Full Steam Ahead: "Inflation Overkill" Revisited

For the past few years, the United States has enjoyed unprecedented economic growth. Warnings that inflation would kick in if the economy grew faster than 2.5 to 3 percent have proven wrong. The theory of "maximum sustainable capacity" has been shattered. Jobs have been created -- despite large corporations' restructuring and downsizing -- by an incredible surge in the growth of small companies, increasingly fueled by the Internet and cheap capital. Unemployment remains near historic lows, and much of the country has grown wealthier.

My September/October 1994 article in these pages, "Inflation Overkill," proposed that the U.S. economy could grow at five to six percent without incurring inflation. It also stated that inflation was not a threat then, nor would it be in the foreseeable future. The six intervening years have proven these observations correct. What was true in 1994 is equally true today. Yet many economists continue to focus on old economic and financial indicators, overlooking the power of a new anti-inflation weapon: competition. Competition -- brought about by trade and technology -- has stripped most businesses of their pricing power. And if businesses cannot raise prices (and cannot make price increases stick), there is no inflation.

Open markets that allow for more trade, together with better information technology, are the best allies the Federal Reserve and central bankers around the world have in their fight against inflation. Those two forces are more effective in controlling prices than the age-old tool of raising interest rates. Yet the Fed does not seem to agree: it has raised its key interest rate almost continuously over the past year. The presumption that the Fed must move faster than inflation to prevent it could become self-fulfilling. Remember, money is a commodity, so raising the price of money can cause the price of goods and services to go up, triggering inflation. Ironically, the only institution today that has the power to raise prices is the Fed.

Inflation happens when too much money chases too few goods and services. Several Fed board members have expressed concern over an imbalance between demand and supply. But with open markets and competition, there is no such thing as a supply shortage. There are no shortages unless normal market forces are disrupted by protectionism, inefficient monopolies, outdated regulations, or overly tight money. There may be short-term bottlenecks in given areas, but competition works very well in open markets fueled by information technology. Competition, the speed of today's change, and the Internet -- with its auction and purchasing sites on one hand and its "dot com" companies on the other -- leave little room for demand to outstrip supply. In other words, it's the competition, stupid.

On the cost side are two potential inflationary culprits: energy and the cost of money (which has risen by more than 20 percent in the last year alone). Higher interest rates, along with higher fuel prices, are the twin factors that exert the greatest pressure on costs. Were it not for the steadily decreasing cost of other basic services like telecommunications and the fact that information technology has let businesses offset profit-margin pressure, inflation could return. Indeed, inflation has affected such old-economy areas as the hotel and airline industries, both of which have been hurt by interest rates and rising energy costs. So where are the "dangers of increased productivity" that many, including Fed Chair Alan Greenspan, fear? In fact, without those productivity gains, higher energy and interest costs might have forced up more prices. In short, the Fed must take care not to cause the very inflation it seeks to prevent.

Greenspan is also concerned about the so-called wealth effect: will greater asset wealth (fueled by high stock prices) cause excessive spending, which in turn creates a supply-demand imbalance? The theory is that every $1 of additional stock-market wealth will boost consumer spending by 3 or 4 cents. Several studies, however, including ones published by the Fed, question any meaningful linkage between greater wealth and excess spending. Are not economic prosperity and the creation of jobs and wealth laudable goals? And if competition keeps prices in check, where is the inflation?

We have seen only the early stages of the Internet's positive impact on economic growth and standards of living worldwide. Developing countries will be able to leapfrog into the economic mainstream as wireless communications and other technologies benefit businesses and consumers. Greater access to better information inevitably empowers consumers, be they businesses, governments, or individuals. Transparency exposes inefficiencies. The Internet reduces entry barriers and brings competition to previously protected arenas. Better, faster information fosters better markets -- in other words, faster supply to meet new demand.

This new world environment bodes well for an extended period of impressive economic growth with low inflation -- unless higher interest rates (or the expectation that the Fed will tighten them) put all this at risk. Let us hope the Fed embraces the power of its newfound allies and allows the phenomenon of the 1990s to continue.

James D. Robinson III is General Partner of RRE Ventures, a private venture investment firm, and former Chair and Chief Executive Officer of American Express Company.