John Hussman: Inflation Myth and Reality

Excerpt from the Hussman Funds' Weekly Market Comment (1/19/10):

Mainstream economists and Wall Street analysts hold two very specific views about inflation almost without exception. The first is that inflation is caused by monetary policy, and specifically by excessive money creation. That view is often accompanied by a slight modification that inflation can also be caused by excessive economic growth. The second view is that there is a predictable relationship between inflation and unemployment, known as the Phillips Curve, such that high unemployment is associated with low inflation, and low unemployment is associated with high inflation.

These views are either incomplete or inconsistent with actual economic data. But what's more interesting is that they're actually misinterpretations of economic theory. In order to fully understand this, you have to briefly suspend what you know, and carefully walk through a little bit of economic theory and what it implies about reality. Reality, as it turns out, behaves very much as theory suggests ... and not much as Wall Street believes (a few portions below are reprinted from the July 7, 2008 weekly comment).

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So how do you get inflation? Simple.

1) Increase the marginal utility of “stuff”: This happens either if the supply of goods and services becomes more scarce, or if the demand for goods and services becomes more eager.

2) Reduce the marginal utility of dollars: This happens either if the supply of dollars becomes more abundant, or if the demand to hold dollars becomes weaker.

Consider how this worked during the Great Depression. Output declined enormously, but the reason was that demand collapsed. The marginal utility of goods and services most likely declined during that period even though production itself was down. At the same time, despite a rapid increase in the monetary base during the Depression, people were frantic to convert their bank deposits into currency, so even the monetary growth that occurred wasn't nearly enough. The frantic demand for currency, resulting from credit fears, translated into a major increase in the marginal utility of money.

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The present situation is mixed. Demand has collapsed, so the marginal utility of goods is depressed. At the same time, there is enough residual risk aversion to keep the marginal utility of money elevated. For that reason, inflation has been contained despite a monstrous increase in the quantity of government liabilities. This situation is likely to endure for a while in the likely event that we get further credit difficulties and sustained unemployment. But it will not endure an eventual economic recovery a few years out. At that point, the huge stock of government liabilities will weigh on the marginal utility of money, while recovering demand presses upward on the marginal utility of goods and services. The result will be a very large and probably sustained inflation in the U.S. in the second half of the coming decade.