Growth and inflation
July 30, 2006
For the last seventy years or so, economists have concerned themselves with the relationship between growth (or unemployment, or some other proxy for positive economic conditions) and inflation.
Which is too bad for them, because there is no relationship between growth and inflation.
That is rather blunt, but we will now examine it more closely. Anyone reading this will by now understand that inflation (or deflation) is caused by a change in currency value, typically indicated by a change in the currency’s value in relation to gold. If the “dollar goes to $0.50,” or, to take a more specific example, if the dollar’s value goes from $350/oz. of gold to $700/oz. of gold, then over a period of time, it will tend to take more dollars to buy everything else as well. This is inflation. The opposite condition, in which the “dollar goes to $2,” or from $350/oz. to $175/oz., is of course deflation.
From this we can see that any amount of growth is non-inflationary, if the currency is stable in value. Historically there have been economies with measured nominal growth rates in excess of 20% per annum, and with a stable currency this “nominal” figure is equivalent to “real.” Indeed, these super-high growth rates are made possible by a stable currency.
Today’s economist is often concerned that “too much growth will lead to inflation.” Translated into our terms, this means that “too much growth will lead to a decline in currency value,” which is somewhat absurd. However, to make sure there is not “too much growth,” the central banker may feel a need to cripple the economy with some sort of monetary policy mistake, and the government may feel a need to cripple the economy with some sort of policy mistake such as tax hikes. Alas, these attempts to stifle growth (and thus inflation) often backfire. “Tax hikes (to stifle growth) lead to currency decline” does not seem so implausible, no?
From these fallacies we also get a number of conclusions that “the way to stifle inflation is to blow up the economy.” Paul Volcker is often commended for “wringing the inflation out of the economy” in the early 1980s through a series of monetary policy maneuvers that created very high interest rates. He is supposedly to be congratulated for causing some very bitter recessions. Actually, Volcker successfully “wrung inflation out of the currency” by stopping its trend of declining value. However, he did this in a very poor and clumsy fashion which also caused bitter recessions. A proper solution would have been to adjust the monetary base directly with the intention to target some stable gold value for the dollar, perhaps around $400/oz. If Volcker had done this, the result would have been lower interest rates, an end to inflation, and economic boom instead of recession. After all, if inflation is bad for an economy, then stopping inflation should be good, right?
The idea that “growth causes inflation” comes from another idea, popular in the 1930s-1970s period: that inflation improves growth (or lowers unemployment). In those days, it was very common to look to Our Savior the Fed to apply a gentle but persistent inflationary bias, which was seen to keep economies out of recession. If they looked like they would slip into recession anyway, the central bank would apply a less gentle inflationary bias (i.e. monetary policy that tended to lead to currency decline). It is certainly true that, when one starts from an environment of roughly stable money, a dose of inflation (currency decline) can lend an artificial “rosy glow” to economic conditions. Today, when central bankers are somewhat more circumspect about the advantages of an inflationary bias, they look at economic growth and begin to get worried that the growth implies that some inflationary bias exists.
A recession or economic slowdown is no cure for whatever inflation may exist. If a currency falls further in value, then there is more inflation, whether or not the economy is booming or busting. Today, some people think that “inflation is not a problem” because the economy is beginning to slow down. I think that inflation will get worse in part because people have this attitude: if they are relying on recession to do their inflation-fighting for them, then they will be disappointed, because it doesn’t work. In the meantime, the complacency created by this expectation creates an environment where the value of the currency may fall further, without much concern, just as the decline thus far has not caused much concern although we are now in the most inflationary environment in over twenty years.
One major reason for currency decline is a lack of concern about past currency decline. If a currency declines in value, and nobody cares, wouldn’t you consider dumping it?
Likewise, economic contraction is not “deflationary” even though prices may plummet as businesses hold a “going out of business sale” and workers compete for scarce jobs by accepting lower wages. Deflation is caused by a rise in currency value. So, if recession is “deflationary,” then it must be that “recessions cause a rise in currency value,” which his also rather absurd. It is not well recognized today that the 1930s were an inflationary environment, as currencies around the world were devalued beginning in 1931 (but not before).
Oddly enough, one thing that can cause deflation is something that’s good for the economy, like tax cuts. “Tax cuts (to encourage more growth) lead to a rising currency” makes sense, right? The late 1980s in Japan, when the yen went from 240/dollar in 1985 to 120/dollar in 1988, was actually a period of deflation despite a booming economy at the time. This boom was encouraged by a large-scale reduction in taxes beginning in 1986. Deflation is bad for economies, however, and the economic boom was eventually overwhelmed by the negative effects of monetary deflation, to which was added a series of rather punishing tax hikes in the early 1990s.
Today, many people are confused by the situation, as they see a potential for a major economic slowdown which would likely include price declines for major asset classes. But then, didn’t stocks go down in the inflationary 1974 recession? And bonds too? “Deflationary,” they say, though they are not taking into account the possibility of major inflationary price rises going forward, such that you could be spending $10 for a Big Mac.
