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.

I just read an April report by Jeremy Grantham, who argues that in view of resource constraints we need to make serious policy changes. I agree that serious policy changes are desirable, but not simply because the cost of natural resources will now go up undefinitely, as Grantham predicts. It is almost always intellectually feasible to generate negative projections from a selection of current trends, as G does from the growth of population and wealth, the rising price of commodities, etc. He's a true descendent of Paul Ehrlich, who wrote the Population Bomb in the sixties. It is much harder, however, to generate positive projections for the simple reason that the driving forces are often unknowable.

In my view, there are four forces that generate economic growth. (1) Throughout most of history, population increase was the only one measurably operating. (2) With the development of systematic R&D in the late 19th century, innovation became a second force for economic growth. The availability of new and desirable products stimulated demand, and there was resulting economic growth PER CAPITA, not just in gross. (3) The third force for economic growth is marketing, a force that intellectuals like me often deride. But marketing makes goods and services desirable, often vastly more so than technological innovation. I think that marketing has vastly improved in quality during the late 20th century as R&D and technology have made it more effective. (4) Finally, we should not neglect institutional improvement.  As with innovation, this force was very much hit or miss for most of history. But with record-keeping, historical and social learning, and improved education—even for politicians—our understanding of how institutions affect economic activity has greatly improved, political craziness notwithstanding. Compare the 2007-8 response to market crashes with those of 1930-31. 

If we look at the resource constraints that concern Mr. Grantham—a longstanding bear, as I recall—population growth obviously works in favor of increasing constraints and, therefore, costs. Even that effect is greatly exaggerated in straight-line projections, however, because it ignores substitution. If we now factor in the power of innovation, marketing, and institutional improvement, I think the long-term impact of resource constraints becomes inherently unknowable, and just as likely to diminish as to increase.

My case is best made, I think, by comparing the resources needed to sustain a given level of economic activity in 1970, say, with today. With the possible exception of rare earths, I cannot think of any natural resource whose use would not have significantly decreased in this comparison.

Moreover, if we look at the costs of production even in China, it becomes clear that labor costs far outweigh material costs, and increasingly so as production moves up the value scale.  And the labor cost impact, due to technology and marketing and institutional improvement may well continue to drop, temporary fluctuations notwithstanding.

In short, I am not very worried about INflation; it is still DEflation that keeps me awake, especially given the current political threats to both the Euro and the Dollar.