The New Economic Reality

By Timothy Haight and Derek Stimel

For almost a year, a debate has raged as to whether the U.S. will enter a period of accelerated inflation or experience deflation. Economists aligned with monetarist views worry that the unprecedented trillion dollar deficits designed to stimulate the economy, but financed by borrowing and printing money, will lead to unprecedented inflation in the U.S. On the other hand, Keynesian economists worry that aggregate demand has fallen so low that the U.S. is stuck in a liquidity trap. A liquidity trap means banks and households increasingly hold money over less liquid assets out of fear, and households choose to save rather than spend. That further reduces aggregate demand, and the process repeats and deflation results. In that environment increases in the money supply will not cause inflation or stimulate the economy. To escape the liquidity trap, increasing inflation expectations through government stimulus is an advocated solution. Keynesians point to the experience of Japan during their 'lost decade' of the 1990s to support their position. Monetarists point to the U.S. experience of high inflation in the 1970s to support their position. While resolving this debate is important, ultimately, other events may decide the issue.

These monetary issues may in the end be dominated by longer-term trends. In that regard there are troubling signs. The increased integration of the world economy's production and markets has increased opportunity but also competition. In particular, the supply of labor from quickly industrializing countries including China, India, and Brazil among others raises the possibility of lower wages and higher unemployment in the U.S. going forward. Simultaneously, the increase in demand for energy and raw materials from these countries suggests a period of increasing commodity prices and ultimately inflation. The implication of these two events is lower purchasing power of wages and lower living standards for many Americans.

At the same time, our education system, which can help equip our workers with the necessary human capital to compete in that environment is lacking. Far too many high school students graduate or drop out without mastering needed skills. The strain the current recession places on state budgets will only make the problem worse. Further, the U.S. population is aging much like other developed nations. This 'graying' of the population implies an increased burden from health care and other entitlement costs that may dwarf our current fiscal problems. All of this is happening at a time when the winds of the political world appear to have shifted away from capitalism and towards socialism. Increased government interference in the marketplace distorts the price system leading to less efficient resource allocation and distorts the market discipline that rewards good decisions and punishes bad decisions.

While bleak, a course correction can mitigate some of these long-run trends. Unleashing the creative and entrepreneurial spirit of the U.S. like never before may be required in order to reap the benefits that innovation and technological progress bring. New approaches to energy are needed. Reforming education and entitlements are necessary. Growth and living standard improvements can only occur in an environment of free markets. Solutions must come from entrepreneurs in the private sector. So while the debate about the monetary possibility of inflation or deflation continues, and the realized outcome will affect the economy moving forward, longer-term trends and our responses to them will define our new economic reality.