TCS Daily

That 70s No-Show

By Jerry Bowyer - August 4, 2006 12:00 AM

There's a great scene in Annie Hall in which characters played by Woody Allen and Diane Keaton are talking to their respective therapists. It takes place in split-screen. Both psychiatrists ask "How often do you two make love?" Keaton's character says, "Oh, all the time, usually twice per week." Allen's character says, "Practically never, maybe two time a week."

The recent debate between supply-side economists kind of reminds me of that movie. Consumer price increases over the past year have averaged a little over 4%. Is this high or low? Inflation hawks say it's high; Doves say it's low; I say that it's 'manageable.'

As Abraham Lincoln once said, "it's always harmful when a currency fluctuates in value," and he was right. We don't want any inflation, nor do we want any deflation. But on the other hand not all variations in the value of dollars are created equal. During the 1970s inflation was economically devastating. However these aren't the 1970s; today's markets are much more flexible.

Inflation is historically devastating for two reasons: first, it frequently corresponds with regulatory regimes which employ price controls. When prices rise, they bump into price caps. Companies pay more for raw materials but aren't allowed to charge more for end products. Banks have their loans repaid in debauched currency, but usury laws forbid them from raising interest rates to compensate for the added risks. Much of the damage wrought by inflation in the 20th Century was due to the fact that government forbade the flexibility which inflation demanded. However, it's precisely because of the disruptions of the 1970s that much of that regime was dismantled. Airlines were deregulated under Carter, and prices were allowed to float freely. Various regulations were lifted on the professions, including brokerage fees. Reagan deregulated natural gas markets. Interest rate caps were lifted. Most importantly, Reagan eliminated bracket creep from the tax code, which meant inflation would never again cause unlegislated tax increases.

Second, price inflation is confusing: that's its job. When Keynes justified using the printing press as the means to end the Great Depression, he was essentially advocating deception. Printing money would make people feel richer than they really were. Richer-feeling people would spend more. Eventually, prices would increase -- eventually. In the meantime people would have been tricked into spending more than they otherwise would have. Demand would rise, etc. The problem is that this works, if at all, maybe once or twice; then people catch on. Can anyone seriously argue that consumers and entrepreneurs are unaware today of the possibility of inflation? The expectation is baked into commodity prices. Business loans have clauses to deal with it. It screams from the headlines.

That's why deflation is so much more damaging now than inflation. That's why even a mild bout of deflation in 2000-2001 caused a job crushing recession. We had so little experience with it. We hadn't seen deflation of any real duration since the Great Depression. Price floors (such as minimum wages, living wages, and labor contracts) hadn't been dismantled. More to the point, deflation had been completely unexpected, so other than a few supply side economists, no-one understood what was going on until the damage had been done.

As we've discussed before, different markets are signaling different things. Gold and commodities markets are quite worried about inflation. Currencies, not so much. Bonds, hardly at all. Last week the stock market weighed in with its vote by rising 212 points in a single day because it believed that Bernanke had signaled an end to rate hikes. US equities are more worried about too little money than they are about too much of it. In fact, they're more worried about too little money than they are about the Middle East. That's why I'm not calling for greater Fed tightening. Not only do we think inflation risks are small, we also think that given the Fed's history of overreaction (too tight, then too loose, etc.), after 18 hikes in a row it might be about time to take a breather.

Jerry Bowyer is an economic advisor for Independent Portfolio Partners.



Inflation Paranoia
"...after 18 hikes in a row it might be about time to take a breather."

The FED should have taken a "breather" about 6-10 hikes ago. The economic "pause" of 2006/2007 is to a large degree a result of FED inflation paranoia.

inflation paranoia and currency fluctuation
As Abraham Lincoln once said, "it's always harmful when a currency fluctuates in value," and he was right !

Fully agree with both evaluations:
- inflation paranoia by Central Banker's;
- harmful currency fluctuation, when comparing USD
and EURO flcutuation during the last 3 years.

Now, any reasons or possibility for the USD to regain its correct value towards various currencies and particularly the EURO ?

author seems confused
The author seems to be mixing terms. Inflation is a term used when economists (the ones that know what they're talking about)refer to increases in the money supply via credit expansion--aka "the printing presses". Inflation (aka hidden tax to fuel government's out-of-control deficit spending)leads ultimately to general increases in the prices of goods and services. The reason is simple: too many dollars competing for limited goods and services.

There is, and never has been, anything good about inflation---no matter what Keynes and his minions thought.

Jerry, you are going to hate me again...

Love your writing. Love your stories. But, I do have a problem with your analyses.

Jerry said: "During the 1970s inflation was economically devastating. However these aren't the 1970s; today's markets are much more flexible."

Response: Inflation in the 1970s was very different. The rates were higher and the inflation was sustained for periods of years. From 1974 through 1981 inflation averaged 9.4%. And at the end of this period it averaged 11.7% for the three years from 1979 to 1981 with a peak of 13.5% in 1980. Our markets are not "much more flexible" (as you said) or more resilient (as you implied). Double digit inflation for a period of years would really hurt us today. Competing currencies would further weaken the dollar and high interest rates would collapse our real estate market. High interest on the National Debt would drain Federal budgets and high interest on business debt would cut deeply into the GDP (tax base). Bad.

Actually, we did go through a period of somewhat "higher than we would like to see" inflation (average 4.4%) during the four years from 1987 to 1991. We came out of that in pretty good shape. I agree that our current 4+% inflation rate is probably not going to kill us and the Fed is being appropriately aggressive about it. Soft landing.

