Sunday, June 1, 2008

‘Pervasive inflation psychology’ developing?

“Consumers and some on Wall Street are expecting price rises to accelerate, a hint that a pervasive inflation psychology could be developing and posing a serious challenge to the Federal Reserve,” Kelly Evans of the WSJ writes.

What is so serious about this development?

On the welcome page of this blog there’s a quote from Ludwig von Mises’ Economic Freedom and Interventionism, 1951:

“What makes it possible for a government to increase its funds by inflation is the ignorance of the public.”

What relevance does this have to the Fed’s “challenge”? Here’s Mises’ statement in context:

“What makes it possible for a government to increase its funds by inflation is the ignorance of the public. The people must ignore the fact that the government has chosen inflation as a fiscal system and plans to go on with inflation endlessly. It must ascribe the general rise in prices to other causes than to the policy of the government and must assume that prices will drop again in a not-too-distant future. If this opinion fades away, inflation comes to a catastrophic breakdown.

The Housewife's Behavior

“If the housewife who needs a new frying pan reasons: ‘Now prices are too high; I will postpone the purchase until they drop again,’ inflation can still fulfill its fiscal purpose. As long as people share this view, they increase their cash holdings and bank balances, and a part of the newly created money is absorbed by these additional cash holdings and bank balances; prices on the market do not rise in proportion to the inflation.

“But then -- sooner or later -- comes a turning point. The housewife discovers that the government expects to go on inflating and that consequently prices will continue to rise more and more. Then she reasons: ‘I do not need a new frying pan today; I shall only need one next year. But I had better buy it now because next year the price will be much higher.’ If this insight spreads, inflation is done for. Then all people rush to buy. Everybody is anxious to reduce his holding of cash because he does not want to be hurt by the drop in the monetary unit's purchasing power. The phenomenon then appears which, in Europe was called the ‘flight into real values.’ People rush to exchange their depreciating paper money for something tangible, something real. The knell sounds of the currency system involved.

“In this country we have not yet reached this second and final stage of every protracted inflation. But if the authorities do not very soon abandon any further attempt to increase the amount of money in circulation and to expand credit, we shall one day come to the same unpleasant result. It is not a matter of choosing between financing the increased government expenditure by collecting taxes and borrowing from the public on the one hand and financing it by inflation on the other hand. Inflation can never be an instrument of fiscal policy over a long period of time. Continued inflation inevitably leads to catastrophe.” [All emphasis mine]

With Bernanke publicly committed to inflation as the great cure for market meltdowns, he could find himself facing a bull with two deadly horns: on the one, hyperinflation, if he runs the presses in earnest and the ignorant public gets wise to his policies, or on the other, the risk of turning the recession into a depression if he slows the presses for a protracted period. Of course, Bernanke doesn't want a financial calamity and will continue with Fed CPR to try to get the economy out of the recession without bringing on massive inflation.

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