Sunday, June 20, 2010

Inflation and Speculation

The longest serving chairman of the Federal Reserve was William McChesney Martin, who served from 1951 to 1970 and is famous for his remark that the job of the Fed is to "take away the punch bowl just as the party gets going." Paul Krugman's book comments that this referred more to the Fed's role in fighting inflation than pricking speculative bubbles.

That may be because, although the 1950's and '60's had serious and growing problems with the threat of inflation, they were little troubled by bubbles.* In the 1970's, the Fed tried to stimulate the economy in the wake of oil shocks at the expense of fighting inflation. Inflation escalated throughout that decade, ultimately reaching 13%, but with no sign of a bubble. In the early 1980's, Federal Reserve Chairman Paul Volcker severely tightened the money supply, raising interest rates as high as 20% and throwing the economy into its worst recession since WWII, with unemployment over 10%. In this he succeeded in bringing inflation down to acceptable levels, where it has remained to this day. However, the speculative bubble made a comeback.

In fact, since Volcker broke the inflationary spiral, we have averaged about one bubble a decade, each worse than the one before. In the 1980's Savings and Loans set off a real estate bubble, driving land prices to unsustainable heights and ending in a costly bailout (just as expensive, relative to GDP, as the TARP). Real estate and building had a several-year hangover where the boom was biggest. Opinion is divided on whether the bubble contributed to the 1990-91 recession, and, in any case, it was a mild one. In the 1990's we had a tech stock bubble (Krugman argues that it was a general stock bubble), which burst in 2000, leading to the 2001 recession. That was also a mild one, but recovery was worrisomely slow, and ultimately only came about because of the new housing bubble. That one has proven catastrophic.

Which leads me to an Enlightened Layperson's conjecture that I wish some real economist would address -- that inflation and speculation are really variants on the same thing. Both can come from demand straining against capacity, too much expansion of the money supply, too-easy credit, debt building too quickly, or whatever your theory of the business cycle. The difference is essentially that inflation occurs at the consumption level and speculation occurs at the investment level. Inflation occurs when too much money chases too few goods, i.e., when consumers with too much cash want to buy more than the economy is capable of producing. Speculation occurs when too much money chases too few investment opportunities, i.e., when investors with too many resources want more opportunities to invest than the economy can productively offer. Inflation drives up the price of consumer goods. Speculation drives up the price of investments.

There are also differences between them. Inflation does not appear to have any natural limits. So far the record is held by Hungary, 1945-46, with a inflation that peaked at over 40 quadrillion percent in one month. Speculation, by contrast, does have limits. Speculative bubbles invariably burst, well before they approach some of the more extreme excesses of hyperinflation.** Furthermore, when speculative bubbles burst, asset prices fall, sometimes to more realistic levels, sometimes to serious undervaluation. Halting inflation does not normally mean deflation; it simply means that prices stabilize where they currently are. And finally, although halting inflation is always traumatic to an economy, the prospects for a quick recovery are better than the prospects after a bubble bursts.

I am not suggesting that inflation and speculation are mutually exclusive; it is certainly possible to have both at once. Nor do I claim to know if internationally or over time there has tended to be any trade-off between them. But certainly in the post WWII US, there seems to be a pattern. For three decades, lots of inflation and little bubbling. In the next three decades, low inflation, and one speculative bubble a decade. Without claiming to know why, I could venture a wild guess. From the end of WWII up until the mid-'70's, most economic growth took place among the general public with relatively little at the top. This may have caused consumption to outpace investment and inflation to result. Since the, growth has been concentrated primarily at the top. This may have caused investment to outpace consumption and speculation to result.
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*Confession: This is more a general impression than anything thoroughly researched. I stand ready to be corrected.

**A hyperinflationary bubble could be said to burst when people just stop using the depreciated currency and move directly to barter, so that currency stops circulating altogether. In that case, the hyperinflationary bubble could be said to have burst and given way to hyperdeflation.

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