Thursday, May 01, 2008

Do recessions lead to inflation?

Robert Murphy thinks so, and produces a graph that to him suggests prices go up during a recession, not down:

However, this picture suggests to me that recessions follow periods of higher inflation, and maybe where that inflation continues during the recession, it could be put down to a sort of residual momentum. Why should prices fall at precisely the moment the NBER says a recession has started? Even a cut flower will maintain its bloom for a while.

On the other hand, it seems clear from the above graph that prices do generally seem to fall after a recession. Perhaps this is because of the recently reinforced lesson about thrift, so people become less keen to spend too much on stuff they don't need.

But it's also possible that the recession has cleansed certain inefficiencies in the use of capital - businesses that should have folded faster - and as that capital gets better employed elsewhere, it does its work of improving productivity.

Which it needs to, when people have become more cost-conscious. I recall reading about an American who found a way to sell dresses for a dollar in the Great Depression - he used a machine to stamp out the outline of 100 at a time, so only the machine sewing was needed, not the measuring and cutting. So it was still possible to buy a dress for your sweetheart when money was tight.

But the little hand-mill of monetary inflation continues to grind...


pejvan said...

I would have to agree on the interpretation of the graph with you.

What I am not sure about, is whether or not a recession in the US would be followed by a deflation. The potential reasons could be:
1- Bernanke pledging he won't let deflation occur in the US and is willing to print as much as needed

2- the USD being so weak against the other currencies and loosing ground in terms of "world-currency" which is AFAIK quite unprecedented?


Hi Pejvan. It's a tough call. Devaluation steals from foreigners who hold your currency, and makes your exports more competitive. If one party exploits this tactic, others will be tempted to do the same so they don't suffer these consequences. So it's possible to inflate the currency and still not stimulate the economy. All you might achieve is to steal from lenders and savers.

The banks would therefore wish to raise rates to preserve the value of the money they've loaned out, and also to retain their savers' money, which supplies the capital margin the banks are required to maintain. Otherwise, you'd get a run on the currency as savers cash out and invest in anything they think will hold its value.

Some say the desperation to avoid a deep recession will indeed push central banks into creating runaway inflation; these commentators tend to recommend gold, other commodities, farmland, or in extreme cases, food, medicines and weapons!

It looks as though you can have either a recession, or a recession plus the ruin of your currency.

By the way, why not install Google's translation widget on your blog?

pej said...

Hi Sackerson,

I believe than the US and UK governments will do everything they can to prevent the face-value of property from falling. Teaming with their non-independent central banks, they will have a very easy way to get out of the crisis: inflate a lot to prevent the face value from falling, even if in real terms the price would be collapsing.

They have shown already for the past 10 years that they don't work in the interest of their people nor of their country...

This way US citizens who tend to emphasize a lot the value of patriotism would never see that their central bank and government are the most unpatriotic people/institutions since within about 10-15 years, they managed to wipe out all the saving of their people, reduce the value of their currency for about 50 to 60%, create a huge deficit and spend trillions of USD having their own people killed on foreign soil, and probably breed what I think will be one of the worst recessions ever and plant the seeds of terrorism...

And since these people are firm believers/followers of Keynes theory, they probably agree that on the long term, they will be dead so why bother getting things on the track now?

Re: my blog, it's kind of outdated now and was dealing with politics in France so probably not of interest for non-French speaking people. I have been willing to build a new macro blog for many months now, I just need to find the time. Hopefully, I will be able to force myself into writing the first blog this week-end :-)

Semaj Mahgih said...

Another angle on why inflation doesn't drop is given by Mike Moffatt at Aboutdotcom:

Measures of inflation such as the Implicit Price Deflator for GDP are procyclical coincident economics indicators, so the inflation rate is high during booms and low during recessions.

Why is the inflation rate still positive in recessions?

The answer is that all else is not equal. The money supply is constantly expanding, so the economy has a consistent inflationary pressure. The Federal Reserve has a table listing the M1, M2, and M3 money supply.

During the worst recession America has experienced since World War II, from November 1973 to March 1975, real GDP fell by 4.9 percent.

This would have caused deflation, except that the money supply rose rapidly during this period, with the seasonally adjusted M2 rising 16.5% and the seasonally adjusted M3 rising 24.4%. The Consumer Price Index rose 14.68% during this severe recession.

A recessionary period with a high inflation rate is known as stagflation, a concept made famous by Milton Friedman. While inflation rates are generally lower during recessions, we can still experience high levels of inflation through the growth of the money supply.

So the key point here is that while the inflation rate rises during a boom and falls during a recession, it generally does not go below zero due to a consistently increasing money supply.


Thank you, James. Please see next post for the "little hand-mill".

pej said...

Hey Sackerson
Just created my new blog and made a couple of Q&D entries if you're interested.
Looks like I am more bear than bearwatch though I would like to avoid being too extreme in my comments...

Semaj Mahgih said...

Shall do so now.