Inflate Me, My Darling, And I’ll Trickle Down

“Inflation is always and everywhere a monetary phenomenon,” economist Milton Friedman once said. Whether the symptom was rising wages, rising prices, booming assets, inflating housing prices, or all of the above, it all had its root cause at the printing press. Money is created at a faster rate than the growth of the economy, which leads to ever more paper chasing products and services, driving the price of everything up.

Regardless of one’s pet theory on the reasons for inflation, there’s wide agreement that too much of it, like vodka and Britney Spears, is a bad thing. Visions of Argentina style hyper-inflation, or Germans pushing wheelbarrows full of worthless paper to the baker’s to buy bread during the Weimar-republic, are not the stuff that sweet economic dreams are made of for most people.

But inflation can take many shapes, and is by no means a new phenomenon. If one goes back to the time before the two world wars forced expenditures most countries could only cover at the printing press, most currencies were in fact, or backed by, precious metals. At first glance one would think that left little room for churning out money out of the blue. But where there’s a will, there’s always a bad way. One solution is of course to go to war to lay claim to someone else’s gold and silver. But wars cost money, necessitating more wars, and so on. It gets tedious after a while.

Another way, which doesn’t have the drawback of quite as much calamity, at least at first, is simply to strike bad, or debased, coin. The Romans, after the rich pickings of civilised nations had been conquered, and mainly barbarians, poor in possessions, but fierce fighters, remained, went down this road to keep the imperial coffers filled.

Coins that had once been almost pure precious metal, a century or two later were perhaps 95% copper, or even base metals through and through. This worked fine at first. Inflation is, again like vodka, one of those things that are fun at first, less so afterwards, when you wake up with a lampshade on what used to feel like your head, or a nest-egg that’s shrunk to the size of a frog’s egg. The thing is that it’s very hard to lose a little trust.

If inflation becomes a mindset for people, and is pre-calculated into every price, as tends to happen after a while, it takes on a life of its own. Prices rise by sheer momentum, creating the need for more currency, if the whole merry-go-round isn’t to grind to a crashing halt. But in the end, the charade just becomes too transparent. The money just becomes too obviously Monopoly-money for people to accept them in exchange for things that are actually worth something, whether that be a hair-cut or a side of beef.

Towards the end of the Roman Empire, trust in the coin of the realm had been so undermined that the whole currency based market system was collapsing. People more and more reverted to the barter system. A side of beef might be worth ten chickens and some sexual favours. But the money wasn’t worth spit.

Large scale long distance trade, which the Roman economy had rested on, becomes well nigh impossible under such conditions. Everything becomes local. The feudal system of the Middle Ages was all but established before the western, truly Roman, half of the empire fell. Keeping several legions of full time soldiers stationed along the border to keep out the barbarians who had always pushed against the boundaries of the empire also becomes a logistical problem when just about everything had to be sourced locally and paid for in kind. It didn’t end well for most concerned.

Even with honest stewardship of the mint, there are serious drawbacks to a currency based on precious metals. Growth in GDP during periods of technological or economic breakthroughs might outpace extraction of silver and gold, leading to credit crunches, throttling of growth due to lack of available capital, and even wars over access to said precious metals. The vagaries of mining for a metal becomes a potential choke point for the entire economy. Few countries today are still on a currency backed by precious metals, and not only because of the cost of modern warfare.

There is also a case to be made for inflationary measures and deficit spending, most famously made by John Maynard Keynes, that when credit runs for the hills and deflation sets in, as people sit on what money they have, waiting for tomorrow’s even more depressed prices, the government and monetary authorities should grease the cogs and get the wheels moving by injecting liquidity into the economy.

The pointed example is that it might make sense, in a situation where it’s vital to get people working and spending, to bury jars of money and pay people to dig them up again.

There are two caveats to this theory. One is that for the whole exercise to make any sense, it’s important to stimulate the economy as close to ground level as possible, to put money in the hands of the workers and middle class who would actually put it to use in the economy by spending it, not the groups that are already so rich that any increased income wouldn’t lead to any additional spending.

The second is that responsible Keynesian policy is predicated on cutting back on the stimulus when the economy is moving under its own power, and building up reserves for the next cyclical downturn. But in an environment where some governments can not only draw on a global market of capital seeking parking spaces, but one in which currencies and interest rates are manipulated on a vast scale, the need to do so is greatly reduced; the wish to do so, among industries profiting from the stimulus and the politicians profiting from the economic activity at the ballot box, has of course always been minimal.

