Keynesians Jump The Gun On Inflation

Advocates of government stimulus are running victory laps before the race is even over. In particular, Paul Krugman compares the sluggish growth in Europe to the somewhat-less-sluggish growth in the US to prove that stimulus was more effective than austerity. Other economists are using government inflation measures to vindicate Fed Chairman Bernanke’s easy-money policy. The only problem is, they’re calling the race before the finish line is even in sight.

As usual, Paul Krugman overlooks basic economics, which, despite his Nobel Prize, is a science about which Mr. Krugman really knows very little. The reason stimulus is so politically popular is that it appears to work in the short-term. However, appearances can often be deceiving, as they are right now in the US. Stimulus merely numbs the pain of economic contraction, as the underlying illness gets worse. The bitter taste of austerity is not nearly as pleasant to swallow – but it works. America has chosen the former and Europe the latter (albeit not quite as large a dose as needed). The fact that in the short-run Europe is suffering more than the US does not vindicate Washington’s approach. On the contrary, this is exactly what is to be expected.

The true test is not the immediate effects of stimulus or austerity, but the long-term results. For that reason, Krugman’s conclusions are meaningless. The apparent success of stimulus simply results from spending more borrowed money on government programs and consumption. But don’t we all agree now that this is exactly what caused the financial crisis in the first place?

As far as inflation is concerned, a vindication of Federal Reserve Chairman Ben Bernanke is equally premature. First of all, it’s not that Quantitative Easing will lead to inflation; it’s that QE is inflation. Secondly, there is a lag between QE and rising consumer prices, so the jury is still out as to how high consumer prices will ultimately rise as a result of current and past Fed policy mistakes.

But even more fundamentally, it is absurd to look solely at government price measures, which are built to understate inflation, and conclude that QE has not already produced an elevated cost-of-living . For example, the 2.4% rise in the Personal Consumption Expenditure (PCE) Index in 2011 is more of an indictment of the accuracy of the index than a vindication of Bernanke. In fact, of all the ways the government purports to measure inflation, the PCE is perhaps the most meaningless, as it relies on built-in mechanisms like goods substitution to hide a lower standard of living. For an example of how this works, imagine you are used to eating farm-fresh butter but have to switch to cheaper but also less-healthy margarine from a factory; the PCE would say you are no worse off. That’s exactly why the Fed chose to use this uncommon metric.

Mark Gertler, an economics professor at New York University, argues that even the Consumer Price Index, which rose at a more vigorous 3.2% in 2011, proves Bernanke’s critics wrong. According to Gertler, the CPI has risen at an average annual rate of 2.4% thus far under Bernanke’s tenure, significantly less than the 3.1% average under Alan Greenspan, and the 6.3% under Paul Volcker. However, Gertler overlooks two key points. First, the methodology used to calculate the CPI was much different during the Volker era. If we still calculated the CPI the way we did then, the numbers would be much higher for both Greenspan and Bernanke. Second, given the huge economic contraction that has taken place under Bernanke, consumer prices should have fallen – significantly. The fact that they rose anyway indicates tremendous inflation.

Of course, the Fed’s ability to stimulate the economy with inflation only works as long as bondholders remain ignorant of their plan. For now, the seemingly hopeful news reports are giving the Fed cover to keep stimulating. As long as the market remains convinced there is no inflation, the Fed can continue to create it. However, once the effects are so pronounced that even the PCE can no longer hide them, the Fed will be in a real bind.

Regardless of what the triumphant Keynesians would have you believe, the truth is that the current combination of monetary and fiscal stimulus will likely lead to disaster. Instead of a real recovery, the US will experience an inflationary depression.  Europe, on the other hand, will suffer much less, precisely because it was not seduced by the short-term appeal of stimulus.

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