There are many negative things we can say about inflation: it provides incentives to avoid planning for the future; it erodes the value of fixed assets; it hurts those with fixed incomes; it creates a “buy now” attitude; it rewards excessive production; it erodes the purchasing power of the dollar with respect to foreign trade; and it acts as a deterrent to savings.
At the other extreme are those who claim inflation is not an issue at all because it will be adjusted by the free market over the long run. While that may be true, the path to the final adjustment can be treacherous, at best.
Let me explain why I think the current level of inflation is right for now — and may need to go even higher next year.
Currently, our economy appears to have a pretty reasonable balance of consumption and investment. In 2006, personal consumption currently ran slightly less than 71% of GDP, which is higher than the average of any decade to date.
Some economists would argue that this is a reflection of the theory that inflation makes consumption attractive and long-term fixed investment unattractive. But I think that analysis ignores the possibility that we have a growing population with more people actively working and thus able to spend more.
Personal spending is also up because investment earnings are providing people with more disposable income. And the productivity gains from investments are yielding ever-increasing returns, since the incremental investment is becoming less expensive and the scale of the output affected is much larger. This means that today smaller investments are yielding even greater results than history would have predicted.
Could trying to put a lid on inflation lead to a stranglehold on the economy? I think it could. Let's look at what happened in Germany during the late 1940s and early 1950s, when high levels of inflation led to anti-inflation regulations and, ultimately, a set of social programs that are very difficult to adjust.
I believe that these regulations led to restrictions on personal consumption, as well as to a decline in investment. Consequently, the economy spiraled downward, creating an environment that was not at all conducive to growth. In addition, the labor restrictions placed on companies acted as a deterrent to those that wanted to pursue speculative growth opportunities. It also led to a need to go outside the country to invest in capacity.
It's important to remember, too, that Germany went through a period of hyper-inflation, which is very different from the kind of inflation we see in the U.S. today.
During 2006, businesses in the U.S. increased investment in structures, i.e., production capacity, by 10% over 2005. At the same time, investment in equipment, a source of productivity gains, increased by 7% over year-ago levels. That was on top of a nearly 9% increase in equipment investment during 2005.
If future returns are expected to be lower, regardless of the present-value calculation, the result will be a dampening effect on investment. This is especially true if offshore investment opportunities yield greater returns.
The Federal Reserve Board can impact the rate of inflation by raising or lowering the discount rate, as well as increasing or decreasing the amount of money in circulation. While most would applaud the historic efforts of the Federal Reserve to meet its obligation to keep inflation in check, there comes a time economic growth must trump inflation.
Clearly, we need to maintain a balance between a level of inflation that is harmful to the economy — and society — and one that restricts economic growth. I think we are now at a point where we're becoming unnecessarily restrictive.