Wednesday, June 10, 2009

Inflation is a monetary and social process, not happening soon

Let’s define an “inflation” as a long-term, sustained run-up of the price level.  Let’s call a short-term run-up in the cost of a commodity or other good a “supply shock.”

Milton Friedman famously wrote that “inflation is always and everywhere a monetary phenomenon.” 

That is only half the story.  In order for the rise in the price level to be sustained, it must be supported by incomes through the operation of the infamous “wage-price spiral.”

State capitalism (see this, chapter 7) has pretty well demolished the bargaining power of the labor market.  With headline unemployment approaching double digits, and the U6 “real unemployment” number approaching 20 percent, there is not a lot of wage pressure.

So all price increases simply reduce real purchasing power and deflate real aggregate demand.  Such is the case with rising gas prices.  See More Firms Cut Pay to Save Jobs for update on wage trends.

It is good to remember that ballooning excess reserves in the banking system in the 1930s did not create inflation right away, it took World War II to light the fire.


In the meanwhile, despite the jawboning of China and Russia about their Treasuries and the laughter of Chinese students in Secretary Geithner’s face when he said their assets were safe with us, American exceptionalism—for better or worse—holds sway.  Europe’s banks are in worse shape than ours (in fact there are big banks in the U.S. that are healthy; study the financials).  Japan’s economy is on the skids.  Moreover, if our creditors who export to us sell off the dollar, they shoot themselves in the foot.  We tank, they tank.  And then there’s deleveraging—of the American consumer first, and then, possibly before the sun flames out, of the American government.

So while my (highest probability) long-term expectation is still that the entire Bretton Woods system of fiat funny-money will go supernova with a cosmic inflation at some point, I don’t think it going to happen anytime soon.  I think we could see ~3 percent inflation for the better part of a decade.  This would be a relatively painless form of debt forgiveness by our creditors as it would not shred the tattered Bretton Woods system just yet.  When will that happen?  If the Fed’s intrepid counterparts in other countries (think: Iceland, Ireland, Britain, Eastern Europe, Russia) manage their inflations worse than we do, their currencies could be pounded worse than the greenback in the markets. 

The Bretton Woods system will probably go supernova when America picks its next big fight and gets its own inflation going, just like last time.  Then as dollar inflation rips the currency markets apart the mad scramble for a new monetary order will occur. 

If we got some sense and stopped trying to “project” military force in foolish ways throughout the world that don’t bring us any strategic benefit (but keep Daddy Warbucks coffers full), the next great inflation might be avoided.  We might gently ease into a more balanced international order with currency markets that clear more or less correctly, and a global deleveraging.

There’s an old saying in forecasting, “You know what’s going to happen, you just don’t know when—and it usually takes longer than you think.”

War => inflation.  Let’s not go there.


  1. Thoughtful analysis. What if oil spikes? Isn't there such a thing as stagflation?

  2. The supply shock case generates stagflation.

  3. We don't need an actual war to get inflation going. You can get the same result with massive military spending for a cold war.

  4. Seems to take a hot war to get one going, a cold war to disinflate.