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Inflation: Return of a Plague

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Inflation: Return of a Plague

To escape the spiral in which the amnesia of central banks and governments has put us will require great political courage. June 14, 2022
Economy, finance, and budgets

You do not need to have read the works of John Maynard Keynes to know, if only approximately, the famous conclusion of his General Theory. He argues, essentially, that all government policies are derived, usually unknowingly, from long-dead economists, whose very names are often ignored. Economic policies are indeed determined today by many people who have not read Keynes, or Friedrich von Hayek, or Milton Friedman, which does not prevent them from applying the Keynesian theory, or its opposite, the Hayek-Friedman approach. Current world economic developments demonstrate this; inflation, which is breaking out everywhere, especially intensely in the U.S., is indeed the consequence of strategies inspired by theories unknown to those who have internalized them.

As Keynes argued, theories are decisive. If only governments could choose the right ones! But the Biden administration mistakenly decided to apply the statist Keynesian theory, whereas it should have followed Hayek and Friedman. In a recession, Keynes argued, one should stimulate the economy by boosting demand—that is, by spreading purchasing power, which requires direct subsidies or easy credit at low rates. Greater production, according to Keynes, would necessarily follow the boosted demand. With the Covid crisis, as after the recession of 2008, Western governments adopted this strategy in the form of direct aid to consumers and an interest rate of zero. The result: a rise in prices, with production unable to keep up with demand. The price hikes that result from these political errors in turn provoke demands for wage hikes, setting off an inflationary spiral from which it is difficult to escape.

Two explanations have been proposed for this phenomenon. The first, quasi-mechanical in nature, we owe to Friedman: the growth in the money supply, fed by the state and by the central bank (the U.S. Federal Reserve System and the Central European Bank), shows up in increased prices, not in gains in production. Along with this “monetarism” of Friedman, which history has validated repeatedly, there exists a factor that the Chicago economist Robert Lucas in the 1960s named “rational anticipation.” According to this theory, economic actors are not dupes of governmental incentives, such as free credit, because they are informed by past experiences. Without being economic experts, consumers and producers know that the creation of money will lead to inflation, and they adjust their behavior by not investing and by spending as rapidly as possible.

Experience has once again verified Friedman’s and Lucas’s theories, reducing to nothing the naïve propositions of Modern Monetary Theory, a recent delusion of the American Left. According to this unscientific, ahistorical theory, legislatures can control the production of money and distribute it in a way that satisfies all needs, with no destructive consequences from expanding the money supply. The question of reimbursing a gigantic public debt is not supposed to arise, because no one can force the government to pay what it owes. But this magical solution, adopted in part by Joe Biden, ignores the fact that public debt produces inflation and that a debt that is not repaid, as in the case of Argentina, eventually ruins the currency. All this was well known, at least by economists, so it is surprising that governments in America and Europe had not taken it into account of late. They have short memories. From the 1980s until recently, inflation had been constrained thanks to public policies inspired by Friedman—but policymakers had forgotten its threatening presence, as if it belonged only to the past. We can liken inflation with pathogens: smallpox has disappeared, but vaccination is what made it disappear; stop vaccinating, and the evil can return. In the 1980s, central banks helmed by Friedman’s disciples, such as Paul Volcker in the United States or Jean-Claude Trichet in Europe, raised interest rates and defeated inflation by reducing the money supply. Today, economic policymakers will need to apply the same remedy as in 1980. Central banks are working on this, but their conversion comes late; they have waited for inflation to establish itself before responding, a delay that will make the remedy more painful.

Why, though, must we eliminate inflation and bring it down to a tolerable rate of, say, 2 percent? Because it is an economic and social plague. It replaces long-term investment with short-term financial speculation, harming the economy. It aggravates social inequality because price hikes have a greater effect on the poor, who consume all their earnings, than on those who are well-off and can invest their earnings to shelter them from inflation—for example, in real estate or works of art.

To get out of the inflationary spiral in which the amnesia of central banks and governments has put us will require great political courage. It will be necessary to explain the disappearance of near-zero interest rates as well as the risk of short-term recession brought on by raising interest rates. It was because of his pedagogical gifts that Ronald Reagan, early in the 1980s, was able to persuade the American people to tolerate this cure called austerity: inflation disappeared, and growth resumed, but only after two years of widespread pain. This policy, which at the time was called “neoliberal,” was later adopted across Europe, because its success was evident. The present lack of political courage and moral legitimacy in the U.S. and in Europe will, I fear, make it necessary in the coming years for us to live with inflation, which means to live badly.

Photo: Panorama Images/iStock

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