Can Capitalism Survive?

Chapter 1

Capital_151-200.indd 183 1/3/12 7:47 PM Chapter 1 The Long-Run Economic Outlook The most probable course of events in the American economy in the next ten to fifteen years is the following : ( 1) continuing, in fact, accelerating inflation; (2) no major depression, but occasional periods of reduced real output (and hence employment); (3) off-and-on price and wage controls; (4) a rising pattern of interest rates; (5) an increasing direction of private economic activity by public agencies; and (6) an increasingly hampered economy, with an associated decline in its efficiency and its capacity to produce economic growth. The most probable final outcome of all this is that the American economy will come to look very much like the English economy of today, an economy that one English observer has described as "sinking slowly under the sea, giggling as she goes down." The reasons for this probable course of events are many and complex. However, many of those reasons relate to what I believe to be serious misconceptions Capital_151-200.indd 184 1/3/12 7:47 PM 184. Can Capitalism Survive? about what inflation is, what causes it, and what it can and cannot produce. Misconceptions about Inflation ( 1) The primordial sin in treating of inflation is that of assuming that interest rates can be kept at some desired level (usually "low") by increasing the money supply, i.e., by an easy money policy. It is typically argued that high interest rates reduce investment, curtail output, reduce home building, penalize the debtorpoor to the advantage of the creditor-rich, etc., and that low interest rates are clearly to be preferred to high. This argument is filled with dubious connections, but the real trouble flows from the attempt to implement its thesis by means of continuous inflation. The fact of the matter is that the level of interest rates is a market phenomenon, and not only is it undesirable for government to seek to control it but it is largely impossible for it to do so as well. It is true that by adding to or subtracting from the rate of change in the money stock, temporary changes, particularly in short-term rates, can be achieved-and this illusion of effectiveness is the precise source of the problem. Suppose for example that the monetary authority (i.e., the Federal Reserve System) were to bring about a significant injection of new money into the economic stream over a short period of time. The point of impact of the Capital_151-200.indd 185 1/3/12 7:47 PM The Long-Run Economic Outlook • 185 injection would normally be the short-term money market , and the rather immediate consequence would be a fall in the short-term rate of interest. However, over the course of the next few months, as this new money churned through the economy, there would be a tendency for spending of all kinds to increase, with consequent upward pressure on prices. This in turn would lead both businesses and individuals to wish to spend more now, to build up inventories or undertake expansion of plant, or buy durables and homes now before prices go even higher. This increased propensity to spend would be translated into a sharply increased demand for loanable funds. This in turn would mean that the original increase in the quantity of money would be offset by the increased demand for loanable funds, and interest rates would start to climb. Moreover , as potential lenders would see prices rising, they would insist on an inflation premium in the interest rate; in other words, the supply curve of loanable funds would shift up and to the left, indicating that it would now take a higher rate to bring forth a given volume of loanable funds than was true before. But why can't this countering effect be matched or more than matched by continuing injections of new money? Because this would mean continuing inflation and this in turn would mean a demand by lenders for an even higher inflation premium on interest rates. To try to cure the problem of high interest rates by increasing the quantity of money, i.e., by inflation, is Capital_151-200.indd 186 1/3/12 7:48 PM 186. Can Capitalism Survive? like trying to cure a hangover by some "hair of the dog" the next morning. The temporary feeling of wellbeing is closely...