We Need Some Inflation!

How much inflation is too much inflation? Germany thinks any inflation is too much, based on their 1920s inflation experience when burning money for fuel was cheaper than burning wood. It has led to the EU's draconian austerity policies, such as calling for spending cuts during deflationary times that has kept the EU in and out of recessions since 2008.

Yet the US deficit hawks -- mostly Republicans these days -- continue to believe that deficits are evil and the Fed should begin to tighten now, rather than wait for 2015 when economic growth is more sustainable. This is even though the unemployment rate is 12.1 percent when the 3.1 million long-term unemployed and part-timers are included and we have too little inflation.

So how much is too much inflation? The easy answer is that rising prices become inflationary when supply can no longer meet the demand for goods and services over a prolonged period, thus raising prices. This last happened in the 1970s, when oil embargos were rampant, the rest of the world wasn't yet industrialized and producing too much of everything, and trade barriers were higher than they are today.

In fact, we are in a world of generally falling prices with Asian Tigers exporting most of what they produce, hence the huge surpluses. So maybe we should be looking at regional or worldwide prices and production capacities, instead of individual countries'. That seems to be Germany's mistake, extrapolating its own past history to the EU as a whole.

Budget deficits don't feed inflation during "zero-bound" episodes (when interest rates are at, or close to 0 percent), such as after Great Recessions when all the Fed can do is try to prevent deflation, as occurred in Japan for two decades.

This is basic Economics 101 that even many economists don't understand, because they have little knowledge of liquidity traps -- which is when money is no longer circulating, but being hoarded. How could they, since it's only happened twice in modern times -- during the 1930s and now.

Budget deficits in fact should prevent said deflationary episodes, which are episodes when wages are stagnant or falling and there is little or no economic growth, if the monies are spent wisely on longer-term projects, because government spending puts more money into circulation. This should be easy to understand, but the inflation hawks are squawking again because the Fed now has some $4 trillion in reserves on its books, yet there is no inflation even on the horizon.

Calculated Risk has started an interesting discussion about when inflation might become a problem, using the US example. And it turns out that even US capacity utilization doesn't give us a good measure. For instance, from 1992 to 2001 during the longest economic expansion in our history, when more than 20 million jobs were created and capacity utilization was as high as 84 percent of capacity, CPI prices averaged 3 percent. Maybe that should be the Fed's inflation target rather than 2 percent, which has accompanied mostly tepid growth.

Graph: Calculated Risk

So why not look at the world's production capacity when looking for the ideal inflation rate? Because China, Korea, and the other Asian Tigers continue to produce more than they consume, more ways should be found to boost demand, i.e., which in the majority are mostly middle class incomes.

Oh, wait a minute. That's what we need to do in the US as well. Maybe raising the Fed's inflation target would encourage more demand and rising incomes, or are we as traumatized by the 1970s era of stagflation as the German's were in the 1920s?

Harlan Green © 2014