Wednesday, May 23, 2012

On Inflation, Deflation, and Austerity

If someone who doesn’t have much of a background in economics reads what the experts have to say, or hears about it on television, he or she is likely to accept on faith what is being said. The trouble is these experts rarely mention the fact that they are only sharing their own opinion, or repeating a particular theory that other economic experts have shown to be riddled with holes. And the economists who write columns or speak on television never mention that their jobs or the performance of their stock portfolios depends on being able to convince people to come around to their way of thinking.    

The partisan two-party system in this country gives people another way of deciding whether or not they agree with what a particular economic expert is saying. When a conservative voter hears the word “austerity,” he or she is apt to think “lower taxes,” and when a liberal voter hears the word “austerity” he or she is apt to think “fewer jobs” or “cuts in services.” 


Most people have an impression of what is meant by inflation, but it is possible that some people do not understand the nuances. Inflation can be beneficial when it is moderate, but it can be dangerous if it is either too low (leading to deflation or disinflation) or too high (leading to hyperinflation).  In other words, inflation is not inherently a bad thing or a good thing. 

Still, the word “inflation” is so dreaded by Americans that no one dares to speak its name. One of the images that come to mind for Americans is that of the German citizen, who in the 1920’s had to withdraw a wheelbarrow full of cash from the bank just to buy a loaf of bread. 

What happened in Germany was the result of a political decision to print money in order to pay off war debts. Inflation, in this instance, was the result of poor decision-making. First, the government led the country recklessly into war, thereby creating an impossible level of debt. Secondly, the government initiated a disastrous monetary policy that was based solely on short-term expedience. The German example does not – or should not – imply that inflation is some sort of a wild beast that, given the slightest encouragement, will run out of control. 

For many people, the term “inflation” is painful because it evokes the experience of the United States during the 1970’s. In this instance, a sharp increase in the price of oil contributed to rising prices for other essential goods. So, instead of there being a sudden increase in the amount of currency, an event occurred (the Arab Oil Embargo, which was a response to U.S. military support for Israel during the Yom Kippur War) which abruptly reduced the buying power of American dollars.  

The period of inflation which occurred during the 1970’s etched such a deep, traumatic memory in the American psyche because, among other things, it forced the country to ration gasoline. In some instances, a customer might only be allowed ten gallons per visit. If such a turn of events were to occur today, many drivers of large SUV’s could not make it home from the gas station.

The 1970's - A Period of High Inflation
Inflation is the temporary end result of a particular chain of events. Specifically, there are times when the amount of money that is in circulation abruptly increases. For example, in the last several years, China has benefited from some very favorable trade agreements with the United States. As a result, there has been a steady increase in the number of American dollars pouring into and circulating within the Chinese economy. Their manufacturing sector has grown to the point that millions of new jobs have been created, wages increased, and the standard of living for ordinary Chinese has improved. Despite all of these benefits, the change has been disruptive. The ability of domestic producers to increase supply has lagged behind the increase in demand for goods and services. Owing to the inexorable Law of Supply and Demand, this has led to price increases. 

In some instances, then, inflation may be viewed as the price one pays for economic growth. In China, the rate of job creation and wage increases will eventually slow down, or supply will catch up with demand. It is very unlikely that the situation will get out of hand. Experience has taught economists and policy makers that inflation can be reliably and effectively managed. In the early 1990’s, Canada set a target rate of inflation of between 1 and 3% and has been able to remain on target ever since. 

If people respond to increased money supply by buying more goods, this increases demand. When demand for goods increases, businesses and manufacturers are likely to respond by: (a) increasing production, (b) increasing prices, or (c) hiring more workers. In response to increased demand, manufacturers may need to purchase additional raw materials, only to discover that other manufacturers are also busy purchasing raw materials, and thereby driving up prices. If prices continue to rise and money is plentiful, people will soon realize that if they buy that washing machine today, it will be less expensive than if they were to wait a couple of months.  Thus, inflation can spur spending and hiring.

As noted a moment ago, the word “inflation” is frightening to many people. So, instead of saying “I’d like to see a little more inflation,” an economist will say, “I am pursuing an expansionary policy” or “I am in favor of quantitative easing.” 

