October 7, 2010

Why Inflation Matters

Key materials
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Although it has yet to make an appearance on the current economic scene, inflation continues to be a ghost that haunts the future of the U.S. economy. As part of the variety of expansions of government power over the course of the financial crisis and recession that followed, the Federal Reserve System has pumped an unprecedented amount of money into the banking system, effectively more than doubling the size of the money it creates. For now, that money remains in the banking system, and has yet to enter the spending stream to drive up prices and burden the economy with the various costs and consequences of inflation.

In addition, the trillions of dollars spent on the bailouts and stimulus package, as well as the expansion of government spending in the regular budget, create conditions favorable for inflation. Those trillions represent a large degree of deficit spending, and when added on to the trillions in debt accumulated by the Bush administration and those before it, the result is the over $13,000,000,000,000 in federal government debt that currently burdens our economy. That debt needs to be paid off somehow, some way. One way to do so is through inflating the money supply.

Moderate to high inflation is one of the surest ways to cause havoc in an otherwise productive economy and to undermine most people’s standard of living, especially those in the middle and lower class and those on fixed incomes. Even though many measures of inflationary expectations remain low, those are premised, to some degree, on the belief that the Federal Reserve (the Fed) can painlessly withdraw all of the funds it has injected over the past two years. Those low inflationary expectations also assume that the market for U.S. government bonds will remain strong and that the temptation for the Fed to buy up those bonds and turn them into money will not emerge.

But what if either of those scenarios did come to pass and inflation became a more immediate threat? Given the damage that moderate to high inflation can cause, as those who lived through the 1970s and early ’80s or who have experienced the hyper-inflations in other countries can recall, it is in our best interest to understand those dangers so as to do what we can to both protect ourselves and our families and to send a clear message to Washington that the policy environment needs to change. Washington needs to get its fiscal house in order before we get levels of inflation that will impose serious costs on the economy and the "fiscal houses" of millions of American families.

This study explains the mechanics of inflation and how large deficits and debts create a more favorable environment for inflation. After looking back at how inflation affected the cost of basic household goods in the 1970s and early 1980s, it explores the way inflation can damage the economy as a whole and undermine the price coordination process that is fundamental to markets and the economic growth they make possible. Even if inflation is not an immediate threat, the explosion in the deficit and debt over the last few years provides a reason to remind ourselves of the problems it can cause.