So what’s the situation in the world’s largest economy today? The United States is running various deficits on their federal budget, trade and current account, financed mainly through the auctioning off of debt instruments. Fresh capital has been flooded through the economy, which represented a major dose of stimulus for the economy. But how sustainable is it?

While the US experienced a nominal GDP growth of $752.8 billion (and real GDP growth of $379.1 billion) for 2005, it was accompanied by a credit expansion of $3,335.9 billion.

This mismatch has been present since the 1980s, but has increased greatly in later years. In the first quarter of 2006, credit expanded by $4,386.5 billion annualised, far in excess of GDP growth.

Following the dot.com stock market crash and the 9/11 terrorist attacks, then Federal Reserve Chairman Alan Greenspan and the board drove interest rates down to historical lows, even below the rate of inflation, and kept them there ’til long after the downturn was officially over. This had the effect of replacing the recently deflated stock market bubble with one with far more widespread effects on ordinary people’s economy.

Some might say that this was good Keynesian policy, cranking the economic engine to life and getting the wheels turning. But that money was going to go somewhere. It was going to drive up the price on something. Oil went up, though partly for reasons all its own. Commodities of all sorts went up, such as copper. Health insurance went sky high, as did the cost for education. And the housing market went into overdrive. But some things did not, such as wages.

Price inflation, without the corresponding wage inflation, is simply a tax on the poor for the benefit of the government and the rich. And in an environment of globalisation, outsourcing and immigration on a scale never before seen, ordinary workers in the industrialised world have close to zero bargaining power with their employers.

But those same ordinary Joes and Janes are the ones keeping the consumer based economy going. 70% of economic growth in the US lately has been based on growth in consumption. How do you keep people buying and spending if they haven’t had a real raise for ages, and their savings rate has turned negative?

It works because inflation has been channelled into certain sectors. Emerging markets, like China produces the cheap goods that produce everyday big profits for US companies such as Wal-Mart, and they export wage deflation to the US and other industrialised countries, helping keep wages of workers in those countries at or below the rate of price inflation. This means that prices on most consumer products have been stable, or even dropping.

But low prices on consumer goods still wouldn’t do the trick, if you take into consideration that the bulk of ordinary workers have experienced stagnant real wages. When inflation is factored in, they’re simply treading water. So how has the consumer soldiered on in the face of stagnant wages, rising fuel and health insurance costs?

The answer is that trickle down economics, what George Bush, the elder, once derisively called “voodoo economics” when he ran against Ronald Reagan, has worked, sort of.

True, the liquidity is injected at such lofty heights, in a financial sector of vast proportions which now rests atop the economy, that by the time it reaches the ground, it is all but evaporated. None of it manifested itself in wages. But all that easy credit made it possible for people to not only afford bigger houses, with lower monthly payments, but also made it possible for a lot of home owners to refinance their loans at a lower floating rate, “take out” some extra spending money in the process, while still making the same, or even lower monthly payments.

More money was chasing houses, driving the prices up, allowing people to refinance again, and extract even more equity from their handy house-shaped ATM, which they then spent on consumer products and services, driving economic growth.

It might be called Keynesian thinking, if Keynes was spawned and brought up in a dungeon by Goldman Sachs.

What was happening was that good old fashioned inflation, cheap money, was inflating a bubble in the housing market, replacing the busted one in the stock market. And for a while it made people seem richer, while still not making any more money. Seeing as you have to live somewhere, and the money extracted is in the form of loans, the only way for this particular growth machine to keep pumping was for interest rates to stay low and housing prices to keep rising.

But no tree can grow into heaven. And housing can’t keep increasing in price at a far faster rate than incomes for very long. After a while almost no new entrants to the market can afford to get on the merry-go-round. And people max out their monthly payments, even with new refinanced mortgages.

Worse still, due to excess consumption, out-sourcing and the weakening of the manufacturing sector, the deficits were putting pressure on the US dollar. Investors wanted more of a premium to carry federal debt instruments, forcing interest rates back up.

Now the housing market is clearly deflating, and chances are it’ll drag consumer spending and GDP down with it. It’s hard to see what could replace it as an engine of growth, seeing as the Keynesian stimulus load has already been blown. Or as the second century Greek physician Galen said, “Post coitum omne animal triste.”