The Constitution of Liberty in 1960.

We have not had space to touch upon the various ways in which the efforts of individuals to protect themselves against inflation . . . not only tend to make the process worse, but also increase the rate of inflation necessary to maintain its stimulating effect.

Let us simply note, then, that inflation makes it more and more impossible for people of moderate means to provide for their old age themselves; that it discourages saving and encourages running into debt; and that, by destroying the middle class, it creates that dangerous gap between the propertyless and the wealthy . . . which is the source of so much tension in these societies.

The increased dependence of the individual upon government which inflation produces and the demand for more government action to which this leads may, for the socialist, be an argument in its favour. Those who wish to preserve freedom should recognise, however, that inflation is probably the most important single factor in that vicious circle wherein one kind of government action makes more and more government control necessary.

There is perhaps nothing more disheartening than the fact that there are still so many intelligent and informed people who, in most other respects, will defend freedom and yet are induced by the immediate benefits of an expansionist policy to support what, in the long run, must destroy the foundations of a free society.  


Sean Corrigan is a principal of  www.capital-insight.com, a London-based economic consultancy. He is also comanager of the Bermuda-based  Edelweiss Fund. See his Mises.org  Articles Archive, or send him  MAIL. See also the  Study Guide on Business Cycles. 

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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