In a misguided attempt to boost the economy, Federal Reserve chairman Ben Bernanke announced another round of fiat money creation, claiming “the battle against unemployment eclipses any concerns about inflation for now.”
This last statement reveals Bernanke’s belief in the “Phillips Curve” – a model that predicts a trade off between inflation and unemployment. In short, the theory goes that keeping inflation low means higher unemployment, and if you want to stimulate employment you need to tolerate some inflation. The Phillips Curve is a staple among mainstream economics textbooks.
The Foundation for Economic Education, however, reminds us of how Henry Hazlitt (among many others) discredited the Phillips Curve many years ago. (for some reason, the high-inflation, high unemployment stagflation of the late 1970′s didn’t completely kill the Phillips Curve). A sample of Hazlitt’s observations:
Meanwhile, even if the inflation is relatively mild and proceeds at a fairly even rate, it begins to create distortions in the economy. It is amazing how systematically this is overlooked. For most journalists and even most economists make the tacit assumption that an inflation increases prices uniformly—that if the wholesale or consumers price index has gone up about 10 per cent in the last year, all prices have gone up about 10 per cent. This assumption is seldom made consciously and explicitly; if it were it would be more often detected and refuted.
The assumption is never correct. For (even apart from the wide differences in the elasticity of demand for different commodities) the new money that the government prints and pays out in an inflation does not go proportionately or simultaneously to everybody. It goes, say, to government contractors and their employees, and these first receivers spend it on the particular goods and services they want. The producers of these goods, and their employees, in turn spend the money for still other goods and services. And so on. The first groups spend the money when prices have still gone up least; the final groups when prices have gone up most. In addition, the growing realization that inflation will continue, itself changes the direction of demand—away from thrift and toward luxury spending, for example.
Note in the second paragraph Hazlitt’s observation that the inflated money supply is not evenly injected into the economy. His example is to use a case in which newly printed money is used for government stimulus projects. More appropriate to Bernanke’s announcement, however, is how the new money is injected into the hands of investment banks (in exchange for the Fed’s purchase of securities and bonds in bank’s portfolios). Notice how the stock market has been climbing in the last couple of years, thanks in no small part to these actions of the Fed.
To the extent this new money enters the loanable funds market, it will cause an uneven rise of prices as the new money begins circulating through the economy (more money chasing a more slowly rising quantity of goods) and will drive down the nation’s woefully low savings rate even more by depressing interest rates. The end result: a market with distorted price signals prompting investments that don’t reflect economic realities, lower rates of real savings – drying up the resources needed for true economic recovery, and rising prices that will erode the purchasing power of citizens – especially those with more fixed incomes like seniors and low-skilled workers.
On a final note, the fact that one man’s announcement can cause such a significant change in the stock market shows just how far we really are from a free market economy.