A great deal of attention has been given to the recent stimulus package and the huge increases in deficits and our long-term debt. Much has been written about how this will lead to run-away inflation and destroy our creditworthiness around the world.
There are two kinds of inflation: "normal" inflation and unanticipated inflation. Generally speaking, most economists tend to believe that normal inflation is healthy; it helps boost employment and productivity, and helps grow GDP overall. When inflation is present but kept in check, unemployment is low. When it is higher than normal, it can lead to high unemployment and a recession, or worse.
So let's look at unanticipated inflation. What is it? Unanticipated inflation is, as the name suggests, a rate of inflation that is unexpected (or incorrectly anticipated) and that results in arbitrary redistributions of income and wealth, uncertainty in price information, reduced or negative real interest rates, and reductions in productivity due to diversions or delays in consumer spending and in business investment of resources and capital.
One impact of unanticipated inflation is on employee wages. Wages are a price, just like the price of apples, except that in most instances wages remain constant over some defined period (ie. the much-anticipated performance review and raise, usually once annually). During periods of "low" or normal inflation, annual wage increases typically keep up with, or closely approximate, these increases in costs. During periods of unanticipated inflation, wages that are fixed will suddenly have far less purchasing power, resulting in reduced demand as workers curtail their spending or increase their savings. In the short term, this will typically have a balancing effect on the overall economy, by counteracting the cause of inflation (if it was caused by unexpectedly high demand across all sectors, or "demand-pull" inflation; here I do not get into "cost-push" inflation, such as is caused by artificial price increases like the 1970's OPEC oil embargo or by printing money until it has more value as toilet paper than actual toilet paper).
In the long term, however, high inflation will have a repressive effect on the overall economy that quickly becomes self-reinforcing, leading to recession if monetary policies are not used to counteract inflationary pressures. Despite the typical rise in employment with higher inflation (re: the Phillips Curve), wages will not typically keep pace with inflation, further reducing overall demand. This will in turn "shut off" the Phillips Curve and unemployment will increase as demand drops below pre-high-inflationary levels. This puts further pressure on demand, the savings rate increases, capital investment stutters to a halt, and lending ceases as lenders have no certainty regarding future price levels and real interest rates. We saw this scenario in the mid-1970's with so-called "Stagflation", and seem to be entering another period with similar properties today (without the option to use monetary policies this time, as Fed rates have been reduced to nearly 0%; we are left with fiscal policies, which pump money into the economy through investment. If you have an argument with someone saying we can't spend our way to prosperity, I would urge you to challenge them to offer any other solution at this point).
So how does unanticipated inflation redistribute wealth arbitrarily? It is really a zero-sum game for the most part. From a macroeconomic perspective, looking entirely endogenously (avoiding such tricky situations as international markets and currency trades), money changes hands but does not affect overall GDP. A banker who loaned someone $30,000 for a car at 8% interest, anticipating a 4% inflation rate, loses some of their expected interest gains if the unanticipated inflation rate is 6% for a lengthy period during the lifetime of the loan. If inflation reached 12%, as it did in the late 1970's and early 1980's, they would actually lose money on the contract. The borrower would win, the banker would lose. (Given how bankers have been acting lately, this sounds rather pleasant, but in the long term it would be disastrous for the overall economy as lending dried up).
Another example of wealth redistribution returns us to the wage issue. Again, this is largely endogenous, but as described earlier, can have an enormous impact long-term. The employer obviously benefits if they are able to pay a worker the same wage as they did before the higher inflation rate struck, because in real dollars it is actually much less. Wealth is redistributed to the employer, while the employee loses purchasing power. This benefits the employer because although prices are rising, so are the costs of supplies, so employee wages during periods of unanticipated inflation become a kind of fixed cost, rather than a variable one. Thus, an employer can focus on the added costs of cash-management and price-change management required during unanticipated and often highly variable inflation.
Of course, the downside in the short-term is that as inflation rises and employers ramp up their hiring to meet the increased demand, employees at firms not offering some incentive to stay (usually through mid-term wage increases or some kind of bonus, although non-financial incentives may also be used to some effect) will tend to leave firms holding fast their wage-rates. This will result in some wage-bargaining as employers and employees shop each other, but if the unanticipated high rate of inflation continues long-term, job-shopping will slow until a recession hits, and unemployment begins to rise.
So during normal inflation, wealth is distributed in a fairly balanced way. Wages are sufficient to ensure a set standard of living, productivity is healthy, growth is strong, unemployment is in normal ranges, and lending is brisk. Risk-taking through entrepreneurship and capital investment is a strong component of the economy. During unanticipated inflation, wages redistribute to the employer, productivity falls, growth stutters, unemployment rises then falls precipitiously as low demand leads to a recession, lenders avoid all but the most rock-solid loans and then only at higher interest rates, and entrepreneurship becomes less robust as more risk aversion enters the marketplace. This all means wealth stagnates and ends up in places it normally wouldn't go, such as savings and high-risk speculation rather than consumptive spending and capital investment.
And of course, a real economy consists of both exogeneous and endogenous factors, and is stochastic, not deterministic. It relies on regulatory stabilizers to prevent runaway side-effects, and involves international markets, currency exchange rates, and much more. When high levels of unanticipated inflation hit an economy, it has repercussions globally. The 1990's saw the Asian Crisis, in which economies that were otherwise strong were pulled down because the value of their currency fell (increasing inflation rapidly), because some was invested in countries whose economies suffered some kind of collapse due to real or imagined threats to investors. Unanticipated inflation can be a very real threat to an economy, and does not have to come from some internal factor. Simply having other countries who are invested heavily in your currency lose faith in its value can spark a serious inflationary crisis.
Should the current recession continue much longer, this may very well happen to the United States, as China and so many others rush to dump dollars. The idea of $300.00 loaves of bread is not as crazy today as it was only a year ago. Much will be determined by how robust our recovery from this recesssion becomes, and whether our long-term productivity levels look rosy, or bleak.
So what does this all have to do with the stimulus spending, deficits and the risk of inflation? Simply put, in the long run I anticipate that even if we go for a second stimulus package, or even a third, that overall inflation will not be more than a percentage or two above normal levels. The reason? Because if we can pull out of this recession with a vastly improved infrastructure, more capital investment, better educated workforce, full employment, and spiraling healthcare expenses curtailed, then I see GDP rising even faster than before and the price indexes stabilizing.
Providing we put all this into place through this stimulus spending, worries about run-away inflation are, well, over-inflated; they are the result of looking at what our national productivity is today, and assuming that will it be little different in the future. I see a completely re-shaped economy coming out of this, with more emphasis on weaning ourselves off petroleum, creating millions of new Green-industry jobs, rebuilding roads and bridges and creating high-speed transportation lines that reduce the number of cars on the roads, and much more. I see a completely new emphasis on what constitutes our economic infrastructure, by focusing on new ways of having money actually create "things" and a de-emphasis on money in the form of financial instruments that are basically empty air.
So will infltion hit, and will we leave a massive debt for our great-great-great-great grandchildren? Some inflation will hit, yes. It won't be nearly as bad as the doom-sayers pronounce, however. And as for the massive debt, that will be paid back, with interest, by the boom of productivity this massive change will engender. Our great-great-great-great grandchildren will be thanking us for having the courage to change our ways and seek a future based not on greed and rapacity, but on shared growth and a mutual respect for our common humanity.
