Monday, March 01, 2010

A Tale of Two Inflations

The one thing Keyneseanism is devastatingly, destructively wrong about -- and the thing Keyneseans seem to promote the most -- is inflation. Keynes believed that inflation causes a strong economy, but the fact is that a strong economy causes inflation. And it matters quite a bit which one is true.

1. Natural Inflation

Let us say that we have an economy with 10 objects (X) and 10 objects (Y) in it, that both were in equal demand, and $200 was all the money in the economy. That would make each object worth $10. Now let us say that the consumers in the economy wanted more of X. Competition among consumers would drive up the price of X relative to Y, which would go down in price. Thus, we would see inflation for X. Businesses would then produce more X, redirecting resources and labor toward producing what consumers want. More business would come in to produce more X as well. This would then drive down the price of X. With the same amount of money in the economy and more objects, prices would drop over the long term. Further, we would have more people working, and they would also demand more product, which would drive up prices, leading to a virtuous circle of price increase/decrease that ultimately leads to lower prices for many products. In other words, we would have natural deflation for certain products. Of course, we see exactly that with new technology. Those buying something the first year it comes out pay much more than those in subsequent years, especially if the product is popular.

2. Artificial Inflation

Let us return to our artificial economy of 10 X, 10 Y and $200, with X and Y worth $10 each. Now let us double the money supply by, say, printing it. Now we have 10 X, 10 Y and $400, with X and Y worth $20 each. Companies do not know where the price increases are coming from, and most companies would interpret any price increase as consumer competition for their products, meaning they need to produce more. Established companies would probably notice that their inventory hasn't gone down, but others would see the high prices and definitely interpret that as a signal that they should enter the market to produce more of that object. Thus, there would be money and labor directed toward the production of both X and Y, when there has been no increase in demand for either one. Inventories of X and Y would increase and increase -- especially as the higher prices disocuraged people from buying as much as they had in the past. After a while, companies, faced with large inventories, would stop production. That would mean they would need to lay off people. Now people aren't working, prices are dropping because companies are trying to get rid of inventories (thus, 50% and more off sales), and the economy has entered a recession caused by the economic bubble created by inflation.

3. And Then There Is Interest Rates

I have already discussed the problems created by interest rate manipulation by the Fed. In sum, low interest rates tell (encourage) people to take more risks; high interest rates tell (encourage) people to take fewer risks. When money is cheap, people are more willing to take financial risks. When money is expensive, people are less willing to do so. Further, low interest rates discourage people from putting money into savings accounts. Money in savings accounts is money the bank now has to loan out. High interest rates encourage people to put money into savings accounts. Now, if you have low interest rates, you will have fewer people saving money at the same time you will have more people borrowing. Both savers and borrowers have an effect on interest rates in a natural economy. But when the Federal Reserve artificially drives down interest rates, you have banks lending more money than they have (after all, you also have the Fed guaranteeing the bank's holdings, providing even more incentive for the banks to take risks). A crisis is bound to occur.

4. The Marriage of Artificially Low Interest Rates and Artificial Inflation

To "combat" the current economic downturn, the Fed has printed more money and is continuing to keep interest rates artificially low. (I do not argue the Fed should push interest rates up or reduce the money supply, as those will also have devastating effects on the economy.) Any guesses as to what is bound to happen? If this recession isn't going to take us down, the next one the Fed is creating most definitely will.
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