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Phillips' Curve dissent
economic thought
MBA/MA - Anglo-American University International Finance
ERASMUS - International Finance
MBA - Money and Financial Markets
ERASMUS Money & Banking
M.A. Public Policy Economic Sociology
On the Origin of Facts

December 23, 2008

The Deflation Delusion Is the Phillips Curve In Reverse

By John Tamny
"…we must never lose sight of this maxim, that products are always
bought ultimately with products." Jean-Baptiste Say, A Treatise on
Political Economy
The Phillips Curve economic model is based on the notion that if a
nation's economy exhibits a great deal of strength, the end result is
inflation for demand allegedly outstripping supply. Federal Reserve
vice chairman Donald Kohn embraces this view along with the vast
majority of academic economists, including our present Fed chairman,
Ben Bernanke.
In a 2003 speech made while vice chairman at the Fed, Bernanke spoke
of looming inflationary pressures thanks to high levels of U.S.-based
capacity utilization, and in a July 2005 op-ed for the Wall Street
Journal, Bernanke asserted that there is a "highest level of
employment that can be sustained without creating inflationary
pressure." Intriguing thoughts at first glance, but Bernanke's very
assumptions are quickly disprovable once we consider the real-world
impact of economic strength.
When labor shortages in a nation's economy reveal themselves such that
wages rise, the latter is a signal to sidelined workers to offer up
their services in order to capture higher wages. And since economic
strength in one nation is rarely uniform (compare employment rates in
Detroit vs. Las Vegas), rising wages in one region of a country also
attract workers from areas where jobs are less plentiful. In the end,
labor shortages are always moderated by new entrants to tight labor
It should also be remembered that U.S. firms are not solely reliant on
workers within these fifty states. As CNN's Lou Dobbs frequently
reminds us, companies with an American address regularly access the
world's abundant labor supply in carrying out their operations. And if
that's not enough, the next time readers pump their own gas or buy
gifts and plane tickets on the Internet, they should remember that
innovations of the mind allowing self-service are the market's way of
working around labor shortages.
When we consider capacity utilization or what some economists call the
"output gap", the same scenarios apply. If manufacturing capacity is
running low in Tennessee, unused capacity in Flint (MI) can be
accessed. More importantly, Nike has never manufactured its myriad
products stateside, so when Bernanke suggests high capacity
utilization in the states could lead to inflationary pressures, he
ignores the basic truth that U.S. firms aren't limited to the
available capacity within our nation's borders.
But of greatest importance is the certain reality that demand is
simply the flipside of supply. We can only consume after we've
produced first. And if we've not produced, we must have collateral
based on past production so that we can borrow the capital of the
productive to facilitate our own consumption.
So while it's an appealing thought among academics that demand can
outstrip supply, the logic is easily disprovable. Our productivity in
the workplace is our demand, which means supply and demand in any
economy balance. Inflation is always and everywhere monetary in
nature, so absent monetary disturbance, demand spikes are by
definition preceded by supply spikes.
But with the U.S. economy presently struggling, many are suggesting
that deflation is now what ails us. The problem there is that just as
strong economic growth cannot cause inflation, flagging economic
health can in no way cause deflation. Indeed, all it takes to show why
this is the case is to reverse the above scenarios.
If a slowing economy leads to an increase in the supply of available
labor, this at first could lead to lower wages and salaries offered by
employers. If so, and we're seeing this already, the number of workers
that sideline themselves in response to falling wages rises. There's
also less labor migration from weaker regions, which means falling
wages are moderated by a reduction in the supply of workers.
And if wages are falling stateside, there's less economic incentive
for U.S.-based firms to access labor not in these fifty states.
"Outsourcing" is the certain result of strong economic growth, but if
growth is less than robust, it's marginally easier for companies to
limit their hiring to the states. Lastly, if labor's plentiful,
technological innovations meant to work around labor shortages become
less essential.
When the "output gap" is considered, if due to slower growth the
alleged gap rises, this simply means unused capacity will no longer be
accessed. There would be no pressing need to put mothballed factories
in weaker U.S. regions into operation, not to mention production
slated for overseas venues would more likely remain stateside.
Most important, however, is the basic truth that supply and demand are
one and the same. If discretionary spending among Americans declines,
that also means their supply has declined too. And for those who say
fear of the future has producers saving more, it can't be stressed
enough that saving in no way detracts from demand. Money saved is
merely lent out to others; some with near-term demands. So while it
might be appealing to assume that economic declines are deflationary,
simple logic tells us that a falloff in demand is nothing more than a
decline in supply.
Some of course would reply that clearance and going-out-of-business
sales that bring prices down are deflationary, but these examples too
don't pass the most basic of tests. Indeed, falling demand that is met
with fire sales is yet another market signal transmitted to producers
telling them to manufacture or offer less. So while retail sales are
the "deflationary" seen, the unseen is the reduced production that
eventually moderates retail pricing. Think the various airlines, and
the number of planes they have and will continue to remove from the
In 1992, this writer placed a 30-minute "long distance" call from
Austin (TX) to Houston that cost $15. Today, long distance calls
anywhere in the U.S. are mostly free. But is this deflation? Not in
the least. Thanks to competition making long distance essentially
costless, Americans have been able to demand other goods previously
unattainable, thus driving up their prices.
And if the theoretical is not enough, we can look at the empirical. If
the Fed's logic were remotely true, recessionary periods in the U.S.
would have been deflationary, while strong periods of economic growth
would have been characterized by rising prices. In truth, the opposite
has always been the case. The U.S. economy experienced no less than
four recessions from 1965 to 1982, but far from a deflationary era,
there's a general consensus that we experienced massive inflation.
Conversely, from 1982 to 2000, the U.S. economy pretty much grew
without interruption, and while the CPI is faulty at best, it
registered in the teens in the early '80s versus a 2.7% reading at the
end of the millennium.
In the end, today's deflation warnings are a perversion of the
concept. Inflation results when the currency is debased, and deflation
is the result when the currency's value rises above a non-inflationary
level. With the dollar still testing all-time lows, deflation only
exists if we're willing to completely redefine the notion altogether.
So with the dollar very weak, inflation is our problem, and it's one
that has the potential to get worse if the Treasury and Fed continue
to communicate to the markets their nonchalance when it comes to the
dollar's value. Put simply, the Treasury and Fed are presently
fighting non-existent deflation with more inflation.
For investors, this is a very bad signal indeed, because stocks
despise inflation for it eroding real returns on investments. In
short, the deflation delusion foretells many years more of subpar
market returns; all this thanks to a misreading of what is a very
basic concept.

John Tamny is editor of RealClearMarkets, a senior economist with H.C.
Wainwright Economics, and a senior economic advisor to Toreador
Research and Trading ( He can be reached at

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