A Time Magazine cover from 1970.
In today’s economic environment, the risk of excessive or unmanageable inflation is very low. As stated in the Harvard Political Review, “Quantitative easing aims to encourage lending for the purpose of investment by pumping liquidity, namely cash, into the financial markets. Analysts recognize that extra money, all else equal, creates the risk of higher inflation, yet a low-interest rate environment like the present may mitigate those risks (source).”

Inflation reduces the real value of the dollar (in terms of purchasing power) in relation to its nominal value (the amount printed on the bill). If a person has a fixed rate mortgage, inflation is a blessing. Because the real value of the dollar has shrunk, the real value of the debt has also shrunk (this also applies, by the way, to government debt, the real value of which shrinks when inflation increases). However, the creditor who holds the mortgage is sorely discomfited by a shrinking dollar.  To a creditor, other peoples’ debt is an asset, and when the real value of debt decreases, wealth eludes the grasp of creditors and comes into the hands of debtors. This is where austerity comes in.


When countries face uncomfortably high inflation (or the threat of inflation), there is often a call for austerity measures. Austerity measures consist of steps such as cutting public spending and services. The phrase “cuts to public spending” means, among other things, putting people out of work. When unemployment rises, spending decreases and the demand for goods declines. Employees are willing to work for less money. Businesses and creditors benefit.

Economists appear to agree that austerity is an effective means of counteracting inflation. When members of government call for austerity measures, it is vaguely troubling, because it betrays the fact that said members of government are unaware of the fact that a state of austerity already exists. 

Austerity will always have its champions. And there is also a natural constituency of people who would benefit from inflation. The trouble is that the people who stand to benefit from inflation are generally not as well-informed about economics as business-owners, politicians, and bankers. And the economists who write columns and appear on TV are, in some cases, holders of assets and will personally benefit if austerity measures are adopted. 


Even if his lackluster performance as Chairman of the Federal Reserve gives little evidence of the fact, Benjamin Bernanke is a formidable scholar in the field of economics. In his younger days, he was well known for his writings on The Great Depression. During the Great Depression, the Federal Reserve responded to the decreased demand for money by reducing the supply of money. This is an example of an austerity measure. Professor Bernanke believed that this action by the Reserve made the Great Depression more severe, by bringing about a situation known as deflation

Not everyone agrees with Chairman Bernanke’s assessment. Milton Friedman, for example, felt that the depression could have been averted, if the Federal Reserve had avoided direct intervention and instead done more to bail out failing banks. One of the questions that had once distinguished Democrats and Republicans was this: is it better to manage the economy centrally (as Keynes recommended), or is it better to rely on “market forces” instead? 

Today, Democrats and Republicans no longer represent the two sides of this question. Instead, both parties have sworn allegiance to the principle that market forces ought to be given wide latitude to steer the economy. In support of this conclusion, consider the toothless regulations that some politicians propose and others decry as being too strict. Consider also the utter failure of political leaders to prosecute a single corrupt banker. This may have something to do with the fact that Wall Street subsidizes both political parties.

Regardless of disagreements over the causes of the Great Depression, there appears to be a general agreement among economists that deflation occurs when a reduced supply of money meets an increased supply of goods. In this situation, the real value of the dollar will increase and the cost of goods will remain low. In time, the market reacts by reducing production, and this often leads to high unemployment. There is also agreement that, whereas inflation can be managed, there is little that can be done about deflation (source). 

End the Fed?

