24 May
2010
Posted in: Blog
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Inflation and the politics of fear

Something funny is happening with inflation… or isn’t happening: Despite more than two years of interest rates near zero percent and vast amounts of “liquidity” being pumped into the system, consumer prices are falling.

On Wednesday the Labor Department reported an unexpected -0.1% drop in April, the first decline since March 2001. So-called “core inflation,” considered a better long-term indicator because it excludes volatile food and fuel costs, is also grinding lower. It increased just 1% from a year earlier, the lowest reading since May 1963.

This phenomenon raises some major question for people who worried that all of the Fed’s “easy money” and “low interest rates” would cause an inflationary spiral. Instead the opposite thing seems to be underway, and is remarkably similar to what started in Japan 20 years ago. In both countries, debt-fueled bubbles collapsed and central bankers responded by attempting to prop up asset prices by “increasing the money supply.”

Given that “monetary conditions” are now much more “accommodative” than they were in the 1980s or even 1990s when inflation was higher, it’s becoming clear that these policies are an utter failure. However that shouldn’t surprise anyone because they’re actually based on the philosophy of the welfare state and the Democrat party.

Most people are still trapped in the intellectual paradigm of Milton Friedman, who famously said “inflation is always and everywhere a monetary phenomenon.” While this may be inherently true, the problem is that most observers — including economists — don’t really think about what money is.

The conventional wisdom is that central banks such as the Federal Reserve “create” money, either by printing paper or by allowing the accumulation of bank reserves. But this view assumes that a government agency can, in fact, create money. In this belief, allegedly free-market economists such as Friedman and countless others place unlimited confidence in the authoritarian power of the state. While they might argue against any government fiat in areas such as education, agriculture and housing, they unthinkingly accept the idea that the government can create, with the stroke of a pen, not only something of value, but the very essence of value.

Consider the case of prisoner camps during WWII, where cigarettes were used as money. In a famous article from 1945, economist R.A. Radford describes cycles of inflation and deflation fluctuating along with the supply of Red Cross packages. Even prisoners who hated smoking started accumulating Camels and Lucky Strikes as a means of savings and to exchange for goods and services.

Where was the Fed? Where was the Open Market Committee? Where were Ben Bernanke and his wise beard? How about Alan Greenspan and his famous stack of papers?

They were nowhere to be seen. Money in prisoner camps came into existence like language or culture. People needed to express value, and they found a medium to do so.

Let’s take it one step further: If money can exist without a central bank, it’s logical that a central bank can exist without money.

Once economists accept this basic, indisputable fact, they need to refine Friedman’s problematic dictum. The consequences are scarier than most mainstream analysts are willing to accept.

Friedman’s may have been right. But his error could be in assuming that the central bank creates money. In reality, central banks create currency. What’s the difference?

Money has two essential characteristics: It must be interchangeable and wanted (or scarce). Take away either attribute, and it’s no longer money. For instance land is wanted but cannot serve as money because it isn’t easily interchangeable. And cigarettes today are still interchangeable, but many fewer people want them, so they no longer serve as money. (Plus dollar bills are much more convenient and the bank will take them.)

Fiat currency by definition will always be interchangeable. The question is whether it’s wanted or scarce?

There was a time when people did want dollars, for instance in the 1980-2000 period, when you could often earn more than 5% after inflation just by keeping money in the bank. Now, however, interest rates are essentially zero and central bankers are comfortable creating trillions of dollars out of thin air to help ailing banks.

Of course, there will always be plenty of need for greenbacks because it’s legal tender. The same thing can be said for the yen, the Venezuela Bolivar and the Zimbabwean dollar. But in the end the only thing backing them up is the force of law: government fiat and the tax code.

Most economists, including Friedman, would agree that government fiat cannot spur real investment, innovation or economic growth. Conservatives already know that government crushes human genius when it tries to run industry and or tells people how to live their lives. Why then do we accept the government setting the price of our money?

Just as government bureaucrats ruin every other business they touch, the Fed is destroying the U.S. dollar’s ability to serve as money. They are destroying its scarcity and its dearness – one of the two key things it needs to be money.

This isn’t hurting ordinary consumption — or at least not yet. The real danger is that it prevents people from saving and kills capital formation. That means less investment, less income growth and less demand. Japan-style deflation, here we come.

Most conventional economists have no paradigm to deal with this process because they simply assume that entrepreneurs will start companies. What they fail to understand is that capital must first accumulate in large pools risk-free before being deployed. If you don’t create a hospitable environment, this simply won’t happen. Capital is like fish eggs: If the water isn’t the right temperature or doesn’t have the right pH balance, the fish don’t hatch and then migrate elsewhere. They’re simply never born.

The other thing most economists fail to appreciate is that the collapse of bad companies creates opportunities for good ones. Failure imposes discipline by teaching people what works and what doesn’t. Higher rates would cause many banks to implode and force the liquidation of their real-estate assets. This would trigger wholesale foreclosures and bankruptcies across the country. Entire towns would be wiped off the map and the people who move elsewhere. Their schools and government offices would close.

That isn’t as bad as it sounds because hundreds, if not thousands, of towns emptied of people and faded into the frontier in the 19th century (ghost towns). It didn’t keep us from going on to win two World Wars, splitting the atom, inventing rock and roll and becoming a global superpower in the following century.

So why don’t we raise interest rates now? Because we are afraid, that’s why. We’re afraid banks will fail and people will lose their jobs. We’re afraid government workers and their unions will be unemployed. We’re afraid of recession. We’re afraid of higher interest payments.

One political party in this country has always survived by pandering to people’s fears: fear of Wild Indians, fear of free blacks, fear of foreigners, fear of Catholics, fear of economic reality, fear of weather, fear of war, and — most importantly — fear of failure.

With leaders such as Andrew Jackson, Woodrow Wilson, Fernando Wood, Nathan Bedford Forrest, Robert Byrd, Al Gore Sr., Lyndon Johnson and Jimmy Carter, it’s not hard to guess which party I’m talking about.

The truth is that the country would benefit from many government employees losing their jobs and their pensions. Instead of sitting around and literally “doing time” until they collect their retirement money, those people would be forced to learn new skills, invent new products and grow as human beings. Now they are being coddled in the prime of their lives, so how will they ever achieve greatness and help society progress?

None of these issues can be separated, but it all starts with money. It’s time to stop sucking our thumbs with low interest rates and to stop embracing the mentality of the welfare state in our financial system. Americans don’t cower in fear when faced with adversity. Only Democrats do.

DISCLAIMER: This post and the contents thereof are the views of only the author identified immediately above and do not necessarily represent the views of the New York Young Republican Club (the "NYYRC"), its officers or its members. The NYYRC expressly disclaims responsibility for the contents thereof and by its charter documents may not, and does not, endorse any candidate for any office, except in a general election.

1 Comment

  • Well, I now fear for the country.