Another Way to Think about Inflation

By Kevin D. Williamson

Wednesday, June 02, 2021

 

The times are frothy. The markets are frothy. Politics is frothy. If there’s anything we have in abundance, it is froth: The price of that isn’t going up.

 

Other prices, though . . .

 

Inflation really means an artificial increase in the money supply beyond what is demanded by economic growth, though we mostly use it to mean a general rise in consumer prices. And it is sometimes useful to keep that distinction in mind: For example, there is some reason to think that years of efforts at economic stimulus have, by flooding the U.S. economy with cheap money, contributed to skyrocketing prices for assets and commodities even while most consumer goods trucked on at their usual moderate rate of price increase. You might not have seen much inflation at Walmart, but you’ve seen it if you’re shopping for a house or a ton of aluminum.

 

The higher prices associated with inflation don’t have to be everywhere — some prices can rise in silos, as we have seen with market rallies and bubbles of different kinds, while other price increases put much more intense and direct pressure on the wider economy. Fluctuations in the price of Bitcoin are a minority concern, but when the price of a gallon of gasoline or a pound of chicken goes up, most Americans feel it.

 

Traditionally, the U.S. government combats problem inflation (meaning rapid, disruptive inflation — most economists judge a little bit of steady inflation to be salutary, or at least unobjectionable) with higher interest rates. In 1980, the baseline interest rate hit 20 percent as the Federal Reserve stomped on the money supply in order to slow down inflation that was running at 14 percent. This meant that if you wanted to take out a mortgage to buy a house or a loan to start or expand a business, then you could expect to pay something like 16 percent interest, as opposed to the 3 percent you might pay on a mortgage today.

 

Higher interest rates can knock back inflation because they slow down and interrupt economic activity — which might be desirable from a macro point of view but isn’t exactly a barrel of monkeys if your business is one of the ones that gets the pointy end of it. The market for new and used cars is very hot right now, but try selling $50,000 Buicks with auto-finance loans at 18 percent. Try buying — or selling — a house or a car, or building an apartment building or expanding a factory, with loan rates at 14 percent. As sales of cars and houses and whatnot slow down, autoworkers and builders feel the pinch — and so do their local restaurants, shops, and service providers. President Ronald Reagan held firm to win the fight against inflation, but if he had been up for reelection in 1982, he’d have been slaughtered. As the deep recession of the early 1980s showed, slowing down inflation is not a bloodless process.

 

And, sometimes, it is a truly bloody mess.

 

The U.S. economy is complex, and the global economy into which it is integrated is even more complex. The policymakers and central bankers in Washington are, for the most part, smart and capable people working with good intentions. (The truth about Washington is far more terrifying than any conspiracy theory: The government is full of intelligent, honest, patriotic people, and this is the best they can do.) Our economy isn’t a lawnmower engine. Fixing any malfunctioning parts is not a straightforward matter, and it is easy to get it wrong. In fact, it is so easy to get it wrong that the usual working assumption in government is that policymakers are going to get it wrong — the question is whether the policy will be catastrophically wrong or close enough to right that everybody looks smart and the boss gets reelected.

 

Consider the case of the 2008 financial crisis and the Great Recession. Because of the 2001 recession and the economic fallout from 9/11, interest rates had been very low for years. This was an attempt to stimulate the economy, and, like most such stimulus efforts, it produced unintended side effects, including a bubble in the housing market. Higher interest rates were intended to deflate that bubble and avoid what cliché-loving economists call “overheating” the economy.

 

But it didn’t actually work out exactly that way: The way in which mortgages are funded had been changing for years, and the lending boom continued even as the Fed was tightening — until it didn’t. With interest rates rising, millions of homeowners suddenly found themselves unable to make the monthly payments on adjustable-rate mortgages that now far exceeded the values of their houses, the prices of which were plunging while many could not be sold at all. The subsequent wave of mortgage defaults far exceeded what the people who had designed and evaluated those mortgage-backed securities had contemplated, and poof! went the world financial system.

 

That’s a hugely simplified summary, of course, but the key points will be familiar from the vantage point of 2021: deep national crisis, massive economic stimulus, skyrocketing prices for houses along with other assets and commodities, and the specter of serious inflation that will, should it manifest, demand serious action from the Fed and other policymakers.

 

How might that shake out? The lesson from the financial crisis is: Nobody really knows.

 

What joins inflation and interest rates is the issue of risk. You charge interest on a loan because there is risk involved when you let someone else use your money: For instance, the borrower might not pay you back, or a lovely investment opportunity might be dropped into your lap at a moment when you cannot benefit from it because your money is tied up somewhere else. Inflation is another such risk: If there is high inflation, then you may lose money on the loan in real terms even if it is paid back in full with the agreed-upon interest.

 

Because inflation erodes the value of a dollar — meaning that the dollars you get paid back with tomorrow will be less valuable than the dollars you lent today — the real rate of return on an investment is the return after inflation. (When you read about real GDP or real incomes, that’s what they’re talking about — GDP or incomes or whatever adjusted for inflation.) Sometimes, the problem of inflation is addressed by avoiding some risk, as in the case of inflation-indexed bonds, which pay interest at a rate that includes inflation, whatever it turns out to be over the term of the bond. But at other times, the problem of inflation is addressed by seeking out more risk, with investors forced to seek higher returns to offset inflation or lose ground in real terms.

 

The Austrian school of economics blames recessions and much economic unhappiness on artificially low borrowing costs. Austrians call it “malinvestment,” by which they mean that a whole lot of loans, business plans, and personal financial decisions that looked smart when interest rates were low do not look smart when interest rates are high. According to this model, artificially cheap money lures investors into making bad investments that will unravel once reality reasserts itself, as it always does, and a recession is what happens while that’s getting sorted out and capital is being shifted from unprofitable investments into profitable ones. The problem, from this point of view, isn’t the bust — it’s the boom.

 

There is something to that. Republicans have traditionally been allied with the business lobby, which generally cheers low interest rates and easy money and tries to keep the party going as long as possible. But a genuinely conservative economic policy would address risk and complexity in the only reliable way we know how: by being careful with both borrowing and lending, by paying close attention to both sides of the taxing-and-spending equation, by exercising thrift, prudence, and restraint.

 

Commodities prices at the moment are, as they say, frothy. That doesn’t mean policy can or should be frothy, too — we can’t afford it to be, even if that isn’t immediately obvious.