Mises Daily Articles
Under the Shadow of Inflationomics
Inflationomics, in popular terminology, indicates the sway of inflation thought in education and the affairs of government. It permeates political life and behavior, especially when economic policies are discussed and decided. It usually speaks well of an increase in the amount of money by a central bank and of deliberate expansion of bank credit in order to finance government deficits and stimulate economic activity. Inflationomics is a basic ideology of our time.
Its intellectual roots are very old, growing in Europe during the 17th and 18th centuries and serving as guiding principles of state policy. They produced strong central governments with monetary powers as a means of economic well-being and with central banks to control the money of the country. The Bank of England, which was founded in 1694, set the example for all others. Most European countries followed suit during the 19th century. The United States established the Federal Reserve System in 1913. Today, nearly every country has a central bank or is a member of a central bank system.
Paper money first appeared some 300 years ago, but it was usually backed by gold or silver into which it was convertible on demand. Even during its early history, governments often made it inconvertible, i.e., they made it "fiat". Gold and silver were used as standard money and coined without any limit set by legislation. But the ratio between gold and silver was fixed by law without close relation to the market value of the metal. It always activated Gresham's Law according to which "bad money drives out good money." Whenever the ratio between two kinds of money, e.g., gold and silver, was fixed by law without relation to the market value of the metal, people used the artificially overvalued metal and hoarded the legally undervalued one. The common failure of the bimetallic standard tended to give rise to a de facto monometallic currency, usually silver coins. In England it led to a gold standard.
The monetary system of the United States was based on bimetallism during most of its history. A full gold standard was in effect from 1900 to 1933. The Legal Tender Act of 1933 made all American coins and paper money "legal tender" which must be accepted at face value by creditors in payment of any debt, public or private. The Gold Reserve Act of 1934 stipulated that gold could no longer be used as a medium of domestic exchange, making paper money the only lawful medium of exchange. During the early 1970s the US dollar became fiat money also in international money markets.
Inflationomics sprang from the old roots of central banking and fiat money. The most influential mastermind undoubtedly was John Maynard Keynes, who made "expansionism" the essence of his teaching. The "Keynesian Revolution" made credit expansion a powerful method for stimulating business and creating employment. Cloaking his reasoning in the sophisticated language of mathematical economics, he swayed public opinion and most politicians with the urgent need for currency devaluation, inflation and credit expansion, unbalanced budgets, and deficit spending. In short, Lord Keynes provided a new justification for old policies.
Keynes viewed most problems of the business cycle as symptoms of "underconsumption," which has been a popular explanation of depression ever since. If economic recessions and depressions are caused by low demand for money and goods, an increase in spending is bound to revive economic activity and increase employment. Keynes therefore considered government control an economic necessity in order to restore and maintain desirable levels of spending. In this respect he resembled the Mercantilists of old. But in contrast to the economists of the 17th and 18th centuries he also injected popular notions of social conflict. Passages from his General Theory of Employment, Interest, and Money (1935) clearly make this point.
"The richer the community, the wider will tend to be the gap between its actual and potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest." (p. 31.)
In Keynesian tradition most American professors and media commentators favor credit expansion and deficit spending whenever a recession comes in sight. And most elected representatives call and vote for more government spending that promises more employment and higher incomes for their constituents. But whatever government may do to increase spending and whatever the central bank may devise in order to avert a recession, they inflate and depreciate the currency, aggravate the maladjustment, and prolong the pains of readjustment.
Ours is an age of inflationomics. It dawned with the sway of Keynesian economics in Europe as well as America and commenced visibly in 1971 when President Nixon abolished the last vestiges of the gold standard and repudiated all international obligations to make payments in gold. The US dollar has depreciated at various rates ever since, at double-digit rates during the 1970s and early 1980s and at single-digit rates since then. The present dollar is worth some 10 cents of the 1970 dollar and is bound to lose ever more in the future. Moreover, inflation misleads businessmen in their investment decisions, which is the root cause of the business cycle. Indeed, inflation breeds many evils and haunts many Americans who are rather unenlightened about its causes.
A cursory look at presidential policies since 1971 corroborates the point. When wages and prices soared, President Nixon, with Congressional approval, imposed a four-phase program of wage and price controls which immediately led to shortages in many areas. A serious "energy crisis" reduced home heating-oil supplies and led to gasoline shortages. A recession gripped the United States together with other Western industrialized countries and Japan; while the rates of inflation exceeded 10 percent a year, production declined and the levels of unemployment rose sharply. This new combination of high rates of inflation and high rates of unemployment, which was aptly called stagflation, caught all Keynesian economists by surprise.
