Stimulus and Inflation

We have, of late, been enjoying a booming economy.  The economy has been growing.  Jobs are up.  Unemployment is down.  GDP is heading up.  These are all good things meaning an improved standard of living for the American people.

However, as sure as death and taxes there will come a time when the economy takes a downward turn.  This is not a gloom and doom prediction.  The economy can continue to grow in the long term but there will be ups and downs along the way.  Given a long enough perspective we’ll see that the ups average bit higher, the downs not quite so low, and the general trend is up.

This long term general upward trend is why the average standard of living is higher than in the paleolithic age, or Roman times, or Medieval, or even the 19th and early 20th century.  But there will be stumbles and down turns along the way.  This is normal.

But when a down turn happens, people forget that it’s normal and don’t simply batten down the hatches, as it were, to ride it out.  Nope.  The urge is to do something.

In the modern era the thing people generally turn to in order to “do something” is government stimulus of the economy.  The government will spend money on public works projects or offer loans or outright grants to select businesses to “stimulate” economic activity and foster economic growth.

This sounds very good in theory but what about in practice?  Well, the first thing you have to do is ask where this money the government is spending comes from?  Since government does not generally produce and sell products in a competitive marketplace, there are really only three ways government gets money:  tax it, borrow it, and a third way I’ll get to shortly.

The problem with “tax it” is that the money the government puts into the economy must first be taken out of the economy.  More money in sector A, where the government “stimulus” is going is at the cost of less money in sector B.  Classic Peter and Paul situation.  The money taken from B cancels out the money put into sector A.  People in favor of this approach can only argue it on the basis that the “experts” in government will use the money more wisely than will the market if the money is left there.  In short, it’s a specific instance of the command economy theories that date all the way back to Plato’s “Republic.”

The history of actual planned economies suggest that nothing could be further from the truth.

The second way to get the money for stimulus is borrow it, take it as a debt on the future economy.  This has much the same issue as the “tax it” approach although it’s a bit slower in application.  The impact of taking that money out of other elements of the economy is not felt quite so immediately but the end result is the same.  Paul is very happy at Peter’s expense, but the net that they both have does not improve.

Then the third way.  And that way, one that has been very attractive to governments in history:  simply make more money.  In the days when most money was in the form of coins of precious metals, the way this was done was to debase the coins in various ways. They would do things like alloy the coins with base metals, make the coins smaller while retaining the same denomination, or even make the coin entirely of base metal and just give it a “wash” of the precious metal.  All of which meant more coins in circulation, more money which the government could use to pay for more goods and services (starting there, since the governments generally gave itself a monopoly on the making of money) and then the coins could be used by others to buy other things.

Paper money made that process easier.  Want more money?  Print more.  The paper for $100 bill costs no more than that for a $1 bill.  And in the modern age, they don’t even need to do that.  Much of the “money supply” consists of nothing more than electronic bank records.

So, when an increase of money supply significantly larger than the growth of economic output hits the market, what happens?  Businesses, and soon individuals, have more money to spend on things.  And that means they buy more.  For example, people might buy more pencils.  As a result, the dealers order more pencils from their distributors.  The distributors order more from the manufacturers.  And the manufacturers order more raw materials, maybe even hire more people to increase their capacity to supply the new increased demand for pencils.

The economy humming along and more people working.  A good thing, right?

Well, for a while.  You see, normally an increased demand for one particular product, pencils in this case, would be because people are choosing that product over some other product.  Increased demand in one would mean reduced demand in another.  Perhaps, say, the popularity of pencil drawing increased in the art world over that of pen and ink.  People would buy more pencils, but fewer pen nibs and less ink.  And these shifts would in the end (through various intermediate steps) divert resources from the manufacture of pens and ink to that of pencils, thus managing the allocation of scarce resources which have alternative uses.

But that’s not what happens with an increase in money supply.  Instead, the demand for everything  goes up.  So instead of resources being shifted from something that has decreased in demand to something that is increased, everybody is clamoring for the same resources.  The result is that they have to bid against each other and prices for those resources goes up.  The prices of the materials for manufacture of those pencils goes up.  The manufacturers have to charge more to the distributors, who charge more to the retailers, who charge more to you.

This doesn’t happen instantly.  It takes some time to work through the system.  You get an initial “stimulus”, then prices rise and eat up the result.  However, it’s done its job for the politicians.  They got their “stimulus” and enough time has passed that they can blame the problem of the increased prices on someone else.

By the time the prices have all caught up with the money supply, the stimulus effect is gone.  The demand is no longer being propped up by the increased money supply.  If anything demand can fall.   Someone who bought a bunch of pencils at the start of this doesn’t need any now.

So what’s the politician to do?  If you said “increase the money supply some more”, you get a gold star.  We get another “stimulus”, another rise in prices, and another flagging of the economy as prices catch up to supply.  Which means another increase and…

Thus you have the inflationary spiral.

The only way to get out of it is to stop increasing the money supply faster than economic output is growing.  The problem is, that “stimulus” that happened at the start?  It happens in reverse.  Demand falls.  People buy less.  Businesses do less business.  Unemployment goes up.  All things most people see as “bad”.  Now, with a bit of patience these will settle and the economy will go back to its normal operation.  The thing is, neither politicians nor their constituents are noted for their patience.  “Things will be fine if you can just hold out for the next few months” is not something that plays well in the political trenches.  Thus, as I’ve noted elsewhere, it’s not politically feasible to fix such a problem all at once.

That doesn’t mean that you can’t fix a problem with inflation.  It just has to be done gradually, in stages that are politically feasible.  You’ll still get the drops in demand with the concurrent reduction in business, but they can be kept to a smaller, less painful level.  It just takes longer.  That requires more patience.   But, again neither politicians nor their constituents are noted for their patience.

And so, here as well, Economics is the Dismal Science.

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3 thoughts on “Stimulus and Inflation”

  1. It’s a bit like Relativity. The speed of light is constant, therefore clocks and rulers must change. The true value of goods is (roughly) constant in short term – thus the value of money changes. Yeah, this doesn’t account for real progress where a once-expensive item (in term of hours of labor to earn the money to buy it) is now a dollar store item….

    I do wonder when we’ll see the beginning (or if we already have) of the 5&10 DOLLAR stores. I can just barely recall a place called a 5 & 10 cent store – but even then there was precious little to be had for a dime, and I doubt anything was available for a nickel.

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    1. On the one hand it’s very simple: money supply on one side and total output of goods and services on the other. More money supply relative to goods and services, prices go up. Less, prices go down.

      Complications arise because it can take time for the results of changes to propagate through society. So the first stages of inflation looks a lot like economic growth.

      The problems of inflation (money supply growing notably faster than economic output) are fairly easy to understand. What a lot of people don’t get is that deflation–failure of the money supply to keep pace with economic growth–has its own problems. I’ll probably need to go into that a bit on a future post.

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