Inflation or Deflation: Can Economists Tell Up From Down?

Much economic commentary today is gloomy. Even those investors and economists who sound bullish for the moment, are often somewhere between non-committal and bearish about the longer term when pressed for anything more than a sound bite. Enthusiasm for the immediate future is understandable. The economy appears to have stabilized following its near-death experience two years ago, and the stock market has enjoyed one of the sharpest rises in its history from the low point struck during the crisis. Most consumer prices, at least according the popular indices, are relatively stable. Yet almost no one believes that things are right with the economy, or considers an era of sustainable growth and trustworthy investment values to be just around the corner. It's hard to pick up an article in the popular press that doesn't make reference to bubbles of one sort or another, as though optimism and reckless illusion were indistinguishable.

So what's wrong? Our most dogmatic commentators are entirely clear about this, of course. The problem is that their ideas offer seemingly incompatible 180-degree perspectives. Goldbugs, often allied with the political right, warn breathlessly about uncontrolled deficits leading to avalanches of worthless money and hyperinflation. In their articles they like to show pictures of harried middle-class Germans pushing wheelbarrows full of paper currency out to buy groceries in 1923. Old-style political lefties, on the other hand, talk with equal fervor about a new Great Depression on our immediate horizon if we don't stop fretting about deficits and start driving the economy full-tilt with bigger government programs and projects. On their websites, they favor pictures from a decade later of people in baggy clothes, no currency at all in their pockets, waiting grimly in lines for bowls of free soup.

There are, of course, more moderate voices suggesting nuanced versions of these same negative views. So-called "inflation hawks," like Dallas Fed Chairman Richard Fisher, often mention inflation risk to support calls for tighter monetary policy. Across the ideological fence, liberal economist and Nobel Laureate Paul Krugman routinely invokes Depression fears to justify ever-higher levels of fiscal stimulus.

People looking for reasons to be optimistic sometimes draw comfort from all this, like atheists who find hope in the dogmas of Jihadists and Christian fundamentalists. The implied assumption is that these people must all be wrong, since they can’t all be right.

Religion aside, however, maybe the time has arrived indeed to consider the counterintuitive possibility that all these diverse economic naysayers are onto something. Perhaps a few of them, including some of the more lathered Jeremiahs, see accurately into our current predicament, even when none of them has solutions to offer beyond revolution or gold bars and fortified bunkers.

Over at least the intermediate term, inflation risk is real. In the United States, chronic budget deficits continue to compound, while our politicians devote enormous energy to grandstanding about inconsequential reductions in federal spending or adjustments to the tax code. There is no politically viable solution even under consideration at the present time that brings deficits under meaningful control in the foreseeable future. New economic theories have arisen that conveniently purport to explain why we shouldn't worry about this. Yet the fact remains that the only reason we've gotten away with our financial high-wire act as long as we have is that the U.S. Dollar has so far retained its reserve currency status. Foreign governments continue to take down and rollover our bonds at low interest rates, regardless of the deficits. This kind of monetary power on the part of the United States is an historical anachronism and cannot be relied upon much longer. At the first real sign that the bond markets are becoming restive, rates will rise. Given the huge base upon which new interest would then start accruing, compounding interest costs would soon offset, and eventually overwhelm, hard-fought cuts in discretionary spending. At that point, we would find ourselves in an intolerable bind.

Our Federal Reserve is, of course, vigilant and fully aware of this potential scenario. Concern about it has to be one of the reasons it has dusted off the once old-and-obscure monetary tool that carries the appropriately obscure name "quantitative easing," even though economic stimulus has been the public rationale for its application. Once considered an extreme measure for dire circumstances, QE was employed during the height of the 2008 financial crisis and then, before much had settled, again last year. Rumors abound that QE3 may currently be in the works, and QE is looking increasingly as though it's been elevated to a standard weapon in the Fed's arsenal. We can be 100% confident that QE would be employed with an intensity not yet imagined in the event of a serious international run on the U.S. Dollar. At that point, new money would be pouring into our system and doing nothing whatsoever to stimulate the flow of new goods and services. That is one prescription for inflation, to put it in the blandest possible terms.

So if inflation risk is thus real, what can be done to circumvent it? Well, obviously in the minds of certain partisans, deficits have to be forced under control with tax increases, plus draconian cuts in entitlements and all other spending.

At this point in the debate we blunder haplessly onto the home turf of Professor Krugman and others who tirelessly and accurately point to the problem here. With unemployment still high, and economic growth anemic this far into a supposed economic recovery, austerity measures robust enough to make a difference would surely throw us back into recession. And another recession this soon after the last one, however our economists might choose to label it, would constitute a depression and probably intractable deflation.

