If the case for increased monetary stimulus could be summed up in one picture, it would be the above chart. For the last several decades, nominal spending in the U.S. has increased at a fairly steady rate, and businesses and individuals acted in the expectation that this trend would continue. Contracts were written, debts undertaken, and business ventures began under the assumption that there would be roughly 2% inflation per year. The lower total spending means that there is not enough money flowing through the system to fulfill these contracts and pay back these debts, which the result that you get lots of defaults, unemployment, and less economic growth. Monetary stimulus, such as the Fed’s QEII program, is aimed at returning nominal spending to trend, leading to lower unemployment, fewer defaults, and higher economic growth.
Some conservatives and libertarians, however, have been warning not of deflation but of hyperinflation. Here, for example, is libertarian economist Bob Murphy:
I have been warning of severe price inflation for some time, and when people ask me “hyperinflation?” I respond, “What do you mean by ‘hyper’?” Recently someone coaxed a number of 25% annual inflation out of me, since I think Bernanke will do what needs to be done to bring it down to the maximum acceptable level, which I somewhat arbitrarily put at about 25%. (Of course the true increase in CPI will probably be more like 35%, but the official press releases–if you have a gun to my head and force me to pick a number–I’m picturing around 25%.)
Sarah Palin has blasted the Fed’s QEII program, as have a few Republican-leaning economists and commentators. Of course, many other conservatives do support the Fed program (see here, here, here and here). However, it is worth considering why people think that the threat right now is that inflation is or will be too high, and whether this worry has any real justification.
The Fed has massively increased the monetary base in the wake of the current crisis. And increases in the monetary base do tend to be inflationary. It is only natural, therefore, that some people have concluded that there must be lots of inflation. This, however, is like noting that a house’s heater is on full blast and concluding that the house must be really hot. In reality the opposite is more likely to be the case: the reason the heater is on full blast is that the house is really cold.
Suppose that, in the fall of 2008, a mutant strain of cotton and linen-eating termite appeared and quickly gobbled up a third of the paper money in the United States. Demand for new dollars to replace this destroyed currency would rise dramatically, and unless the government printed large amounts of new money, the result would be massive deflation. Yet if you just looked at the rate at which Uncle Sam was printing greenbacks, you might easily conclude that the U.S. was due for massive inflation, not that it was acting to counteract massive deflation.
In actuality there was no dollar eating moth let loose on America in 2008. But something quite similar in effect did happen. Stocks crashed, home prices cratered, credit contracted. The a substantial portion of the net worth of many Americans disappeared into thin air. Without government action to counteract this, the result would have been a huge deflation akin to what happened in the 1930s. Its actions, therefore, were not inflationary so much as anti-deflationary.