by Steve Forbes
On Forbes.com investment advisor Richard Finger voiced the widespread concern about the economy’s inflationary direction: “Nobody knows the ultimate denouement of money printing on this scale. Germany tried ‘abnormal’ money printing in the early 1920’s after WW I and the result was hyperinflation, the collapse of the German economy, and the rise of Hitler.”
What will happen as the Fed continues to pile more money on top of hyperinflation-level bank reserves? The answer is that we’re in uncharted territory. Forecasting disastrous inflation may be the equivalent of refighting the last war—an analysis too closely based on events of the past. Indeed, something different may be happening: a historic decline into a corrosive environment of stagnant growth. Instead of a deadly pneumonia, we may be experiencing a chronic disease that saps away America’s traditional vitality. Either prospect is destructive and underscores the need for a stable dollar.
The Danger of a Little Inflation
Right now the Fed is scaling back the amount of bonds it buys each month and hinting at future interest rate increases. Nonetheless the monetary base remains enormous by historic standards. Keynesians, including IMF officials, central bankers, and finance ministers, have of late been beating the drums for “a little more inflation.” In an eyebrow-raising article titled “In Fed and Out, Many Now Think Inflation Helps,” Binyamin Appel–baum in the New York Times suggested in the fall of 2013 that the Fed under Janet Yellen would expand the monetary base enough to spur price increases. According to the Times, Yellen believes:
A little inflation is particularly valuable when the economy is weak. Rising prices help companies increase profits; rising wages help borrowers repay debts. Inflation also encourages people and businesses to borrow money and spend it more quickly.
The story quoted a Harvard economist who proposed expanding the monetary base to achieve an inflation rate of around 6%. He made this astonishing statement: “A sustained burst of moderate inflation is not something to worry about. It should be embraced [our emphasis].”
Proponents of QE make a distinction between severe inflation, which they see as unlikely, and moderate inflation, which they think can be a good thing. The notion that there can be harmless inflation is a toxic fallacy. The real estate bubble of the early 2000s that brought on the 2008 stock market panic resulted from the weakening of the dollar that took place in the early and mid-2000s before quantitative easing.
Whether the rate is 2% or 12%, inflation fundamentally distorts market behavior because it impairs the critical signals provided by the price system. People who see prices going up rapidly will start buying on the mistaken assumption of increased demand. Or else, sensing trouble, they’ll seek to shelter their money. Either way, events can easily spiral out of control.
In the words of noted historian Amity Shlaes: “The thing about inflation is that it comes out of nowhere and hits you.” She gives the example of 1972, when “all appeared calm . . . before inflation jumped to 11% by 1974, and stayed high for the rest of the decade.” Inflation similarly shot up, almost overnight, after both world wars.
Germany suspended its gold standard and started running the printing press in 1914 at the start of World War I. But it took six years for a real hyperinflation to get started. Inflation was moderate at first. The dollar and gold price of the mark improved sharply in 1920–1921. Shlaes tells us, “Many financial analysts thought the Weimar authorities weren’t producing enough money.” A New York Times headline at the time declared: “Tight Money in German Market: Causes of the Abnormally Rapid Currency Deflation at Year-End.” In actuality, Shlaes writes:
The Germans didn’t know it, but they had already turned their money into wallpaper; the next year would see hyperinflation, when inflation raced ahead at more than 50% a month. It moved so fast that prices changed in a single hour. Yet even as it did so, the country’s financial authorities failed to see inflation. They thought they were witnessing increased demand for money.
Prices, however, continued rising. Finally, Germans lost faith. The mark began to collapse. “Disillusionment,” warns Shlaes, “can come as fast as a gust.”
The Absurdity of the Phillips Curve
Policy makers insist on stoking inflation because of their rigid belief in the Phillips curve, the unscientific and unproven theory that price increases are the way to the Holy Grail of full employment.
Back in the 1950s, William Phillips, a New Zealand economist, helped promote this idea with a graph that became known as the Phillips curve. It showed the supposed correlation between inflation and unemployment. According to Phillips and his fellow Keynesians, vigorous growth corresponded to price increases, while lower inflation correlated with higher jobless levels. In other words, there was a trade-off between inflation and employment. Stable money, they concluded, is bad for the economy.
Advocates of this preposterous theory maintain that raising or lowering inflation is like adjusting the climate controls on a thermostat. Just as you’d use your climate control keypad to raise or lower the temperature in your living room, loosening or tightening up on the money supply, they believe, can increase or decrease the level of employment.
Seven Nobel Prizes have been awarded to economists whose work disproved the Phillips curve: F. A. Hayek, Milton Friedman, Robert Lucas, Robert Mundell, Finn Kydland, Edward Prescott, Edmund Phelps, Thomas Sargent, and Christopher Sims. Yet Keynesian policy makers and pundits cling to this idea, despite the Fed’s $4 trillion balance sheet expansion that has left labor participation rates at a 35-year low.
