Idle Resources Don't Eliminate Inflation

Friday, August 13, 2010
One of the gravest sins of modern economics is its tendency to treat resources, both capital and labor, as essentially homogenous aggregates. Capital is more or less interchangeable with other capital, and labor is treated much the same. One reason for this is that such homogeneity and aggregation make mathematical modeling much more tractable, as well as making it easier to engage in econometric studies. But these assumptions can lead to major conceptual errors that matter for policy. For example, one of the arguments being trotted out these days is that we don't really have to worry about inflation because of all the resources that are currently idled. The high level of unemployment and idled machinery (and the increasing number of folks leaving the labor force altogether) is said to be "slack in the system" that will prevent any upsurge in spending deriving from the enormous excess reserves banks are holding from generating price inflation. The idea is that if spending rises, the idled resources can just be called forth into production without putting any upward pressure on prices. In the language of economics, we'll just make quantity adjustments rather than price adjustments. The problem with this is that it assumes that the idled labor and capital will be equally productive no matter where the additional spending takes place. That is, it is treating resources like lumps of clay that can be shaped into whatever form is needed to produce the goods demanded from the rise in spending. The problem is that resources are not clay. Both people and machines are more productive at some things than others, and are not productive at all at quite a number of things. Only if the increased spending leads to the demand for goods and services that the idled resources are distinctly capable of producing will inflation likely be low or absent. To the degree the spending is on items where already employed labor and capital are needed to produce them, then firms will begin to try to bid those resources away from their current uses, which can only be done with higher prices and wages given that the idled resources are not a close enough substitute for them. The result will be rising costs and prices, or inflation. In the complex world of the 21st century, labor and capital tend to be even more narrowly specialized than in the past, which suggests that any sort of match between the essentially random pattern of spending that starts inflation and the skills and productivities of the idled resources is not a likely outcome. Even with idled resources, there's plenty of reason to fear that the build up of excess reserves could manifest as price inflation. What Nobel Laureate F. A. Hayek said almost 80 years ago of John Maynard Keynes is no less true today: "aggregates conceal the most fundamental mechanisms of change." This article was originally posted on the NBR Blog, August 13, 2010. Image by Suat Eman / FreeDigitalPhotos.net.