- No Inflation?!

So where is the inflation? Ben Bernanke doesn't see it so I guess it isn't there right? If you believe that I have a bridge I’d like to sell you. The problem is that inflation (right now anyway) is global and Ben's measurements are all taken nationally where his numbers are being influenced by the massive deflation we’ve seen in housing prices. This, like so many other issues of imprecision in Economics, is a problem of aggregation.

I have a friend who’s a Physicist. He's a blisteringly smart guy who’s interested in understanding the economy, but has no formal economic training. So we've been spending some time talking through things like the business cycle, and the difference between the Austrian and Monetarist economic schools.

Like most very smart people, particularly those who work in the sciences, my friend thinks it should be possible to build a model to ‘normalize’ the business cycle (assuming in fact that it really is cyclic.) In that way we can eliminate the boom and bust and replace it with slow stable growth. I explained to him that he’s not alone in that opinion. He’s adopting the Monetarist view, and his ‘control the flow’ idea is shared by most of the credible economists in America.

(Keep in mind I said credible. That excludes Krugman – he’s a laughing stock. It also excludes the hired guns in DC – they’re neo-Keynesian apologists like Krugman.)

But the tools for controlling an economy are imprecise at best, and this business with inflation is an excellent example. Domestically Ben Bernanke sees no inflation. Is that because the inflation in commodities and food is just ‘back filling’ the deflation from housing? What about the rising cost of food? Does that count less than the price of other things? If we had rampant inflation in corn and oil, but none in copper do we have inflation or don’t we?

There are those who say you can’t have actual inflation without wage pressure, and we haven’t got any of that in the US. But what about China? Their wages are rising rapidly. And so long as the Yuan is fixed to the dollar, China is for all intents and purposes our 51st state. Do those wages count or don’t they? Across the emerging world rapidly rising food prices are already adding to political instability. Can you imagine what will happen to the global economy if food price inflation is allowed to continue at this pace for another year or three?

This is the issue that Austrian school tries to cope with. The Austrian school says that no matter how smart you are, the structural limitations of gathering information make it impossible for you to know enough to ‘control’ an economy from the top down. Better would be to allow the information to be as broadly distributed as possible and allow each person to act independently in their own best interest.

In the Austrian school, any attempt to ‘control’ the economy inevitably affects the price of something. And by affecting that price, the people acting to ‘control’ things are lowering the information content of that price. They are therefore making the market work less well, and decreasing the efficiency of the economy in the process. They are preventing people from discovering what they need to know in order to make the economy work at maximum efficiency.

Rice prices could skyrocket in Bangladesh. A monetarist would see this as a crisis that needs to be ‘handled’ by government. They would react to it by implementing price controls - forcibly suppressing price. But that would mean that lots of people can afford what only a few can consume. Demand would rapidly outpace supply and the result would be shortages, and starvation.

But an Austrian School economist would say that the rising price is a signal to suppliers to move as much supply to that location as they can manage. The high price is a signal of urgency. And there is little doubt that private actors are better at rapid response to new information than the bloated bureaucracy of a top down government.

The point is that both the Monetarist and Austrian schools of economic try to minimize the boom and bust cycle. But where the monetarist school still goes for the top down ‘leave it to the experts’ sort of approach, the Austrian school does not. The Austrian school says that the only way to avoid a global ‘boom and bust’ is to encourage markets to distribute as much information as possible, which will keep all the booms and busts small, local, and of a short duration. When you aggregate that, it looks much more effective than any top down approach.

What do I personally prefer? Well I make my living assessing the information delivered to me by markets so I’m ‘mostly’ and Austrian school guy. But I recognize that I live in a neo-Keynesian world. Government thinks it’s smarter than everyone else, so my peers and I need to be cognisant of its actions and their effect on the markets if we want to remain profitable. I think it does more damage than good – but that doesn’t mean I can pretend it isn’t there. I’m completely convinced that the Austrian school would work better at managing the ‘bad news’ of the business cycle – but I’m not going out of my way to argue for it.

So what about my friend’s model for controlling the boom and bust cycle? Well lots and lots of intellectual horsepower has been thrown at finding a top down model, but no one has yet succeeded. I don’t think they’re going to. I don’t think it’s possible no matter how smart the model designer is.

But what about this - why not give your model a basically Austrian design? It can use local market pricing as an input and its operating controls can be the elimination of barriers to the free flow of capital, resources, and labor in response to those prices. It would focus on efficiency rather than top down control, and empower markets and their freely negotiated pricing be the ultimate arbiter of resource allocation – allowing (and therefore encouraging) everyone to act in their own best interest. They could try to ensure that ‘price’ contains as much information as possible – free from interference from non economic actors.

But Economists don’t generally like that sort of thing. It would mean that your ‘model’ essentially is a free market where each individual can do what they like with a minimum of top down direction from the ‘experts’. And if you’re one of those experts who has trained for decades in the musty halls of academia writing papers and drafting proposals - waiting patiently for your turn at the helm in one of those rare government awarded positions of influence, what fun would a free market that basically ignores you be?