Despite unprecedented creation of money over the past three and a half years, consumer prices remain moderate. This seemingly vindicates the policy of the Federal Reserve and, more recently, the European Central Bank, and arguments have been advanced that more monetary ease, known as quantitative easing, should be implemented to spur the world economy. However, economists and the public should recognize that consumer price inflation is only one way of debasing currency, and that over the past two decades the value of paper money has fallen steeply — even though this process has not been accurately measured by any official indices.
The experience of the inflationary 1970s raised the importance of the consumer price index, the GDP deflator and other consumer price gauges. These are what central bankers are watching now as they conduct monetary policy. As Economic History 101 maintains, large budget deficits and the accommodating monetary policy of the Vietnam era led to runaway inflation a decade later, and the Fed is determined not to allow the same inflationary spiral to be repeated this time, since monetary and fiscal conditions are now far more lax than anything seen in the 1960s.
A few years ago, Ben Bernanke, then an economics professor at Princeton, would have probably been among the fiercest critics of the Fed had it been printing money so profligately. Now, on his watch, the central bank increased its balance sheet from $900 billion to an unprecedented $2.9 trillion over the past five years. But contrary to mainstream economic science, the impact on inflation has been negligible — even at a time when oil prices have been rising. Something else was clearly at work in the 1970s to spur price increases through the entire economy, which is clearly absent now.
Consumer price inflation is sometimes defined as an increasing amount of money chasing a set quantity of goods and services. Four decades ago, the U.S. economic system was a fairly insular one, with foreign trade accounting for a small percentage of GDP. Relatively few countries around the world were competitive in making products, and trade in services was virtually nonexistent. “Outsourcing” was as yet unknown. At the same time, the domestic labor markets were far less flexible and a large percentage of the workforce enjoyed a monopoly pricing power provided by the unions, so that workers could press their wage demands almost at will. When oil prices jumped in 1973, workers demanded and got raises that compensated them for the loss of purchasing power, while companies raised their prices to reflect higher costs. An inflationary chain reaction followed, and the Fed accommodated price increases by printing more money. Only when Chairman Paul Volcker stopped the printing press was inflation finally defeated.
No such scenario is possible today. Labor markets are far more flexible. Power has shifted to employers, making workers, to use an economist’s term, wage takers rather than wage setters. High unemployment ensures that workers are glad to have a job and will accept whatever wages they are offered. On the other hand, companies are now price takers as well (with such exceptions as Apple and some other successful consumer brands, and some industries, such as higher education and health care, where special conditions prevail). Companies have little ability to raise prices without losing market share, since domestic and foreign competitors alike would be only too happy to undersell them.
Monetary policy has been loose for decades now. While it has never been quite as extraordinarily so as it is today, the printing press was working overtime for most of Alan Greenspan’s tenure at the Fed, spurred in part by the fact that consumer price inflation during most of that period was a dog that failed to bark.
But if prices didn’t rise, liquidity had to go somewhere, into some kind of overflow pools. We now know that before 2000 it went into dot-com stocks, and after that into the housing market, where an unprecedented bubble was allowed to inflate. The bubble burst, destroying $7 trillion worth of homeowners’ equity and nearly toppling the global financial system. The banks were rescued — but only by means of massive infusions of additional liquidity.
Since the Case-Shiller index showed another 4% drop in house prices nationwide during 2011, housing no longer functions as an overflow pool for liquidity — at least for now. But other bubbles have emerged. One such bubble-in-the-making is the oil market. Oil was overbought back in 2008, when crude peaked at nearly $150 per barrel, and after a four-year respite oil prices are moving toward this record once more. Oil prices are spurred by political uncertainty, notably by the conflict between Iran and the West over its nuclear enrichment program, even as underlying demand is clearly peaking.
However, that is not the most dangerous bubble there is. Back in my February 2009 column, I warned that a far worse bubble was inflating in government bonds. So far, it has started to deflate in the euro zone, while U.S. Treasuries have not only been immune but actually benefited from the euro zone government debt crisis. Despite a steady stream of new supply coming from a string of $1 trillion-plus federal budget deficits since President Obama came to power, Treasury bond yields have been at a record low. But that doesn’t negate the point that the giant U.S. T-bond market is also in a bubble stage and that this bubble will deflate at some point in the future.