One of the most peculiar aspects of the economic crisis is also one of the least remarked upon. Never in recent memory have so many economic experts warned of the prospect of inflation while an equally large group warned of impending deflation. In all but the most unusual cases, inflation and deflation are mutually exclusive. Either one or the other might be a threat, but not both at the same time. The current bizarre situation is as if a group of doctors examined a patient and half of the doctors warned that the patient was freezing to death while the other half diagnosed the patient with heat stroke.
Inflation is the phenomenon of too much money chasing too few goods, thereby causing rising prices, whereas deflation is the opposite – i.e. a glut of goods and services with not enough demand, thereby causing prices to fall. So, how is it possible that both could threaten us simultaneously?
The answer to this seeming paradox can be best understood by way of a metaphor. Imagine that the economy is a ship sailing through a channel. On one side of the channel are dangerous rocks representing the risk of economic stagnation (i.e. deflation), and on the other side are equally dangerous rocks representing the risk of economic overheating (i.e. inflation). The captain of the ship (i.e. the Fed and the economic authorities) are responsible for steering the ship through the channel without straying too far off to either side.
Under normal economic conditions, the captain has a healthy margin of error in either direction. If the ship starts to veer toward the side representing deflation, the Fed can lower interest rates or Congress can cut taxes and/or increase spending. The ship will then float back toward the center of the channel. Conversely, if the ship veers off to the other side, interest rates can be raised or fiscal policy tightened, and inflation will be contained.
There are circumstances, however, in which the channel becomes narrower and the margin of error becomes smaller. Such situations are usually caused by reckless or irresponsible behavior on the part of the ship’s captain. Just as is the case with steering a large ship, if the captain over-steers in one direction, the risk of a dangerous deviation in the opposite side increases. I would argue that the response of the Fed to the collapse of the internet bubble represented the beginning of just such an episode of a hazardous narrowing of the economic channel.
The history of the internet bubble is fairly straightforward. An invention came along that completely revolutionized the way humans live and work. Unprecedented sums of money were thrown indiscriminately at the new invention until the patent absurdity of companies with no earnings commanding billion dollar valuations became clear to everyone. Such an episode is always followed by a reckoning in which the wheat is separated from the chaff. The enterprises that never really made sense in the first place collapse, while those that did weather the storm and become the leaders of a more mature and rational industry.
Such episodes of boom and bust have been with us since the beginning of time and seem to be unavoidable. This is the dynamic famously referred to as “creative destruction” by the Austrian economist Joseph Schumpeter. Creative destruction is a double-edged sword whereby some parties suffer from the destructive aspects of economic progress, but society as a whole benefits from an increase in the overall size of the economic pie.
The problem with the response of the authorities to the collapse of the internet bubble was that they wanted to have their cake and eat it too. They wanted the creation without the destruction. Instead of allowing the boom & bust dynamic to run its course and letting those who made bad decisions suffer the consequences, the Fed tried to alleviate the destruction by slashing interest rates to unprecedentedly low levels. This action had the desired effect. The economy suffered far less from the internet collapse than might otherwise have been the case, but there was an unintended consequence. Just as in the example of over-steering the ship, by using aggressive monetary policy to alleviate the pain of the dot-com bust, the Fed inadvertently caused a dangerous deviation in the opposite direction, which manifested itself as a real estate bubble. Since that time, the economy has never really returned to a steady course. It has gone through a cycle that is characterized by either extreme euphoria (2001-2007) or catastrophic gloom (2007-present).
The latest actions of the Fed and the government have been truly extreme. Creating trillions of dollars out of thin air and rescuing banks, auto and insurance companies through enormous infusions of cash are measures of last resort, and they entail very serious consequences. Much of this “emergency medicine” has been crammed down our throats with little deliberation or transparency based on the argument that not doing so would bring certain disaster. However, it is simple common sense that you can’t violate the most basic assumptions of a market economy without weakening its foundations.
To return to the metaphor of the ship, what has happened is that the channel has become narrower and narrower as a result of the drastic maneuvers executed by the captain of the ship. We have now reached the point at which the channel is so narrow that it is barely wider than the ship itself. And this explains the apparent paradox presented at the beginning of this piece. In ordinary circumstances, inflation and deflation are mutually exclusive, and you would never observe the phenomenon of an army of professional economists predicting inflation while an equally large army warns of deflation. However, due to years of economic missteps by the Fed and the US government, the channel has become so narrow that there is virtually no margin of error on either side, and this is why we are in the uniquely difficult position of having to worry about both inflation and deflation simultaneously.