Economic historian Brian Domitrovic pointed out on Forbes.com that “inflation and unemployment regularly move in tandem.” They don’t move the way Keynesians would have you believe. In the inflationary boom/bust era of the 1970s and early 1980s, unemployment reached higher levels than during the financial crisis. The very opposite was the case in the 1980s. After Ronald Reagan cut taxes and stabilized the dollar, in Domitrovic’s words, “inflation and unemployment both rappelled down a cliff.”
The United States has had what could be characterized as “full employment”—jobless rates of under 5%—during eras of stable or relatively stable money. Two dramatic examples are most of the 1920s and 1960s.
Cheapening the value of money is not the way to create real, sustainable employment. Jobs are created in a healthy economy when entrepreneurs start companies like Starbucks or Staples that succeed in the marketplace. They get capital to expand and hire more people.
This is not what takes place in an inflationary economy. There may be some job creation—Germany had low unemployment during its hyperinflation of the 1920s—but the burst of activity is the result of false market signals and misdirected resources that come from government’s distortion of money. It is ultimately artificial and unsustainable. Very little new wealth ends up being created, and sooner or later much more is destroyed.
Former congressman Ron Paul sums it up: “If governments or central banks really can create wealth simply by creating money, why does poverty exist anywhere on earth?”
Stimulus or Redistribution?
The Appelbaum New York Times article about the advantages of inflation draws a different picture. The paper reported that plenty of people on Main Street as well as in Corporate America would actually welcome inflation. In fact, the reporter suggested, they could barely wait for it to get started:
The school board in Anchorage, Alaska, for example, is counting on inflation to keep a lid on teachers’ wages. Retailers including Costco and Walmart are hoping for higher inflation to increase profits. The federal government expects inflation to ease the burden of its debts.
It is true that some people benefit, at least at first, from inflation’s burst of activity. But, as we’ve pointed out, very little new wealth is being created. It is simply being transferred from one group in the economy to another.
Murray Rothbard, noted economic historian, made the point that inflation favors “firstcomers,” those who are the earliest recipients of the new
money. They include not just retailers like Walmart and Costco, singled out by the New York Times, but also countless others who benefit when people start spending the government’s newly created money. The losers are “latecomers” who are slower to receive the inflationary money. They generally belong to fixed-income groups such as retirees and people on salaries.
Forbes.com contributor Richard Finger puts it bluntly. The Fed’s low-interest-rate, easy money policies, he says, “punish the virtuous, the millions of responsible savers. . . . They can no longer count on decent risk-free returns for retirement.”
Bill Taren, a Florida retiree, found that his retirement account at his credit union paid a measly 0.4% interest. Meanwhile inflation was averaging 2.8% in 2012. Horrified by his dwindling savings, he and his wife decided to stuff their money under their mattress. He explained that at least that way “we can see the cash when we want.”
Debtors Win, Creditors Lose
The seventeenth-century philosopher John Locke was among the first to observe that inflation rewards debtors who are able to pay what they owe with less valuable money, while stiffing creditors who get paid back in less valuable currency. In his words:
Whether the creditor be forced to receive less, or the debtor be forced to pay more than his contract, the damage and injury is the same, whenever a man is defrauded of his due; and whether this will not be a public failure of justice thus arbitrarily to give one man’s right and possession to another, without any fault on the suffering man’s side, and without any the least advantage to the public, I shall leave to be considered.
Government, of course, is the biggest debtor of all. By diluting the value of your money, it gets extra money to spend—or to pay its debts. As Keynes famously acknowledged, inflation is a stealth tax whereby “government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
Uncle Sam also gets to pay back bondholders, such as China and others that have bought U.S. Treasuries, in cheaper dollars. This is especially true with QE, thanks to record low interest rates under Operation Twist that are saving Washington hundreds of billions of dollars, which it would otherwise have had to pay to bondholders.
Richard Finger calculates that if the U.S. government paid normal historical rates of interest on its $17 trillion national debt instead of the Fed’s current rock-bottom rates, it would be facing, he calculates, an additional $500 billion interest expense.
In other words, lower interest rates as a result of QE mean a $500 billion windfall for Washington—money that makes it easier for politicians to keep spending. For example, $500 billion is nearly enough to cover benefits paid to participants from all of Medicare, which amounted to $536 billion in 2012. And it is many times the amount the administration needs to keep expanding the food stamp program, which now costs around $80 billion a year.
Manias, Bubbles, and Distortions
Weakening a currency may produce activity that looks like wealth creation. But real wealth creation, as we’ve noted, comes from meeting genuine needs of the marketplace—inventing new technologies like the iPad or the flat-screen TV that improve productivity and raise standards of living. Activity that results from monetary policies intended to stimulate an economy, on the other hand, is a response to artificial price signals and is usually misdirected.
In the inflationary 1970s, for example, higher prices fostered the mistaken perception that developed nations were running out of energy. The price of oil went from $3 a barrel to almost $40. Capital flooded oil production. The number of workers in the energy industry soared. The same thing happened in the last decade. Since 2008, the number of employees in the oil and gas industry has increased by over 30%. This was only partly due to the surge in exploration accompanying the growth of hydraulic fracturing technology (“flacking”). It was also on account of the herd or bubble mentality created by inflation.
There are two kinds of bubbles. The first takes place naturally in a free economy when people jump on a promising technology, like the PC boom in the early 1980s or auto manufacturing in the early twentieth century (or, for those who remember the 1950s, the hula hoop craze). People start new businesses in a promising sector until it gets too crowded, and some of them fail. They can set the stage for later success, like Apple’s failure with its Newton handheld device, which paved the way for smartphones and other mobile devices. Forbes publisher Rich Karlgaard calls such ventures “noble flops.”
The second kind of bubble is created when people respond to inflationary price signals. Money tends to flow into protective investments instead of into entrepreneurial job-creating ventures. How does buying a bar of gold translate into production and economic growth?
During the German hyperinflation of the 1920s, Germany’s panicked citizenry bought every hard asset they could get their hands on, including diamonds, works of art, and real estate. Adam Fergusson noted in his classic chronicle of the era, When Money Dies, that families bought pianos even if they didn’t play them. The act of buying was a form of speculation. People were rushing to put their money in possessions with value, because they didn’t know what their money would be worth the next day.
Inflation also misdirects money in other ways—for instance, by sending it into nonproductive investments like tax shelters. They were a way of life during the 1970s, when inflation kept pushing people into higher tax brackets. Seeking to avoid “bracket creep,” tax filers invested in everything from producing azaleas and almonds to mink and trout farms. Markets were distorted by activity that took place solely for the purpose of tax avoidance. Movie production soared, as did the amount of vacant office space. Tax shelter madness also helped fuel the collapse of the savings and loans in the 1980s.
Most tax shelters were eliminated with Ronald Reagan’s tax reform of 1986. In the low-tax, low-inflation years that followed, there was little need for them. Just a warning: if the Fed attempts to engineer a little inflation, mink farming and other tax schemes may soon make a comeback.
The Subprime Mortgage Meltdown: The Twenty-First Century Mississippi Bubble
Though widely blamed by politicians and the media on predatory lending, the subprime mortgage disaster of 2008 that started the worldwide financial crisis was the twenty-first century’s answer to the eighteenth-century inflationary debacle known as the Mississippi Bubble—the result of a loose money scheme engineered by the Scottish mathematician John Law.
The extremely colorful Law was the author of a tract titled Money and Trade Considered, with a Proposal for Supplying the Nation with Money. It made the Keynesian-style argument that increasing the supply of money would boost trade, employment, and production. After serving time in prison for killing a romantic rival in a duel, he escaped to France. Using his aristocratic connections, he managed to convince the French government that his expansionary scheme was the answer to the crushing debts left over from the reign of Louis XIV. Law was appointed to the powerful position of controller-general of finances, where he got his chance to put his loose money theory into practice.
Law consolidated France’s trading companies into a monster monopoly known as the Mississippi Company. Owning a vast swath of what today is the central United States, the public-private company sold shares to investors throughout Europe. A mania for New World real estate ensued. Law had also created a virtual central bank that pumped immense amounts of liquidity into the French economy. France’s total money supply exploded. Inevitably, investors lost faith in Law’s overhyped New World scheme. Combined with a roaring inflation, the bubble burst, devastating creditors throughout Europe and nearly bankrupting France. Law was forced to flee the country.
The subprime mortgage meltdown of 2008 contains more than a few echoes of the Mississippi Bubble. As with John Law’s French debacle, the crisis was the result of excessive amounts of liquidity created by a central bank, the Federal Reserve, that ended up fueling giant government-created enterprises. Here the culprits were Fannie Mae and Freddie Mac, the mort
gage companies originally created and later spun off by the U.S. government.
Responding to political pressures for affordable housing that intensified under the Clinton administration in the 1990s, Fannie Mae and Freddie Mac set out to make housing loans more available. They did this through the securitization of mortgages—the risk-spreading practice of buying and bundling mortgages and selling them to investors as mortgage-backed securities.
As the push for affordable housing accelerated, Fannie Mae and Freddie Mac were bundling increasingly risky subprime mortgages. In the early 2000s, the loose money policies of the Bush administration poured gasoline on a fire that had already started to burn. In an attempt to stimulate the economy after 9/11, the Fed, in a series of steps, lowered the federal funds rate to 1%, and the banks loosened their lending standards.
Between 2000 and 2003 the monetary base grew at levels equivalent to the inflationary 1970s. The dollar price of gold moved upward. The size of the subprime mortgage market grew 200%.
Inflation’s herd instinct took hold among buyers and sellers. No longer were home buyers asked for the traditional 20% down before buying a house. “Stated income loans” became common. They were also known as “no-doc” or “liar loans” because borrowers could give just about any income figure and it was rarely checked. Little wonder just about everyone wanted to get in on the action. A homeless man in Saint Petersburg, Florida, managed to buy five houses. Speculators rushed into the market. The weak dollar corrupted pricing information, leading people to believe that housing prices and demand could only go up. If that homeless investor defaulted? No big deal. The houses would be worth more than his mortgages.
The bubble started to deflate when the Fed started to raise interest rates, which reached 5.25% in June 2006. Hundreds of thousands of foreclosures shook major financial institutions that were the holders of this debt, setting off a chain of events that led to the collapse or forced sale of major Wall Street houses and commercial banks.