Wednesday, March 24, 2010

Inflation is Your Friend! Honest! It Is!

Since Paul Krugman and I cannot agree even on the weather, I doubt I can agree with him about the effects of inflation, as our differences are as vast as those between Austrians and Keynesians. Krugman, like all Keynesians, believes that "moderate" inflation can spur real economic growth by giving an economy "traction," allowing the economic gears, as they were, to start moving.

Austrians, on the other hand, believe inflation is destructive, and that it does not spur growth, but rather unsustainable booms that inevitably end in busts. Therefore, there is no way the ideas can meet.

In this blog post, Krugman includes a chapter from his latest textbook (co-authored with his wife, Robin Wells) in which he "explains" the difference between "moderate inflation" and what we have seen in Zimbabwe. Not everything in this chapter is bad, and at times, Krugman can be an interesting writer, and I can see why this book is popular. However, page 867 has this "gem" that exposes his viewpoints:
...policies that produce a booming economy also tend to lead to higher inflation, and policies that reduce inflation tend to depress the economy.
Well, that is only partly true, but Krugman has a real causality problem. (One remembers the opening line in Carl Menger's Principles of Economics (a much better book than what we see with Krugman and Wells) in which he states: "All things are subject to the Law of Cause and Effect."

It is easy to see where Krugman gets his causality. In the early stages of inflation, we see an economic boom, while in the early stages of "disinflation" or deflation, we see a bust. Therefore, Krugman takes the simple approach: inflation good, deflation bad.

There is an alternative view, and Menger and others in the Austrian camp have led the way. As I read through Krugman's chapter on inflation, I realize that the guy is stuck on aggregates. In that way of thinking, all assets are homogeneous, so when new money is pumped into the economy, people begin spending, inventories are cleared, and the economy has "traction." (In Krugman's view, this becomes a problem only when money growth occurs after the economy has reached its "capacity" to produce.)

Austrians believe that assets are heterogeneous, and that inflation changes the relative values of these assets. Ultimately, the push of new money into certain booming sectors runs out of steam, as the asset values in the inflation-led structure of production clearly do not reflect the actual desires and choices of consumers. At that point, the inflated assets lose their value, and the crisis is at hand.

During a recession, the assets come back to their original and proper relationships, and then the recovery can begin. Unfortunately, since the government continues to try to prop up the assets that the markets already have devalued, there really can be no meaningful recovery.

This is a very brief description of our differences on inflation. Nonetheless, I do think this blog can be useful if only to get the points of Austrian economists out there, as they certainly are not going to be portrayed accurately in the mainstream media.


Vincent Cate said...

The economists who do not worry about inflation keep saying that China is forced to buy treasuries every month. The fact is that China clearly owns less treasuries now than they did last June, and further back if you can factor out the $140 billion change in the way the numbers are reported prior to June. In a real science nobody would keep spouting a theory that was so clearly contradicted by the empirical evidence.

Their logic is that a normal peg to the US dollar involves buying treasuries and China is pegged, so it has to buy. But the clear flaw in this logic is that China does not have to do a normal peg, they can invest their reserves any way they want, not just in treasuries. Treasuries are the worst investment, so it is easy to do better. But logic and empirical evidence don't even slow these economist down, let alone get them to change their theories. Dismal science indeed.

The other claim is that Japan did not get hyperinflation so how could America. It is foolish to save money in the bank when the central bank holds interest rates at or below inflation and you have to pay taxes on the interest. After a long enough time in these conditions people learn that saving money in the bank is for suckers. Americans have learned this and do not save. Japanese in 1990 did not yet understand this and still had a culture of saving, so the government could borrow all it needed from its own citizens. America borrows half its money from foreigners who can easily move their money someplace else. Hyperinflation comes when a bloated government can not borrow enough and has to print money. America now is very different from Japan of 1990. America has a high risk of hyperinflation.

Vincent Cate said...

In that chapter Krugman says, "The United States has never experienced that kind of inflation.". This is deceptive. America has twice experienced hyperinflation. During secession from the British and when The South attempted to secede from The Union. Secession talk is stronger now in the US than anytime in the last 100 years, as is the risk of hyperinflation.