Perhaps the greatest threat to the American economy at the moment is an idea. It is the notion that economic growth can cause inflation.Almost all economists accept this false idea, having learned about it in textbooks written since World War II. This idea is also at the heart of Wall Street's fears that if the economy gets too strong the Federal Reserve will have to stop the party by raising interest rates.
This will "cool things off," as they say. Several officials at the Fed are known to believe in this idea, which is why there seems to be such perversity in the news lately.
For example, when the unemployment rate was reported to have climbed from 5.3 percent to 5.6 percent in August, the stock market soared 52 points and bonds rallied. Why? Because Wall Street believed that bad news on unemployment meant that the Fed would not be forced to end the party.
Specifically, the idea is that the economy can become "overheated" if production uses up the available workforce and the capacity of plant and equipment. That is, if too many workers are chasing too few jobs, they will bid up wages, forcing producers to raise prices, leading to a general inflationary spiral!
Likewise, if too many consumers want to buy goods from manufacturers whose machines are working at full steam, this strong demand will bump up prices of consumer goods.
Supply-side economists reject these notions. They argue, instead, that inflation is a momentary phenomenon. This means you can never have inflation because too many people or too many machines are working. Inflation can occur only if the central bank prints more money than workers and employers are demanding for the purpose of facilitating trade.
Imagine if there were no money in the system - that is, if there were all modern barter economy. The price of an orange is one apple. The price of an apple is one orange. Then, say, the demand for oranges rises and, be cause there are not enough men or machines to produce more, so does the price. The price of an orange be comes two apples!
Now suppose there are not enough men or machines to produce apples, because overheated demand spreads into that sector. Now the price of two oranges is two apples. In other words, we are right back where we started, even though the apple-orange economy is overheated.
In reality, inflation will occur only if the Federal Reserve increases the amount of money in the system by printing more of it. If there is $1 in the system to permit the apple grower to buy one orange, the price is $1 per apple (or $1 per orange). But if the Fed then doubles the amount of dollars in the economy, even though only $1 is needed, the price will go to $2 per apple.
In classical theory, all inflations, everywhere, begin with a rise in the price of gold in the local currency. The several supply-side governors of the Federal Reserve who have been resisting "cooling off" the economy with higher interest rates have pointed out that the price of gold has been falling of late, not rising. And, as the Economist recently noted, a falling gold price "suggests deflation, not inflation."
We have nothing to fear from the unemployment rate going to zero or capacity utilization rate going to 100 percent, as long as the price of gold tells us all prices are in balance. Thus, the Fed should not try to cool the economy by shutting it down with higher interest rates.
(Jude Wanniski is president of Polyconomics, a New Jersey consulting firm.)