Sunday, June 19, 2011

Nonsense from the WSJ

This article needs a response. The gist of it is that high inflation is the right medicine for the U.S. economy right now. Unfortunately the writer does not appear to understand inflation and so the article doesn't make a lot of sense. Furthermore, the writer fails to account for the "unseen" as any good economist must. As Bastiat tells us, that is the difference between good and bad economists.

The writer begins with the premise that the real problem with the U.S. economy right now is debt. The federal debt is high right now; it hasn't been higher, as a percent of GDP, since the mid-1950s. The feds ran up a huge debt paying for WWII, and then spent a decade paying it down. The current debt is high for other reasons, although defense spending is certainly a big part of it. Households also have a lot of debt, but the personal savings rate has gone back up recently and is now around 5%.

After going on about how indebted Americans are, at all levels, the writer calls for a round of inflation so that people will have more nominal dollars to make it easier to pay off their nominal debt. This is essentially a wealth transfer from debtors to creditors. This effect is true; I have no quibble about it. But here's where the article makes claims that I find unacceptable.

First, the writer repeats the fallacy that WWII ended the Great Depression. I get that Keynesians still buy into this fallacy, but much recent research has pointed out that WWII did not end the Great Depression in the sense of a recovery in business investment and improvement in labor conditions. Sure, unemployment went down, but that's because boatloads (literally) of young men were shipped off to fight in Europe and the Pacific. Yes, GDP went up, but it was because the federal government was buying a whole bunch of war materiel that was destined for destruction. It should be clear why measuring well-being through GDP is dangerous and we must take great care when doing so. People can't eat tanks, after all.

Next, the writer insists that the inflation must be a general effect: not just commodity prices but also wages must rise. This ignores the non-neutrality of money. Price inflation comes about through money printing (in the U.S. case, monetizing the federal debt). But money doesn't appear in all places at the same time. It works its way through the economy starting with new bank loans. So one might see commodity prices and asset prices go up first, and then maybe only for certain industries where the loans are concentrated. It can take a lot of time for the inflation to get through to wages. In that time period, people will not have higher wages to pay off their debt, and their groceries are going to be getting more expensive. That's just grand for peoples' well being, isn't it?

This brings me to my next point - the writer confuses monetary inflation and price inflation, and he goes on to make the familiar point that a general deflation would be a disaster because there was a price deflation from 1929 - 1933, and that was a horrible time for the U.S. But, as Friedman and Schwarz (1966) point out, that was caused by a massive monetary deflation. That is certainly bad news for anyone, because what happens is you can't get the means of payment for goods and services. You may have productive capacity, but if you haven't the means to pay for raw materials and labor, you can't produce. This is a great danger of having a money monopolist, but I digress. The point is, price deflation isn't a problem, but monetary deflation is. We certainly do not have monetary deflation now. And, I think the writer is going to get his wish, because price inflation appears to be heating up.

The writer's thoughts on why the Great Depression lasted so long appear to be misinformed. He has certainly not kept track of the recent work in this area. Furthermore, the GD wasn't one ten year long depression. It was two depressions and a minor recovery in the middle of the decade.

In the last few paragraphs, the writer seems to be calling for a greater number of transactions to increase the velocity of money. In the quantity theory of money, MV = PQ, where M is the money supply, V is velocity, P is the price level, and Q is the quantity of goods. He seems to be saying that a higher P will cause a higher V, and that itself will be good. This is because he wants prices to be maintained. The problem here is that keeping people in homes they can't afford keeps their money tied up. The better solution might be to let home prices crash and have foreclosures. Declare bankruptcy and start moving forward - stop throwing good money after bad.

In the third to last paragraph, the writer confirms my suspicion that he does not understand the non-neutrality of money when he calls for helicopter drops of money. This is nonsense.

All in all, this article is unfortunately based on a misunderstanding of price inflation, and a conflation of price and monetary inflation. Further, because the writer doesn't appear to understand the non-neutrality of money he calls for high inflation that would likely hurt the very people he wants to help, before it would start to help them.


  1. Never heard of anyone calling for a sustained high inflation rate before. Naturally, you set him straight. The writer also ignores the effect inflation would have on interest rates.

    In the late 70s and early 80s, as inflation soared, interest rates also rocketed upward, going as high as 20% in April 1980 (prime rate). Who could afford to purchase a home at these interest rates?

    Hey, can you send me something on the non-neutrality of money. I'm not sure what this is.

  2. The Daily Capitalist was moved to commentary as well: