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Wednesday, September 01, 2010
Recession, Depression, And Inflation
With Esteemed Co-Conspirator Scott Angell so nicely covering the economics beat here at Eternity Road, your Curmudgeon hasn't had a lot to say on the subject. However, with the approach of a second round of economic contraction -- you have noticed the downtrend, haven't you? -- it would be well to examine the terminology that's commonly slung about on the subject. If we have a good grip on the meanings of the most common terms, we might better grasp the predispositions and intentions of those who harangue us about the economy.
Each of the three critical terms comes factory-equipped with both a "strict" meaning and a colloquial one.
First, recession:
Strict: Two or more successive quarters of economic contraction ("negative economic growth").
Colloquial: When your neighbor loses his job.
Second, depression:
Strict: A severe contraction of economic activity, characterized by a great reduction of available credit.
Colloquial: When you lose your job.
Third and last, inflation:
Strict: An increase in the money supply, especially one that considerably exceeds recent increases in overall productivity.
Colloquial: An overall increase in the price of common goods and services.
Of the three terms, inflation has recently been the one bandied about in hushed tones. Persons with even a modest knowledge of basic economics know that, without an expansion of the money supply, an overall increase in the prices of goods and services is impossible. We also know that the Bush TARP program and the Obamunist "stimulus" bill have caused the injection of a large amount of new currency and credit into our financial system. What's held back prices to this point has been the tightening of conditions for the granting of credit by most significant lending institutions, coupled to the reluctance of creditworthy borrowers to borrow at a time of politico-economic uncertainty.
But money has a way of expressing itself. There's little chance that the huge cash balances on the ledgers of our banks will lie still forever. For one thing, Washington is unlikely to permit it. For another, financial accounting regards cash-in-hand as a debit item, which must be laid against some corresponding obligation for the books to balance.
When those balances are transformed into loans or the purchase of securities, the standard inflationary process will kick off.
In the "closed" United States -- i.e., the U.S. financial system exclusive of any sources or sinks of money outside its borders -- the embryo of inflation forms when the Federal Reserve Bank purchases Treasury bills. Those purchases are paid for with newly created money. The Fed lists the T-bills purchased as an asset to offset the new money, formally balancing its own books. But the T-bills, which are obligations of the federal government, need not be retired; thus, there is no net effect on the federal debt.
In a "normal" economy, the new money will slowly work its way through the economic system, raising prices first on those goods that are first purchased with it, then on the second round of purchased goods, and so on. After a certain interval -- at this time, about eighteen months -- the effect will have pervaded the system; the overall price level will have increased by an amount corresponding to the increase in the volume of money. If no more new money were to enter the system, stability would prevail.
In a recessionary economy, where economic activity has contracted modestly for six months or more, the dynamic is somewhat different. First, if private citizens and institutions are aware that a contraction is ongoing -- and they usually are -- newly created money will tend to travel more slowly through the economy, and will be put to different uses. In particular, it will be used to a greater degree to retire debt and build up reserves. Thus, the effect on prices will be retarded. If the issuance of new money was politically motivated, a measure intended to "fight the recession," that will usually result in further issuances, as politicians are among the least patient people known to science.
The cumulative effect of repeated issuances of new money, however, is the depreciation of the currency unit -- the dollar -- which will ultimately reveal itself as the prices of goods and services rise in concert. This will cause an accelerating tendency to "flee to safety," abandoning dollar-denominated assets for other currencies or for hard assets such as gold, silver, or land. But hard assets are not productive; they generate no new economic activity. Thus, as the dollar weakens and ever more wealth seeks shelter, the recession will deepen, possibly enough to qualify as a depression.
In the "open" United States, which has access to sources of credit outside our borders, the matter is different only in being worse. By borrowing from foreign holders of dollars -- i.e., selling them T-bills -- Washington can seed an inflationary surge without needing to involve the Fed. That increases the national debt and the interest payments on it, thereby reducing the fraction of federal revenue available to fund ongoing activities and increasing Washington's incentive to borrow. The sole evidence that this has occurred is on the federal government's own balance sheets, which are of dubious integrity.
But credit is indispensable to a capitalist economy. Without willing lenders, there will be few or no new enterprises; even existing, long-established ones will find it difficult to operate. When governments have soaked up the greater part of the available credit, economic contraction becomes inevitable -- and is usually severe.
When Carter Administration official Alfred Kahn dared to warn Americans of the possibility of a depression, the White House directed him to cease to use the word. Ayn Rand probably rolled over in her grave at that. (Well, she would have, if she'd been dead at the time.) The terms we use to describe reality cannot change reality. They can, however, affect our attitudes toward that reality, which was precisely what the Carter Administration, which had increased the federal deficit sharply upon arriving in power, sought to avoid.
Carter and his policymakers were liberals and Keynesians. They believed they could moderate the nation's economic malaise by fiscal operations. They were wrong -- Keynesianism must be the most thoroughly refuted economic doctrine of all time -- but like hardened ideologues of all sorts, they persisted nonetheless, even into the teeth of 13% annual inflation and 20% interest rates. In a way, it was fortunate for us, for it brought us the Reagan Revolution and a (temporary) rationalization of federal fiscal policy. Federal revenues nearly doubled over the Reagan years, while price increases dropped to 2% to 3% per annum. That Congress persisted in overspending its budget bears not at all on the success of the Reaganauts' fiscal corrections, but was rather an exercise in Public Choice / special-interest political dynamics.
We have a second Jimmy Carter in the White House, less rational and more headlong than the first one. He's backed by even larger and more complaisant majorities than his predecessor. What's restraining us from a second round of Carterite fiscal and financial disasters is only the reluctance of lenders to lend and borrowers to borrow, owing to the murkiness of the foreseeable economic future.
Remember in November.
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