Why Inflation Could Cripple the U.S. Economy, Capitalism, and Democracy

Ed's Ink

Though the annual deficit has been cut from $1.4 trillion in 2009 to an estimated $544 billion in 2016, a new report by the nonpartisan Congressional Budget Office warns it will balloon again soon.

Why? Because Social Security and Medicare costs will skyrocket to cover an aging population, we will need to pay interest payments on our accumulated public debt, and U.S. economy is plagued with slow/low growth (i.e., 2% per year).

The accumulated public debt—the total of all past deficits—is quickly approaching $20 trillion and will inevitably reach $22 trillion in the not-too-distant future.

Given today's spending trends, the CBO projects we will add another $8.5 trillion to the debt by 2025.

Most people do not realize the implications to their standard of living with respect to our rising accumulated public debt at ever-increasing deficits.

In a nutshell, our rising debt is unsustainable and seriously threatens our country's solvency in a financial or military crisis.

This article attempts to explain why out-of-control yearly deficits and our mounting accumulated public debt could lead to galloping inflation.

How Are Today's Deficits Being Financed?

Our swelling deficits will be financed in one or a combination of two ways: (1) printing more money (i.e. quantitative easing) or (2) raising tax levels.

Of course, government leaders could be practicing systematic abandonment of the things that don't work, never worked, or have outlived their usefulness. That would take hard work.

Further, they could be shifting resources from clearly identified marginal or result-less activities and programs to activities that produce significant societal and economic results. That would take hard work.

We will soon learn that we do not have infinite resources. We have to maximize the effectiveness of the resources we do have. That will take hard work.

The government could be saving trillions of dollars. Yes, trillions.

This would require restructuring government agencies and applying Six Sigma to government agencies with the purpose of streamlining or reengineering operations.

Of course, the government could also be decentralizing critical activities as has been shown in many a whitepaper to create quantum leaps in government productivity. The usage of predictive analytics could save hundreds of billions of dollars in Medicare/Medicaid fraud.

The list is virtually endless. Experts from many fields have written about management practices that could whittle many trillions off our yearly deficit and accumulating public debt. To do all these things takes hard work and a high level of management competence. It takes political courage.

Further, a change in economic policies would produce enormous economic growth. It's been proven, beyond a shadow of a doubt, that Neo-Classical economics (as opposed to Keynesian economics) work like a wonder drug.

But instead of doing any of these things, the government has decided to take the easy path. A path that requires printing more money and/or raising taxes.

The Consequences of Printing More Money

Printing more money almost always equates with inflation. More money in circulation without corresponding increases in goods and services translates into “too much money chasing too few goods.”

Jay Prag, celebrated economics professor at the Peter F. Drucker and Masatoshi Ito Graduate School of Management, provides an easy-to-understand explanation of the relationship between the amount of money in circulation and prices:

Simplifying things a bit, suppose the economy is 100 apples that are sold once a year and the money supply is $100 that is used once a year. The price of apples would be $1 per apple.

If we increase the money supply to $1000, but we don't change the number of apples or the frequency with which money is used, the price of apples would rise to $10 per apple; more money is chasing the same amount of goods.

If the money supply increases every year by more than the supply of apples, the price of apples will rise every year and inflation occurs: a sustained increase in prices.

Bottom line: In a very real sense this is what's happening. The government is printing more money. But they're not doing anything that's working to produce significantly more “apples” (i.e., goods and services).

Take Home Message: Currently, the United States and the European Union are facing the prospect low and slow economic growth until the year 2020.

By some estimates the United States will, on average, experience a 2% (or less) growth rate for the remainder of the decade; and the Eurozone 0.3%. Couple this with runaway printing presses to pay for existing and emerging new entitlement programs, and the price inflation seems to be a future that has already happened.

Inflation Is a Tax

Purchasing power declines with increasing price levels. People have less discretionary income after they buy the essentials. So, what's the inevitable result? They start asking for “cost of living increases.”

Yet giving increases in wages without corresponding increases in employee productivity always results in more inflation. Why?

A simple equation, formulated by C. Jackson Grayson, former pricing commissioner during the Nixon administration, illustrates this quite well:

Wage Increases minus Productivity Increases = Price Increases

For example, if wages increase by 10% and productivity increases by 3%, prices increase by 7%.

From all the available evidence, productivity (especially knowledge worker productivity) will not keep pace with the demand for increased wages.

Some call this wage-push inflation. This differs from the type of inflation created by the government printing more money. That's called demand-pull inflation.

Simply put, many are expecting to be hit by both demand-pull and wage-push inflation. They are interrelated in this situation. Both lead to decreased purchasing power and even slower economic growth.

If people have less money to spend, they buy less. And guess what happens? Companies adjust supply to meet diminished demand. Translated, unemployment goes up. And economic recovery becomes just a slogan.