The Carter Administration's chief economic affliction was rampant inflation and the decline of the dollar's value in relation to that of other major currencies. No matter what it did to assist the dollar, including "massive intervention" in international currency markets, a quintupling of gold sales, and an increase in the discount rate, inflation rose in each year of the Carter Administration.
The Reagan Administration (1981-1989) reversed long-standing Keynesian trends by pursuing a supply-side economic program of tax and non-defense budget cuts. The program built on the thought that high tax rates and government regulation discourage private investment in areas that fuel economic expansion, and that more capital in the hands of private investors will benefit the rest of the population. Facing the deepest recession since World War II with unemployment reaching a rate of 10.8 percent in 1982, it soon suffered huge budget deficits which more than doubled the size of the national debt. Although the economy picked up between 1983 and 1986, the budget deficits consumed most of the capital released by the tax reduction and thus thwarted possible supply-side benefits. Economic expansion remained relatively modest although the rate of inflation fell below 4 percent during President Reagan's tenure. It allowed the dollar to expand internationally and strengthen its acceptability as a world reserve currency.
President George Herbert Walker Bush resolutely returned to Keynesian formulas of spending and happily continued the budget deficits. During his first year in office (1989) his administration enjoyed a $152 billion deficit, in its last year (1993) a $255 billion shortage. After a prolonged battle with the Democratic Congress he agreed to a deficit reduction bill that raised business taxes. He thereby broke his 1988 campaign pledge not to raise taxes, which irritated many Republicans. His presidency was marked by a stagnant economy, rising levels of unemployment, and a prolonged international recession. His inability to institute a program of economic recovery other than deficit spending made him vulnerable in the 1992 presidential election. Arkansas governor Bill Clinton won by a comfortable margin.
As president, Bill Clinton managed to obtain Congressional approval of a North American Free Trade Agreement that was designed to make the United states, Canada, and Mexico more competitive in the world marketplace. But he failed to realize his campaign promise to reform the nation's health-care system, which critics likened to socialized medicine. In the 1994 midterm election his rash proposals not only led to Republican majorities in both the Senate and the House but also provided Republicans with an ambitious agenda for social, economic, and institutional change, which they dubbed the "Contract with America." It influenced and colored the Clinton presidency and surprised the world as it gave rise to the "great expansion of the 1990s." Emerging from recession in 1991, the economy expanded throughout the 1990s. Wages, which had been stagnant throughout the 1980s, rose again; unemployment reached a 30-year low. The rise of individual and corporate tax payments pushed the Federal budget into an extraordinary surplus for four years, beginning in 1998. But the trade deficits with foreign countries continued to grow as Americans continued to import far more than they exported. Foreign central banks readily invested their surplus dollars in US Treasury securities and foreign corporations used their dollars to expand their operations in the United States. The Federal Reserve supplied them at bargain rates.
By the end of 2000, many maladjustments were clearly visible, causing the economy to sink into recession for the first time in 10 years. Other industrial economies slumped as well and were jolted by the September 11 terrorist attacks on the United States. When economic productions fell to recession levels, the Federal Reserve cut interest rates eleven times. Prodded by President George Walker Bush, Congress passed a large multiyear tax cut, and the US Treasury sent out tax rebates to boost consumer spending. Thereafter, the economy seemed to shake off national disasters and soaring energy prices. Labor productivity apparently rose and the nation's unemployment rate declined again. All along, the federal government embarked upon massive deficit spending, which increased its debt from $3.314 trillion at the beginning of the new administration to more than $8 trillion today (May 15, 2006). US trade deficits, too, hit record highs of $618 billion in 2004 and topped $700 billion in 2005. As the deficits widened, the Federal Reserve began to nudge short-term interest rates higher, 0.25% at a time from its base rate of just one percent. The nudging prudently remained far below unhampered market rates which would have called an instant halt to the pleasures of debts and deficits.
All in all, this writer does not have much confidence that inflation will remain moderate. Inflationomics is still in vogue. The Fed is unlikely to raise its rates to a level that would call a halt to the currency and credit expansion and thus reinforce the world-wide trust in the US dollar. Instead, the Fed is likely to limp after the rising market rate and continue its expansion policies until an international dollar crisis calls for drastic emergency measures. In crisis and bedlam, Washington politicos are likely to add their controls and regulations, conditions and restrictions, prohibitions and penalties to the structure they created. In the footsteps of President Herbert Hoover, President Bush may even call for more trade barriers, which would turn the recession into a depression and breed much international conflict.
See also Professor Sennholz's book The Underground Economy (1984), A tribute to Professor Sennholz, by Joseph Salerno, Quarterly Journal of Austrian Economics, Vol. 5, No. 4, dedicated to Hans Sennholz, Austrian Economics Newsletter interview with Hans Sennholz, and Lew Rockwell's essay on Sennholz.