Jerry said: "Banks have their loans repaid in debauched currency, but usury laws forbid them from raising interest rates to compensate for the added risks. Much of the damage wrought by inflation in the 20th Century was due to the fact that government forbade the flexibility which inflation demanded."

Response: This is simply not true. Mortgage rates in 1981 hit 18% for a moment and prime interest rates were above 15% in 1980. During this period of "stagflation" interest rates were too high for companies to borrow money to capitalize expansion and the GDP stalled. Nevertheless, the banks were able to keep their interest rates consistent with inflation...

There was real money to be made speculating that inflation would continue. Real estate was the typical play. Even with high interest rates a modest downpayment could get you into a property that would appreciate rapidly. One could sell into the accelerating market or borrow against the increased equity to raise the funds for more down-payments and keep on buying. At this point (until the Tax Reform Act of 1986) even the interest on your consumer credit cards was deductable. All such leverage constituted a natural tax shelter! Higher interest actually made this feature look better!

The anticipation of inflation led to speculation that sustained that inflation until the economy could not take it any more. The government finally got involved and simply told the banks not to make real estate loans. Real estate values corrected downward dramatically. Many real estate developers (some of my personal friends in Chicago) who were highly leveraged and long on inventory lost everything as the banks foreclosed.

The problem was absolutely not that the government "forbade the flexibility which inflation demanded" (as you said). It was only after the government (Reagan) stepped in and imposed draconian measures that matters normalized. If anything, the government (Carter) might have stepped in sooner.

Jerry said: "a mild bout of deflation in 2000-2001 caused a job crushing recession."

Response: The inflation rate in 2001 was 3.4% and the inflation rate in 2001 was 2.8%. The Stock Market peaked in March of 2000 and the economy dropped into a recession until the Fall of 2001 and then the recession lingered into 2003. The dot com bubble, 9-11, the Enron collapse etc. all contributed to this recession. "a mild bout of deflation" (as you said) certainly did not cause this recession.

And Jerry, what in the world is a Labor Productivity Chart doing in your Article About Inflation? You do not even talk about productivity.

I don' t hate you, I dread you...
Isn't that what Kay said to Michael in Godfather III. I kind of dread long and confusing responses, and the feeling that I've an obligation to untangle them.

Still, once more into the breach:

Yes, inflation was higher in the 1970s. That's one of the reasons it was more damaging. The other reason is that markets were less flexible in responding to inflation. That was the topic of my article.

Yes, there were interest rate caps in the 1970s. So, no I'm not 'flat wrong'. Just because mortgages floated doesn't mean everything else did. Here's a link to a Chicago Fed study on the topic, read the opening paragraph:

There is a chart about productivity because that's one of the major factor keeping inflation under control. The articvle was partly about that, so there it is.

Love your work...
The thing is...I'm a lot older. I lived through the periods you speak about. The impressions and the understandings that I retain from those times are not the fresh vision that you might bring to it. Perhaps with the benefit of some distance your analysis is a more relevant view for the current players to apply in their decision making processes.

Whether you are right or not, it is critical that you express "how it seems to you" because this is reflective of your generation's sense of the art and science of business management. Further, it is important that those of us who have worked for 30+ years to get as good as we are at this discipline (and there are lots of us) should participate in such conversations. Our children won't listen to us. Maybe you will.

keep writing
keep it coming. I'll keep reading, but I won't always respond, only so many hours in a day.

p.s. my kids don't always listen to me either, and I'm their employer!


Abraham Lincoln wrong on this one
Its not the proper role of the goverment to attempt to jigger price stability. We don't depend central planning to set prices most everything else, why do we let a group of guys called the Fed try to set prices using the blunt instruments of politically manipulated aggrigates such as the PPI and CPI. As the ratio of goods to monitary units slowly changes, then prices should adjust naturally, generally down as increasing productivity produces more goods for less money. Deflation is another word for prices going down, how is this bad? Inflation rewards speculators and punishes savers- these days we need less of the former and more of the later. Having a counterfieter in our midst takes real value from the market but returns nothing in exchange. Doing so to prevent prices from falling hurts everyone except the debtors and the counterfeiters themselves.

Is inflation really harmless?
What harm does inflation do?

Businesses pay taxes on inflated dollars, reducing their real profits and leaving them less money to pay for maintenance, expansion and salaries. Also, it makes planning more difficult, because businessmen don’t know if price increases are due to increased demand or monetary growth.

Government agencies rarely plan for enough inflation, so taxes don’t cover maintenance of infrastructure, which is one reason roads are in such bad shape.

Consumers always underestimate inflation. As a result, they don’t save enough for retirement and medical expenses and end up relying on the government to take care of them in their old age. Wages rarely keep up with inflation, especially those for low-skilled work, which means inflation hits the poorest hardest. Finally, inflation encourages borrowing money, rather than saving, because people can pay back loans with inflated dollars.

Deflation is only bad when it’s unexpected, as in the last recession, but it didn’t cause the recession; it was an effect of the recession. Moderate, regular deflation would automatically increase the value of wages, profits and savings. As a result, we would never need to raise the minimum wage to help poor workers. The savings rate would increase, making more money available for investment in new businesses and reducing foreign borrowing which causes our huge trade deficit. Finally, the purchasing power of tax dollars would increase every year at the rate of inflation, making it unnecessary for government to borrow money and making it easier to pay for maintenance of infrastructure.

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