The Big Inflation Scare is Real v2.0

[Corrected version]

This article comes under the category of “who do you listen to and why?” I ask this question frequently, especially when I read something by Paul Krugman.

Nobel laureate Paul Krugman is one of America’s best known economists through his commentary in theNew York Times. Yesterday he declared we won’t have inflation.

The sign of a good social scientist, and especially economists, is that they should have a healthy sense of skepticism about what they think they know. After all, as we know, economists have a terrible record of predicting things. You would think they would be a bit humble. But they’re not. I don’t get the feeling that Professor Krugman is a particularly humble man.

His recent Op-Ed piece, “The Big Inflation Scare,” said that, although the Fed is pumping up the money supply and is monetizing Treasury debt, banks are just sitting on the money, thus no inflation. Besides, he says, Japan didn’t have any inflation during their recession between 1990 and 2003 when their central bank monetized their debt, as the Fed is doing now. Also, because governments run up huge deficits doesn’t mean there will be inflation. He points to the experience of Belgium, Canada, and Japan.

Banks “Hoarding” Money:

Professor Krugman is correct about the current state of our credit system. The Fed has pumped credit into the system, but because of bad loans and unstable balance sheets banks have been reluctant to lend and many businesses are reluctant to borrow. So, banks have been building up reserves on their balance sheets to offset potential losses and this credit is not hitting the economy—yet.

To observe that since we don’t have inflation now and then conclude that we won’t have inflation in the future is simply a leap of faith by him and is not borne out by history or economics. Is he saying that when the government injects massive amounts of money into a system that inflation will never occur?

Krugman points to the experience of Japan from 1990 to 2003 when the Bank of Japan injected a lot of credit into the system in various ways and no inflation resulted. He is mostly correct on that. Their banks were in terrible shape because of the fallout of the inflationary binge on real estate caused by BOJ money pumping in the 1980s. What he doesn’t say is that when the crash occurred, the Japanese tried every Keynesian trick in the book to revive their economy and they all failed.

Many banks and financial institutions were propped up by the government and weren’t allowed to fail, and the banks added the new credit to their reserves to offset bad loans. The money didn’t hit the economy and they went into a recession.

Professor Krugman wrote about this problem quite a bit during that period and everything he recommended the Japanese government to do had been tried. His recommendations failed. For example, he thought government sponsored infrastructure projects, though wasteful, were fine. In other words, the Keynesian bromide of paying one man to dig a hole and paying another man to fill it was good because money was being injected into the economy to defeat the dreaded Keynesian “liquidity trap.”

He also recommended monetary expansion (read, quantitative easing) to cause inflation and a weaker yen. That was tried and failed too.

Thus, he’s correct; the expanded credit didn’t hit the economy. They didn’t experience inflation. Demand for credit never revived because government actions inhibited growth.

What Professor Krugman and all Keynesians fail to see is that the problem is not deflation caused by “falling demand,” but massive attempts by the government to prevent deflation. As long as the government props up bad banks with assets that aren’t worth their carrying value on their books, as long as they prop up failed companies and allow their bad investments to continue, and as long as they try to delay the readjustment of prices of assets that are overvalued, they will delay deflation and recovery. That will and did stagnate the Japanese economy and resulted in the longest recession of an advanced economy in recent times.

The very things that Krugman and his fellow Keynesians recommended to Japan caused their economy to stagnate, increased deflation, lowered demand for credit, and they went into a 14 year depression. No inflation resulted because reduced economic activity didn’t require the new credit sitting in the banks. Thus, this credit never reached the economy to result in inflation.

This is what Professor Krugman is now advocating as policy for the Obama Administration: economic stagnation, recession, and continuing deflation for a decade.

Monetized Debt:

Professor Krugman theorizes that since the Japanese monetized their debt and didn’t experience inflation, we also won’t have inflation. Again, he is correct in his view of Japan. During the period of 1990 to 2003, the government borrowed heavily to spend heavily according to the standard Keynesian playbook. The problem is that none of that spending stimulated their economy and as a result they became massively indebted.

The Japanese monetized their debt in various ways. They had a program called FILP (Fiscal Investment and Loan Program—read, TARP and TALF). They lent directly to businesses through this program and borrowed the money from the huge postal savings system. This spending accounted for about 70% of their budget. The government just funneled funds projects run by cronies of the ruling Liberal Democratic Party. The wealth was not spread around to the rest of the nation.

Krugman also recommended that the BOJ buy dollars, Euros, and government bonds to stimulate inflation. The government had already done something like that several years before but that program failed as well. As recommended, they had lent massive amounts to the commercial paper market (sound familiar?). They also bought up 53% of government bonds and tried to devalue the yen. That policy failed.

But, he’s right: they didn’t have inflation. Why? For the same reason as before: the economy kept failing as a result of all this Keynesian monetary and fiscal stimulus. Loan demand was low, bad investments were propped up and still didn’t make economic sense, and savings increased because of uncertainty. The recession continued and continued.

This is what Krugman is recommending today. The resulting massive debt will be a burden on the taxpayers and the economy for generations.

Will we have Inflation?

Yes.

Nowhere in Professor Krugman’s articles does he lay blame for boom-bust business cycles on the government and the Fed. Like most Keynesians he ascribes to the theory that a mysterious sudden drop in demand caused the bust—those famous “animal spirits” of ours that Keynes blamed. He believes that the government must revive demand to prevent the dreaded deflation. Just get everything back to where we were before the crash and we’ll just be all merry.

The Monetarists, such as Friedman and his Chicago School believe that the whole thing was caused by the Fed cutting money supply when they should have been increasing it in times of crisis.

As shown above, all these things were tried in Japan and failed.

Inflation is an increase in the supply of money. The result of inflation is that all prices rise. The fact oil prices go up is not inflation since other prices go down in response to consumers’ need to cut expenditures in order to drive their cars to work. Inflation is what we had in the late 1970s. Then it was called stagflation because the economy went nowhere and all prices climbed.

We are not seeing inflation now because we are not seeing a demand for money. The supply is there though. We will see inflation when the deflationary phase of the cycle ends, when credit enters the market because of new demand, when new money further increases demand, when prices start to go up, and when people see that they need to get rid of cash and get into assets that don’t depreciate like the purchasing power of the dollar (i.e., rising prices).

There hasn’t been a case in history that I can think of (I’m sure I’ll be reminded soon if I’m wrong) where an economy has been seen a massive increase in money supply that hasn’t resulted in inflation. And the history of inflation goes way, way back.

When will deflation end? I don’t know. But all business cycles end at some point. The problem in our present case is that the Fed is setting the stage for the next boom-bust cycle because of all the credit they have staged into the system. They can’t just suck it back out without causing interest rates to increase which would put a damper on the “recovery.” This is a very complicated topic which I’ve touched on a bit before: China and Japan, dollar-yen-yuan, interest load of our national debt, Keynesian policies, and the increased role of government in our economy.

All I can tell you is to watch the M1 Multiplier chart to see if Money Base has hit the economy. Also keep an eye on gross domestic investment (GPDICA) and  total bank credit (TOTBKCR) for example. When these rise, inflation will eventually kick in. How much and how long will depend on what the Fed and Treasury do. As you know, I’m not a big believer in prognostication, just a big picture guy. I do know that there is a huge attempt at credit expansion. And eventually that will mean something.

For a more detailed look at Japan and what Keynesian remedies they tried and why they failed, see my article, The Japanese Disease. The similarity to our present situation is startling. I also point you to several excellent papers: Herbener, Powell, Anderson, Cochran and Yetter, and Anthony Randazzo, Michael Flynn and Adam B. Summers.