Chairman Bernanke’s actions suggest that he would welcome a modest increase in inflation. Indeed, he endorsed this policy when he was a professor writing about the long deflationary period suffered by Japan during its so-called “lost decade.” Yet, Bernanke publicly denies that he’s set a target for inflation. One may infer, then, that he does not have a free hand to pursue the policy that he thinks is best, or to pursue this policy as vigorously as he’d prefer.
An article in the New York Times quoted an economist named N. Gregory Mankiw, who said, “If Chairman Bernanke ever suggested raising inflation to, say, 4 percent, he would quickly return to being Professor Bernanke (source).” Evidently, Mankiw believes that Chairman Bernanke is not entirely free to set policy.
When speculating about who is able to exert influence over Chairman Bernanke, it is important to acknowledge that there is supposed to be a wall of separation that protects the Federal Reserve from political pressure. A wall of separation is a good idea. Economists warn that political pressure on the Federal Reserve can lead to disaster:
“Economic theory and massive amounts of empirical evidence make a strong case for maintaining the Fed's independence. When central banks are subjected to political pressure, authorities often pursue excessively expansionary monetary policy in order to lower unemployment in the short run. This produces higher inflation and higher interest rates without lowering unemployment in the long term. This has happened over and over again in the past, not only in the United States but in many other countries throughout the world (source).”
Theodor (Dr. Seuss) Geisel was a political cartoonist, among other things. He was alert to the risks associated with being too enthusiastic when leveraging the benefits of inflation.

However, politicians aren’t the only ones who might be tempted to exert influence over the Federal Reserve. According to the General Accounting Office, during America’s recent financial calamity, the “Chief Executive Officer of JP Morgan Chase and Co. served on the FRBNY [Federal Reserve Bank of New York] board of directors at the same time that his bank participated in various emergency programs and served as one of the clearing banks for emergency lending programs.” At about this time, the Fed supplied J.P. Morgan with $29 billion to acquire Bear Stearns. The chairman of the FRBNY during the financial crisis was also a board member and shareholder of Goldman Sachs. A director at the Federal Reserve Bank of Minneapolis held stock in Merrill Lynch, later acquired by Bank of America (source).
Another director of the FRBNY is a man named Jeffrey Immelt, CEO of General Electric and currently President Obama’s “Jobs Czar.” Mr. Immelt is particularly notable, in that his company did not owe any federal taxes in 2010 (source). Since taking over at G.E., Mr. Immelt has shed 34,000 U.S. employees while adding 25,000 employees abroad (source).
Rather than launch into a discussion of the reasons why neither the Democrats nor Republicans can be relied upon to fight back the corrupting influence of monied interests on economic policy, a simple table (below) is more eloquent than I could hope to be.
Campaign Donors and Their Largest Recipients (

Goldman Sachs
Mitt Romney (R)
Barack Obama (D)
Kirsten Gillibrand (D-NY)*
Christopher Meek (R-CT)
Scott Brown (R-MA)**
J.P. Morgan
Mitt Romney (R)
Mark Warner (D-VA)***
Barack Obama (D)
Rob Corker (R-TN)****
Mitch McConnell (R-KY)
Bank of America
Mitt Romney (R)
Barack Obama (D)
Ed Royce (R-CA)+
Tim Pawlenty (R)++
Clark Durant (R-MI)
General Electric
Mitt Romney (R)
Scott Brown (R-MA)**
Christopher Murphy (D-CT)
Buck McKeon (R-CA)
John Boehner (R-OH)
Barack Obama (D)
* A leading opponent of legislation to prevent banks from making highly risky investments(source)
** A Leading opponent of legislation aimed at imposing a bank tax to offset the cost of bail-outs, as well as regulations designed to limit investments in risky hedge funds and private equity funds (source); also has a substantial investment in G.E. stock (source)
*** Opposes increased regulation of banks, sits on influential Senate Banking Committee (source)
**** Worried that J.P. Morgan's recent loss of several million dollars through reckless speculation might give Congress the "mistaken" idea that further regulation is necessary (source)
+ Member of the Financial Services Committee that oversees mortgage lenders
++ When asked for his reaction to news that Bank of America paid no taxes in 2009, he responded, "taxes are too high." (source)


  1. Hello, great blog post!

    I thought the link you highlighted between who benefits from different levels of inflation and austerity measures was brilliant and very informative.

    Unfortunately, as you rightly point out, inflation/deflation matters come down to who exerts influence over economic policy and financial decision making.

    Also, I was struck by the list. Seems like the biggest donors don't really care who wins the elections, as they have successfully influenced both sides.


    1. Thank You!
      I am grateful for the encouragement. There's nothing as practical as a good theory, and theory dictates, "follow the money."