That doesn't leave much middle ground, of course, but this is the nature of our problem. It seems depressingly obvious. Investors and savers trying to protect their money confront a dilemma, since investment portfolios prudently designed for one environment can be full of reckless exposures in the other.

Unfortunately it's politics more than economics that will determine which road we may actually be on. Voters contemplating the loss of their jobs, or the erosion of their savings and pensions, can be entirely unpredictable.


  1. Your last words, "unfortunately it's politics more than economics that will determine which road we may actually be on," hit the mark, Mark. I think the widespread sense of malaise and gloom comes largely from the fear that the political wars are preventing the implementation of rational measures to deal with the financial crisis. Not just here, but in Europe even more.

    In both continents, it seems to me that the main culprits are the extremely powerful banks and other financial institutions. They use their money to gain political leverage, and because economics is pretty confusing to most people (including most politicians), few have the knowledge and understanding to resist their selfish prescriptions: "we made bad loans to Greece, Portugal, Ireland? Nationalize the banks and let the governments impose austerity to get the laons repaid at 100%." "You want to provide consumer protection to buyers of financial products like credit cards? That's just more big government interfering with free markets. And that Elizabeth Warren is a hellion out to destroy the American banking system."
    While the Republicans take the lead in protecting the banks, there are enough "blue dog" Democrats to give them majority power in many instances. Probably the same stuff happens in Europe, only under different names. Hence gridlock in the capitals.

  2. Keith,

    I'm not going to defend our large financial institutions. I agree that what ultimately proved to be their reckless practices gave the immediate trigger to the 2008 financial crisis and the recession that followed. I also believe that intelligent regulation has, or should have, an importance role to play in the governance of these institutions. That said, however, I think that Democrats have way too much invested in the notion that "rational measures" to fix everything are somehow waiting in the wings but are being blocked by the machinations and big money of these same institutions. That would be a much simpler problem to deal with than the one I believe we in fact have.

    Hedge funds aside, our large institutions were certainly not unregulated or even under-regulated - they were badly regulated. Bad regulation, by definition, means crude and unenforceable rules that have unintended consequences possibly as bad as or worse than the problems the rules are designed to forestall. Some of the worst excesses of structured finance leading into the crisis, for example, stemmed from efforts to work around archaic balance-sheet rules that should have been revamped years ago but were not because of regulatory intransience. Bigger funding for slow-moving regulatory bureaucracies would not have solved this kind of problem, and could have made it worse.

    However, I think this issue is only tangentially related to the real crisis currently affecting the developed economies, which stems from the inherent instability in the global monetary regime. Politicians and economists, whatever their ideologies or nationalities, seem to be failing to come to grips with it.

    We need to beware of facile diagnoses and prescriptions, all of which distract these people from the pragmatic work that should be getting done.


  3. What's the inherent instability in the global monetary regime?

  4. The Dollar is badly overstretched as the world's primary reserve currency, yet there's not currently viable replacement for it, and no international body with sufficent authority to stand behind a new monetary order.

    Practical collaboration among the U.S., Europe and China is critical to progress, yet all three for their own set of reasons seem not really up to the task. Europe is in increasing disarray, and the U.S. seems more devoted to political theater than economic problem-solving. China is the lynchpin to any long-range solution, yet no one seems to know what their gameplan really is, even though it's probably a good assumption that they have one. One source of comfort is that they clearly want peace, but at the same time the economic security and happiness of Europe and the U.S. are not likely to be high up on thier priority list.

  5. Mark, let us descend from the airy heights of generalities like "badly overstretched." That is, no doubt, a metaphor, but what does it mean? That we have so few dollars that each one must do extra work? As far as I can see, the euro is no longer a viable threat to the dollar as the main international currency, nor is the yen nor yet the yuan. There is one threat only to the dollar:namely, that US politicians will make it so undesirable that people will start refusing to use it. They can do that by allowing a high rate of inflation--not too likely at the moment. Or by default--not too likely either, I think.

    Speaking of the latter, I am glad that the Republicans are making the debt limit a line in the sand, to cross which requires real action on deficits and taxes. SOMETHING has to make the politicians act responsibly, and this is better than a genuine crisis, in that it is entirely controllable.

  6. "Overstretched" means that the international system is overloaded with Dollars relative to the dwindling capacity of the U.S. economy to cash in those dollars with, in the calculations of our trading partners, reasonably priced goods and services. This has not emerged as a crisis thusfar because of the $'s reserve currency status and the willingness of foreigners to warehouse the $ as though it were gold. You're right that there's no other currency currently strong enough to take its place, but we may be approaching a situation where the markets start losing condifidence in all currencies. At that point money would likely pour into commodities and give rise to a global inflation totally different from the tame national inflations that academic economists like to think they understand.