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Inflation Can Cause Recessions

Yesterday, Paul Krugman called someone “The Worst Economist” because that person said that inflation could cause recessions. Oh Paul oh Paul, even though you are a Nobel Prize winner, you are wrong this time. Let’s go this through, step by step:

What most people get wrong is that inflation is not always an overall phenomenon. For instance, nowadays inflation is lower (or even negative) in house prices, since they are overvalued relative to other goods and services. Consumers have realized this and are not willing to spend any more dollars on housing. Instead, they wait for those prices to fall.

Now, everybody’s talking about inflation in Emerging Markets as a result of all the “Western” excess liquidity floating around, looking for high yields. So, where, Paul, do you think would inflation increase the most as a result of money printing by “Western” central banks? And the problem is that demand for exports/imports depends not only on relative prices (which is what politicians and most economists suggest nowadays when they talk about China’s exchange rate). Rather, demand for foreign goods and services often depends much more on the simple question whether these goods and services can alternatively be bought in the home country or not. This is what economists call “structural deficits”. For instance, nowadays most textiles are produced in Asia, not in the USA. In other words, Americans have to import them, no matter what.

If you take a look at US imports and exports over the decades, you will see that imports rose steadily, whereas exports plunged every time there was a worldwide economic slowdown. So, it seems US import demand is rather inelastic, i.e., it doesn’t respond much to changing circumstances This means that a weaker dollar would only make oil and other imports more expensive. Exports react only if there is sufficient demand. And even if there was sufficient global demand (presumably as a result of all the money printing), this high global demand would increase oil prices even more. The result: Recession in the US, followed by recessions all over the world.

Of course, this all sounds like a typical business cycle. We had this in 1973, 1979, 1990, and 2008. The additional problem now is that American households still have not fully “deleveraged” yet, i.e., they need to increase saving. Employment still isn’t rising. As long as consumers are caught in such a feeble economy, they will not be able to endure much higher import prices without having to cut consumer spending even further.

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