The Consequences of Raising Taxes

Again, why would the government want to raise taxes? Because the government has to pay for swelling deficits. Increased taxes reduces consumer expenditures. People have less money to spend. In fancier language, this is called a decrease in disposable and/or discretionary income.

To repeat: When taxes are raised to levels that decrease discretionary spending, business investment lowers and the economy slows or even slips into recession. It's really that simple. And it doesn't have to happen. But misguided economic policies are a choice—a bad choice that will bring with it much misery.

Without substantial economic growth (as measured by GDP), unemployment rates could rise even higher than today's current "real" rate of approximately 10.5%. More of each country's budget will be required to support the growing ranks of the unemployed as those who drop out of the labor force opt for federal assistance.

It scary. But easy-to-understand.

Additionally, the U.S. may be unable to create enough jobs to match its population growth, which is expected to grow to 342 million by 2020.

That's why many econometric models predict real unemployment rates will increase. Printing money without corresponding economic growth and increased taxes are two key explanatory variables fueling this prediction.

The cost of unemployment, as we've all figured out by now, includes lost growth, the price of unemployment benefits, health costs, and a population that increasingly becomes demoralized, frustrated, and embittered.

What are we saying? Printing money and/or raising taxes to pay for runaway government spending leads to inflation which, in turn, leads to decreased consumer spending, increased unemployment, and possibly civil unrest.

This is not a new insight. It's not original or profound. Countless history books have validated this assertion. We just cleared away all the fancy talk about the situation we face.

Inflation Will Get Us In The End Unless…

We've all witnessed that any attempt at cutting entitlements––or even slowing their growth––is bitterly resisted.

But the middle class really has no choice. Entitlements (benefits) will be cut in all developed countries––like it or not.

The only question is by what method. The least painful way is to do it openly––for instance by raising the age at which Americans get full Social Security benefits.

Said Peter F. Drucker: "If this is not accepted, middle-class entitlements will be cut by inflation, that is, by destroying the purchasing power of middle-class incomes."

To repeat: The only way the government can pay for ever-increasing entitlements—without extraordinary economic growth or eliminating resource-devouring result-less government programs and activities—is by printing money and raising taxes.

Now, try to explain this to a friend. Make the linkage between entitlements and inflation.

Hint: The more we borrow for entitlements, the more money we need to pay back creditors. And the EASY WAY to get that money is to print more money and/or raise taxes. That creates inflation.

Inflation reduces the purchasing power of middle-class families. And that gives them less discretionary or disposable income. That causes them to buy less and probably dip into their savings just to keep up with the essentials.

And that creates diminished sales for many businesses which, in turn, leads to more unemployment.

To pay for increased unemployment, the government may have to print more money and increase taxes even more. It's a never-ending cycle.

"This is nothing but Economics 101," most readers will protest, and they are right. It is nothing but elementary economics.

But why, after all this time preaching economics, teaching economics, professing knowledge of economic thought, are so few government leaders willing to follow successful and tested prescriptions in developing viable economic policies? We cannot explain.

The fact remains that so far, any country who is willing to use the teachings of Milton Friedman, James M. Buchanan, Peter F. Drucker, Frederich Hayek, Douglas North, Joseph Schumpeter, George Stigler, and others as the basis for creating sound economic policies sees economic growth and economic dominance in world markets quickly and almost without risk.

Joseph Schumpeter's Uncanny Prediction

Joseph A. Schumpeter was considered by many to be one of the most important economists of the 20th century. Peter F. Drucker summarized a central theme in Schumpeter's best-known book, Capitalism, Socialism and Democracy:

For in a democracy, to be popular, government would increasingly shift income from producer to non-producer, would increasingly move income to where it would be saved and become capital for tomorrow to where it would be consumed…

Government in a democracy would thus be under increasing inflationary pressure. Eventually, he prophesied, inflation would destroy both democracy and capitalism.

When Schumpeter wrote this in 1942, most people laughed. Nothing seemed less likely than inflation based on economic success. Now in 2016, we see many people opposed to the ethos of wealth production, to savings, and to allocating resources to economic productivity.

This is based on naïveté. Perhaps the coming economic shocks will give people pause and motivate them to re-learn the painful lessons of economic history.

Government Economic Policy Decisions to Restore Economic Growth

There's lots of highfalutin talk among policymakers about what can be done. Some prescribe austerity programs, others promote more stimulus, and still others advocate a mix of both. But nothing seems to happen.

So until they decide what to do, it's impossible to predict the rate of economic recovery. But those of us on the corporate battlefield cannot wait.

We have to live with the consequences of inaction. We even have to live with decisions (or really just good intentions) not converted into action.

Thankfully, there's a time lag between today's economic policy decisions (or lack of them) and tomorrow's economic results. It's the time lag that gives us a window of opportunity to thoughtfully figure out what to do.

Over the next two months we will be publishing a series of articles relating to: The Drucker Prescriptions for Weathering the Coming Economic Storm: Strategies You Can Immediately Put Into Practice.