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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.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset management.
Lewis has written for the Financial Times, the Wall Street Journal Asia, the
Japan Times, Pravda, and other publications. He has appeared on financial
television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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