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The Daily Capitalist: The Big Inflation Scare Is Real

The Fed's credit frenzy is setting the stage for the next boom-bust cycle

This article comes under the category of “who do you listen to and why?” I ask this question frequently, especially when I read something by Paul Krugman.

The Nobel laureate is one of America’s best known economists through his commentary in The New York Times. On Friday, he declared we won’t have inflation.

The sign of a good social scientist, and especially economists, is that they should have a healthy sense of skepticism about what they think they know. After all, as we know, economists have a terrible record of predicting things. You would think they would be a bit humble. But they’re not. I don’t get the feeling that Professor Krugman is a particularly humble man.

His recent column, “The Big Inflation Scare,” said that, although the Fed is pumping up the money supply and is monetizing Treasury debt, banks are just sitting on the money, thus no inflation. Besides, he says, Japan didn’t have any inflation during its recession between 1990 and 2003 when the central bank monetized the debt, as the Fed is doing now. Also, because governments run up huge deficits doesn’t mean there will be inflation. He points to the experience of Belgium, Canada and Japan.

Banks Hoarding Money

Krugman is correct about the current state of our credit system. The Fed has pumped credit into the system, but because of bad loans and unstable balance sheets it has been reluctant to lend and many businesses are reluctant to borrow. So, banks’ reserves have been building up on their balance sheets and not hitting the economy — yet.

To observe that since we don’t have inflation now and then conclude we won’t have inflation in the future is simply a leap of faith by him and is not borne out by history. Is he saying that when the government injects money into a system that inflation will never occur?

Krugman points to the experience of Japan from 1990 to 2003 when the Bank of Japan injected a lot of credit into the system in various ways and no inflation resulted. He is mostly correct on that. Japan’s banks were in terrible shape because of the fallout of the inflationary binge on real estate caused by Bank of Japan money pumping in the 1980s. What he doesn’t say is that when the crash occurred, the Japanese tried every Keynesian trick in the book to revive their economy and they all failed.

Many banks and financial institutions were propped up by the government, weren’t allowed to fail, and the banks added the new credit to their reserves to offset the bad loans they made during the 1980s. The money didn’t hit the economy and they went into a recession.

Krugman wrote about this problem quite a bit during that period and everything he recommended that the Japanese government do was done. His recommendations failed. For example, he thought government-sponsored infrastructure projects, although wasteful, were fine. In other words, the Keynesian bromide of paying one man to dig a hole and paying another man to fill it was just fine because money was being injected into the economy to defeat the dreaded Keynesian “liquidity trap.”

He also recommended monetary expansion to cause inflation and a weaker yen. That was tried and failed, too.

Thus, he’s correct; the expanded credit didn’t hit the economy. Japan didn’t experience inflation. Demand for credit never revived because of government action.

What Krugman and all Keynesians fail to see is that the problem is not deflation caused by “falling demand,” but massive attempts by the government to prevent deflation. As long as the government props up bad banks with assets that aren’t worth their carrying value on their books, as long as it props up companies that have failed and allow their bad investments to continue, and as long as it tries to delay the readjustment of prices of assets that are overvalued, they will delay deflation and recovery. That will and did stagnate the Japanese economy and resulted in the longest stagnation and depression of recent times.

The fact that Japan had no inflation is because the country experienced prolonged deflation caused by the very policies Krugman advocated. The very things that Krugman and his fellow Keynesians recommended Japan do caused its economy to stagnate, increased deflation, lowered demand for credit, and Japan went into a 14-year depression.

Perhaps that is what Krugman is now advocating as policy for the Obama administration: economic stagnation depression, and continuing deflation for a decade.

Monetized Debt

Krugman theorizes that since the Japanese monetized their debt and didn’t experience inflation, we also won’t have inflation. Again, he is correct in his view of Japan. During the period of 1990 to 2003, the government borrowed heavily to spend heavily according to the standard Keynesian textbook. The problem is that none of that spending worked and they became massively indebted.

The Japanese monetized their debt in various ways. They had a program called FILP (Fiscal Investment and Loan Program — read TARP and TALF). They lent directly to businesses through this program and got the money from the huge postal savings system. This spending accounted for about 70 percent of their spending budget. It just funneled spending to the cronies of the ruling Liberal Democratic Party.

Krugman recommended that the Bank of Japan buy dollars, Euros and government bonds to stimulate inflation. The government had already done something like that several years before but that program failed as well. The government had lent massive amounts to the commercial paper market. It also bought up 53 percent of government bonds and tried to devalue the yen. That policy failed.

But, he’s right: Japan didn’t have inflation. Why? For the same reason as before: the economy kept failing as a result of all this Keynesian monetary and fiscal stimulus. Loan demand was low, bad investments were propped up and still didn’t make economic sense, and savings increased because of uncertainty. The recession continued and continued.

This is what Krugman is recommending today.

Debt will reduce economic activity by crowding out.

Will we have Inflation?

Yes.

Nowhere in Krugman’s articles does he lay blame for boom-bust business cycles on the government and the Fed. Like most Keynesians he just ascribes to the theory that a sudden drop in demand had caused the bust — those famous “animal spirits” of ours that John Maynard Keynes blamed. He believes that the government must revive demand to prevent the dreaded deflation. Just get everything back to where we were before the crash and we’ll just be all merry.

The Monetarists, such as Milton Friedman and his Chicago school believe the whole thing was caused by the Fed cutting money supply, not increasing it in times of crisis.

As shown above, all these things were tried in Japan and failed.

Inflation is an increase in the supply of and demand for money. The result of inflation is that all prices rise. The fact oil prices go up is not inflation since other prices go down in response to consumers’ needed to cut back on expenditures in order to drive their cars to work. Inflation is what we had in the late 1970s. Then it was called stagflation because the economy went nowhere and prices climbed.

We are not seeing inflation now because we are not seeing a demand for money. The supply is there, though. We will see inflation when the deflationary phase of the cycle ends, when credit enters the market because of new demand, and the new money further increases demand, prices start to go up, and people see that they need to get rid of cash and get into assets that don’t depreciate like the purchasing power of the dollar.

There hasn’t been a case in history that I can think of (I’m sure I’ll find out soon if I’m wrong) in which an economy has seen a massive increase in money supply and money demand that hasn’t resulted in inflation. The history of inflation goes way, way back.

When will deflation end? I don’t know. But all business cycles end at some point. The problem in our present case is that the Fed is setting the stage for the next boom-bust cycle because of all the credit it has injected into the system. The Fed can’t just suck it back out without causing interest rates to increase, which would put a damper on the “recovery.” This is a very complicated topic that I’ve touched on a bit before: China and Japan, dollar-yen-yuan, interest load of our national debt, Keynesian policies, and the increased role of government in our economy.

All I can tell you is to watch the M1 Multiplier chart to see if Money Base has hit the economy. Also keep an eye on gross domestic investment (GPDICA) and total bank credit (TOTBKCR), for example. When these rise, inflation will eventually kick in. How much and how long will depend on what the Fed and Treasury do. As you know, I’m not a big believer in prognostication, just a big picture guy. I do know there is a huge attempt at credit expansion. And eventually that will mean something.

Click here for a previous post, “The Japanese Disease,” and a more detailed look at Japan and what Keynesian remedies it tried and why they failed. I also point you to several excellent papers: Jeffrey Herbener, Benamin Powell, William Anderson, John Cochran and Noah Yetter, and Anthony Randazzo, Michael Flynn and Adam B. Summers.

— Jeff Harding is a principal of Montecito Realty Investors LLC. A student of economics, he has a strong affinity for free-market economics. This commentary originally appeared on his blog, The Daily Capitalist.

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