One of the common ideas floating around is that since the world’s productive capacity is not at its maximum level (that is, there is some slack from ‘maximum’ output), price inflation cannot occur. This is a highly attractive Keynesian idea because the apparent solution is very enticing- (1) just print some money, (2) distribute the money to the masses to spend, (3) thereby raising aggregate demand, (4) which in turn will pick up the slack in productive capacity, (5) thus, resulting in higher employment and higher utilisation of otherwise idle factories (6) without price inflation.
Governments all over the world (including the government of yours truly) are implementing this Keynesian solution in the hope of extricating the world out of a depression and restore economic growth. Unfortunately, this is one of the biggest fallacy in thinking.
Firstly, as Associate Professor Steve Keen has pointed, when you include the high levels of debt incurred by the private sector, a large fraction of the printed money will go into debt repayment. This may not be inflationary (in both the monetary and price sense), but it certainly will not ‘stimulate’ the economy. The economy was already ‘stimulated’ by uptake of debt and although forcing the masses to borrow more will ‘stimulate’ the economy in the short-term, it will set the scene for a bigger bust by pushing the economy one step towards sub-prime territory (the Australian government’s First-Home-Owner-Grant is a great example of a hare-brained policy).
Second, the idea of the level of productive capacity is highly defective. Indeed, there are official estimates that summarise the estimated level of usage of the economy’s productive capacity into a single convenient index. However, there are serious conceptual errors with such an index. As Henry Hazlitt wrote in The Inflation Crisis and How to Resolve It,
This is one reason why we cannot depend on the accuracy of the index. As Alan E. Shameer, associate economist of the General Electric Company, put it, “We have dozens of different plants, producing everything from jet engines to plastics to coal to washing machines. How can we possibly say with precision that the company is operating at such-and-such a rate of capacity? … It’s a jelly-like concept.”
If this is a jelly-like concept for one company alone, then how much more it will be for the entire economy? As Hazlitt continued,
These figures represent the average capacity utilization rate of all plants in all industries.
To understand this idea, consider the hypothetical example,
To make the real problem clearer, let us suppose that at the moment the average capacity utilization rate for all manufacturing is 80 percent. A Keynesian might then say that if we increased the money supply by 20 percent the result would be stimulating but not inflationary, because this new money would merely supply the purchasing power to buy 20 percent more goods, and industry already happens to have the idle capacity to turn out that much more goods “without inflation” or unwanted price increases.
But suppose this 80 percent average figure, though reasonably accurate, conceals a real situation in which the capacity utilization rate in different plants actually ranges from a low of 60 to a high of 100 percent, with the lowest 11 percent of plants operating at only 60 percent, the next 11 percent segment above that operating at 65 percent, the third segment at 70 percent, and so on, with the ninth and highest segment operating at full capacity.
Supposing the Keynesian scheme otherwise operates in accordance with the schemers’ intentions, what would be the result? All factories would be operating, or trying to operate, at a rate 20 percent higher than before. The half that had been operating at less than 80 percent could presumably do this, but the half that had already been operating above that rate would be running into bottlenecks and shortages in plant and equipment, not to speak of the problems of all manufacturers in buying additional specialized input and hiring additional specialized labor. Prices?including wage rates and other costs, which are themselves prices?would begin to soar.
So far, this second point is looking at the supply side of the problem.
The third fallacy with such Keynesian thinking is to look at the demand side. Even if all the printed monies are spent (and not used to repay debts), they will not be spread evenly throughout the? economy. What if a significant portion of them are spent on speculation? Indeed, that happened just a year ago (see Who is to blame for surging food and oil prices?), when the object of speculation was on agricultural commodities and oil. There was an outcry of food ‘shortages’ among the poor in developing nations as food prices surged. As oil prices were pushed towards US$147 by speculators, price inflation pressure intensified.
Even if the newly printed monies are not spent on speculation, the structure of the demand can result in further structural imbalances of the economy. To see why, consider the above-mentioned example. Sectors of the economy that are already in maximum productive capacity are most likely already experiencing high demand. More printed money can result in even higher demand on those already ‘maxed-out’ sectors. Consequently those sectors will experience even greater shortages in labour, material and bottle-necks, which is price inflationary.
Governments all over the world, through their commitment to such a fallacious Keynesian idea, are ignoring (or at least not fully addressing) the structural imbalances in the economy. As we wrote before in Overproduction or mis-configuration of production?, it is not just a simple case of over-capacity.