Sunday, May 8, 2011

The True Meaning of Inflation

The always-compelling Wayne Lusvardi wrote a piece recently on a scarcely-reported result in that LA Times/USC poll we mentioned recently: some 80% of likely voters in California favor solving the state's budget crisis by means of a spending cap, far outpacing those calling for a mixture of spending cuts and tax hikes. Lusvardi wonders whether such a cap might provide a better solution to the state's looming pension tsunami than the current approach of gambling on 8% annual returns into perpetuity.

What real inflation looks like.
Lusvardi argues that inflation-adjusted measures of the state's economic output suggest that California's economy actually shrank over the past decade, even if the unadjusted gross state product grew over that time. The implication being that the state could only grow its way out of debt through nominal, rather than real, economic growth. As such, monetary inflation might save deadbeats like California's governments, but incomes and pensions would have to increase astronomically for the middle class to avoid being wiped out by it. To say nothing of the holders of government bonds, who would lose money as inflation eroded the value of payments. As such, Lusvardi vastly prefers a spending cap as a pragmatic solution to the state's debt.

The problem with this argument is that it relies on a popular misunderstanding of what inflation really is. Lusvardi refers to California's efforts to hike energy prices as "inflation", but this is incorrect. Prices can rise for three different reasons: an expansion in a good's supply, a contraction in the demand for that good, or an expansion in the supply of the commodity society uses for money. Properly speaking, "inflation" refers solely to monetary expansion, even if the public understands the term to mean "widespread rises in commodity prices". The distinction is important because, technically, California can't inflate its way out of debt; it can only hope that the Federal Reserve accomplishes that on its behalf. Renewable-energy policies, cap-and-trade taxes on pollution, and drought policies leading to higher energy prices aren't inflationary insofar as new money isn't created through them. Importantly, these higher prices act as a drag on economic activity, so it's not clear that California will see any more money as a result of them. Which implies that the state really is counting on unrealistic growth assumptions, Ben Bernanke's printing press, or a federal bailout to pay its debts.

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