August 20, 2010 3:03PM

Does High Unemployment Make Inflation Impossible?

By Alan Reynolds

Benn Steil and Paul Swartz wrote a technically brilliant yet readable Wall Street Journal tutorial explaining why “the Fed’s exit strategy is not credible, and that means a serious risk of high inflation down the road.” 


They are sure to be ignored by those of the Keynesian faith who have repeatedly assured us that inflation cannot possibly be a problem for many, many years. Why not? Because there is so much “slack” in the economy—a euphemism for high unemployment.
 
If this “slack theory” of inflation makes you too sanguine about future inflation, recall that it is the same theory that predicted stagflation would be impossible in 1973–75 and 1979–81.


Figures from The Economist, August 21, raise some doubts. The latest unemployment rate in Argentina is 8.3%, but CPI inflation over the past year was 12.2%. Unemployment in Venezuela is 8.2%, but inflation is 13.3%. Unemployment in Egypt is 9.1%, but inflation is 10.7%. Unemployment in India is 10.7%, but inflation is 13.7%. Unemployment in Turkey is 11%, but inflation is 7.6%. Wasn’t high unemployment supposed to make high inflation impossible? 


Perhaps Slack Theorists might take comfort from the fact that inflation is “only” 4.2% in South Africa, where unemployment is 25.3%. But that is not exactly solid proof.


Whenever Keynesian dogma proves so completely at odds with the facts, there is a powerful inclination among true believers and their herd of media apostles to cling to the theory and diregard the facts. 


Some volatile economists who previously worried about near‐​term U.S. inflation have switched to assuming (as they did in 2003) that high unemployment will produce deflation. Yet that is obviously not happening in the countries listed above. The only country with falling prices is Japan, with an unemployment rate of 5.3% (and foolishly high tax rates and decades of wasteful “fiscal stimulus”).


File the Steil‐​Swartz article away for future reference. 


And remember Reynolds’ Second Law: “Inflation is always lower before it moves higher.”