Between a rock and a hard place

On his homeward voyage to Ithaca in Homer’s Odyssey, Odysseus is forced to sail through the narrow straits of Messina between Sicily and Italy. The 3.1 km passage creates a natural whirlpool making the passage dangerous.  Greek myth personifies the risks as two sea monsters. Charybdis lurks near Sicily, whose gapping mouth forms a whirlpool that swallows ships into her insatiable maw. On the Italian side lurks Scylla waiting to snatch sailors off their boats to their rocky doom.

On Circe’s advice, Odysseus must navigate this treacherous route.  Hanging close to Sicily would take his ship within the pull of Charybdis destroying his whole crew in the powerful whirlpool.  But going too close to Italy’s coastline brings him within reach of the six-headed Scylla that is sure to lose a few sailors to this ravenous sea-monster.  In the choice between death of all and death of just a few, Odysseus veers close to Scylla losing some of his brave crew.

This is the choice facing our economy in the year ahead.

Should the United States ramp up our monetary base through continued “Quantitative Easing” and send the ship of state toward the rocks of inflation, or should it slash our excessive governmental expenditures and veer the ship toward the whirlpool of ever increasing unemployment?

Should we risk inflation or should the new Congress stand up to out-of-control governmental expenditures and dampen the effervesce of multiple programs to stimulate with Cash for Clunkers,  $1,500 tax rebates for energy efficiency, $8,000 checks sent to First-Time Buyers of houses and other short-term expenditures?

The best choice typically is the one with more pros than cons. The choice puts us between a rock and hard place. It is the choice of where to be on the Phillip’s Curve tradeoff between inflation and unemployment.

The inflation monster
In the year ahead, the economy will make it safely between the two monsters by steering perilously close to inflation. Like Odysseus, the United States has selected its course to edge very close to the inflation monster, thinking the whirlpool is worse than the rocks.

Some of the signs of inflation appear in the record price of gold and other commodities such as food and gasoline, and other signs are found in weakness of the dollar.  Nevertheless, the consumer price index (CPI) for all urban consumers increased at a modest 1.1-percent rate in 2010. With housing costs declining, the full impact of higher inflation is not yet causing misery. But, this cannot last. The inflation rate will surely begin to rise in 2011, likely reaching 2.3 to 3 percent and then even higher in future years.

The essential “cause” of inflation is monetary growth. Ben Bernanke, chair of the Board of Governors of the Federal Reserve Board, continues to increase the monetary base at an astonishing rate. The monetary base doubled from September 2008 to September 2009, qualifying as the greatest percentage and dollar value increase in the past 100 years in U.S. history. A second round of easing added another 14 percent to the monetary base through November 2010.

Those who understand that the amount of money available tends to influence the price level are called monetarists. They recognize that more than doubling of the monetary base will eventually have to result in higher prices. Thus far, the velocity of money declined to offset the rising monetary base, but this is unlikely to persist for long.

In a recent article aptly titled, “Doubling Your Monetary Base and Surviving: Some International Experience,” Anderson, Gascon, and Liu (Reserve Bank of St. Louis Review, November/December 2010) show that large increases in the monetary base is simulative to GDP, but that the central bank must credibly commit to unwinding the expansion. The U.S. Fed is continuing its plan to stimulate. Few are convinced that the Fed is committed to unwinding anytime soon. So, for 2011 and the next few years, plan on reading that inflation “unexpectedly” ticked higher over and over again. You will know that more than doubling the monetary base by the Fed is the reason.

The unemployment monster
Since May 2009, the unemployment rate has flitted between 9 and 10 percent. Twenty months and counting of extended high unemployment is unprecedented since the Great Depression. While the U.S. has had higher unemployment rates of 10.8 percent in November and December of 1982, the number of unemployed and the duration of the high levels make this recession earn the title of a Great Recession.

Policies to fight unemployment have been indirect and largely ineffective. Programs to jump start the housing market in First-Time Buyers programs have had only short term success in shifting purchases of used houses to the period of the program without stimulating construction employment. Massive stimulus programs have spread money across public sector employers, arts groups and some construction projects, but the ballyhooed claim of shovel-ready job stimulus has sounded hollow as unemployment rates stayed high, month after month.

A rise in unemployment can cascade into pronounced pessimism, reducing consumer expenditures, resulting in further rounds of layoffs in a downward move akin to a whirlpool. Some economists argue that TARP (Troubled Asset Relief Program) or the nearly trillion-dollar Stimulus Package may have helped to save the economy from plummeting further into this whirlpool of decline, but there is an impressive history of economies going through a swoon, only later to come out of it without massive programs. There is also evidence of more than a year of increasing GDP and slowly declining initial unemployment claims that demonstrate that the economy has turned the corner. Given time and no further global shocks, the economy is now not likely to collapse.

The year ahead
The two extremes ahead are either worsening unemployment or worsening inflation.  The United States has skewed to the second – more inflation. Inflation is now quite low, but will begin to rise in 2011 to 2.3 to 3 percent. Higher inflation makes top line revenue look larger and often tends to improve business expectations.

While the Federal Reserve is flirting with inflation, viewed as Scylla, our economic ship will make it past the monsters. But like any monster movie, prowling hidden out there in the years ahead, these monsters never completely go away.

Richard D. Marcus, Ph.D., is chair of the executive committee of the Sheldon B. Lubar School of Business at the University of Wisconsin-Milwaukee.

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