Paul Krugman discusses some of the differences between the current credit crisis and inflationary environment and the 1970s.
Professor Krugman is correct in pointing out that today does not have the spiraling wage inflation of the 1970s. I’ll add that globalization and outsourcing has put a cap on many US wages, especially outside of technology and other high education specialties. However . . .
While that’s better for inflation in general, the failure of workers to keep up with cost increases is worse for the overall economy. At least in terms of consumer spending, which accounts for 70% of the US economy. And, it also means that many US workers are seeing their standard of living slide. Hence, why Inflation is called the cruelest tax of all. While no one wants to see wage increases at 11%, at least keeping up with price increases would help the retail sector, the hard-pressed housing sector, durable goods purchases, and perhaps even encourage some improvement in the savings rate.
And this is before we even get to the issue of how inflation is measured. As the chart above shows, it appears we aren’t anywhere near the levels of inflation seen during the 1970s. But that’s an apples-to-oranges comparison. Since the 1970s, there have been numerous changes to the way the BLS measures inflation — and none for the better. From substitution to hedonics to the rest of the cowardly idiocy of the Boskin commission (approved by one Bill Clinton), the way CPI inflation rate is measured today is, by design, significantly lower than it was in the 1970s. And while in my opinion, the Inflation of 2003-08 isn’t as bad as the 1973-78 era — its actually much closer than the BLS data would suggest.
Further, the OpEd notes that the Fed has — at least so far — staved off a total financial meltdown through their alphabet soup of credit facilities, lending nearly a trillion dollars to banks and brokers against all sorts of sketchy collateral (I am paraphrasing). The Fed has been much more robust in their response to today’s crisis versus the 1930s — they have to be; This crisis has become far more global far quicker than the 30s, thanks to the massive distribution of some $400 trillion dollars in derivatives throughout the global financial system. Where we diverge in our opinions is that rescuing the financial sector and keeping a lid on inflation are mutually exclusive goals. The credit crisis was never one caused by high rates. The Fed certainly could have responded by bringing rates down to 3.5% or even 3% without crimping borrowing.
Slashing rates to 2% is a proximate cause of the further weakening of the already damaged dollar — something today’s column does not mention. Indeed, its hard to discuss commodity inflation today and omit at least some mention of the weak dollar’s impact on oil and other prices. Once the dollar comes into the equation, the Fed’s contribution to its weakness must also be acknowledged.
Hence, we are engaging in a race between the weakening economy and the weakening American peso: If you can tell which will fall faster, you can place your bets on commodity prices. Will demand destruction caused by high prices happen faster than the shrinking of the yardstick that measures those prices? Will the economy contract quicker than the dollar? I don’t know, but whoever figures that out will have unique insight into future prices.
The Fed may have temporarily given the financial system a reprieve from its own worst excesses, but at a cost that is proving to be quite dear. Given the current account deficits and excess spending of the US government, I have little doubt that dollar weakness is not going away anytime soon. And that does not bode well for inflation prospects, regardless of short-term, price-driven demand destruction or further weakening in the economy.
A Return of That ’70s Show?
NYT June 2, 2008
Forms of Federal Reserve Lending to Financial Institutions
Federal Reserve Bank of New York
Embedded vs. non-embedded inflation
NYT, May 31, 2008, 1:27 pm