Greenspan's Empty Words on Inflation - TheStreet

Central banks were set up to bail out broken economies -- usually by creating inflation. So why do so many people on Wall Street act so surprised when they go out and do just that?

Out of the

G7

central banks, the

Fed

is by far the loosest and the most blase about prices. It has been for many several years now. But recent efforts by Chairman

Alan Greenspan

to avert a recession have created the sort of massive expansion of money not seen since the '70s and '80s, when inflation ravaged the U.S. economy.

Facing an increasing tide of skepticism about his ability to keep prices down, Greenspan said this weekend that "inflation is not a significant problem." He has plenty of support for that view on Wall Street, which has staked everything on Greenspan getting it right.

What They Say

The argument one often hears from the orthodoxy is that inflation can't be a problem when the economy is slowing down. How so? When firms are operating at below capacity, their productive facilities are underemployed and they often enjoy an excess supply of labor and materials. Ergo, their input costs are low and they have few higher costs to pass on.

In a low-growth period like this, according to the mainstream, a central bank can safely print money. This will stoke consumption and spur producers to utilize more of their spare capacity and invest more in new facilities. Before long, the economy is back on the road to growth.

And the Fed has allowed an enormous sum of money to be created so far this year for this purpose. The money supply measure called M3 grew by $362 billion in the four months to the end of April, which works out at $3 billion a day. M3 is growing at 14%, annualizing its three-month increase.

Past as Prologue

How does this compare with history? Not well. Sean Corrigan of

Capital Insight notes that current rates of increase haven't been seen since 1970-71, when "the U.S. fell off the gold exchange standard, presaging a breakdown in the world monetary order and sowing the seeds of the inflationary recession of 1973-1974."

'Not a Significant Problem'
Inflation vs. Capacity Utilization

Sources: Freelunch.com, Detox

Clearly, to allow an explosion in money of this proportions, Greenspan must be extremely relaxed about inflation. But the

Consumer Price Index

posted an annual rise of 3.3% in April. That doesn't seem terribly high, but that number was 3.1% in April 2000, 2.2% in April 1999 and a meager 1.5% in April 1998. It's also much higher than the current rates in the

European Union

and Japan.

So how can one have inflation during a slowdown? Before answering that, it's worth remembering that in the last 10 years inflation has twice risen when capacity usage has fallen off (see chart above). As now, capacity utilization came tumbling down in 1989 -- yet inflation zoomed above 6% soon after. The same sort of drop occurred in 1998 and prices ratcheted sharply higher. Capacity utilization tells us little.

Price Pressures

The problem in contemporary economics, at least on Wall Street, is that no one concentrates enough on relative prices. An economy can slow primarily because one sector has been hit -- tech, in this case -- but if other sectors are experiencing a bottleneck in the supply of labor, materials and capital, inflation can still rise. Because too little was invested in energy production in the '90s, prices in that sector are soaring. And something similar can be seen in health care and housing.

Rich Man's World
Money Growth Surges

Source: Detox

Now, a more level-headed country would let the adjustment process we're seeing continue unabated. If the central bank did nothing and printed no more new money, the extra money spent on energy bills would be subtracted from other expenditures.

This crunch also would ensure that firms that are producing unwanted products (DSL lines, routers and

knitting machines) downsize to the right degree. Overleveraged consumers would pay off debts and people would start to build up their savings from the chronically low levels. Something approaching balance would return to the economy.

However, if the Fed prints money so that people can pay for higher-priced items, including energy, the economy doesn't have to make a big adjustment -- for the moment. Paul Kasriel, chief economist at

Northern Trust

, gives a simple illustration of this point. Say an agricultural economy experiences a drought and production falls off. The central bank increases money supply. But the economy needs water to make the corn grow, not money. Instead, more money simply means higher prices. And today, the Fed can't supply natural gas, gasoline, new drug therapies, residential housing, or anything else that is in short supply. All it has to offer is paper money. "This increase in money supply is a recipe for inflation," Kasriel says.

Distortion

In essence, the central bank's meddling stops all the correct pricing signals from being sent, just as all governmental intervention in an economy will distort prices. Nearly all economists had accepted this by the time communism fell. Heck, even

The New Yorker

hailed one of the most penetrating thinkers on price distortion,

F.A. Hayek. But Hayek, who predicted the 1929 crash, also wrote that central banks can end up causing huge messes in capitalist systems by thinking they know exactly how much money an economy needs.

How does this all play out? One hugely useful force suppressing U.S. inflation is the strong dollar, which puts downward pressure on import prices. This weekend, Greenspan acknowledged the role the strong dollar has played in containing prices. The dollar's strength is as much the result of yen and euro weakness as confidence in the American economy. Here one can see the Ponzi-like nature of the U.S. economy. If the dollar were to fall, then inflation would really soar. But it may soon start plunging

because

of these inflation fears. If that happens, Greenspan will be forced to slam on the brakes by hiking rates aggressively, causing a rout in the stock and bond markets.

Many readers ask what Greenspan should have done when

Detox criticizes his policies. One must answer that all central bankers end up thinking they can correct the messes they have made, and often making things a lot worse -- look at Japan today. For that reason, the only answer is to get rid of the Fed altogether.

Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to

peavis@thestreet.com.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.