Without productivity improvements, inflation will get us in the end

Governments face hard choices about spending and deficit levels but doing nothing will lead to inevitable decline. They would be well advised to heed this age old advice as they decide what to do: "there’s no such thing as a free lunch."

Editor’s note: this article is a precursor to the mini e-book: Managing in turbulent times: 4 Drucker strategies for weathering the economic storm

The U.S and the EU are facing the prospect of low and slow economic growth for the balance of this decade. Most economists believe this will be characterized by mounting deficits, rising unemployment, more sovereign credit downgrades, increased interest payments, galloping inflation, misguided economic policies and a host of other economic ills.

Simply put, the outlook is not good.

Anyone with a detectable heart beat who is up-to-date on current events realizes that swelling deficits will be financed in one or a combination of two ways––namely: (1) printing more money (i.e. quantitative easing) or; (2) raising tax levels.

Of course, government leaders could be practicing systematic abandonment of the things that don't work, never worked, and/or have outlived their usefulness. That would take hard work.

Further, they could be shifting resources from marginal or resultless activities and programs to activities that produce significant societal results. That would take hard work.

We will soon learn that we do not have infinite resources. We have to maximize the effectiveness of the resources we do have. That would take hard work.

Governments and consumers are feeling the squeeze

The government could be saving trillions of dollars. Yes trillions. This would require restructuring government agencies requiring formalized strategic planning as was done in the Clinton/Gore era to enforce the Government Performance and Results Act (GPRA) in addition to applying Lean Six Sigma to government agencies with the purpose of streamlining/reengineering operations.

Of course, the government could also be decentralizing critical activities as has been shown in many a white paper to create quantum leaps in government productivity. The usage of predictive analytics could save hundreds of billions of dollars in Medicare/Medicaid fraud.

The list is virtually endless. Experts of every stripe have written about management practices that could whittle many trillions off our mounting national debt. To do all these things takes hard work and a high level of competence.

Further, a change in economic policies would produce enormous economic growth.

But instead of doing many of these things, the government has decided to take the easy path. A path that requires printing more money and/or raising taxes.

The Consequences of Solution #1: Printing More Money

Printing more money almost always equates with inflation. More money in circulation without corresponding increases in goods and services translates into "too much money chasing too few goods."

Jay Prag, an economics professor at the Peter F. Drucker School of Management, provides an easy-to-understand explanation between money and prices:

"Simplifying things a bit, suppose the economy is 100 apples that are sold once a year and the money supply is $100 that is used once a year. The price of apples would be $1 per apple.

If we increase the money supply to $1000, but we don't change the number of apples or the frequency with which money is used, the price of apples would rise to $10 per apple; more money is chasing the same amount of goods.

If the money supply increases every year by more than the supply of apples, the price of apples will rise every year and inflation occurs: a sustained increase in prices."

Bottom line: In a very real sense this is what's happening. The government is printing more money. But they're not doing anything (that's working) to produce significantly more "apples" (i.e. goods and services).

Inflation is a tax

Purchasing power declines with increasing price levels. People have less discretionary income after they buy the essentials. So, what's the inevitable result? They start asking for "cost of living increases."

Yet giving increases in wages without corresponding increases in employee productivity always results in more inflation. Why?

A simple equation, formulated by C. Jackson Grayson, former pricing commissioners/czar during the Nixon administration illustrates this notion this quite well:

Wage Increases minus Productivity Increases = Price Increases

For example, if wages increase by 10% and productivity increases by 3%, then prices would increase by 7%.

From all the available evidence, productivity - especially knowledge worker productivity - will not keep pace with the demand for increased wages.

Just for the record: This type of inflation is called by some wage-push inflation. This differs from the type of inflation created by the government printing more money. That's called demand-pull inflation.

Simply put, many are expecting to be hit by both demand- pull and wage-push inflation. They are interrelated in this situation. Both lead to decreased purchasing power and even slower economic growth.

If people have less money to spend, they buy less. And guess what happens? Companies adjust supply to meet diminished demand. Translated, unemployment goes up. And economic recovery becomes just a slogan.

The Consequences of Solution #2: Raising Taxes

Again, why would the government want to raise taxes? Because the government has to pay for swelling deficits. Increased taxes reduce consumer expenditures. People have less money to spend.

To repeat: when taxes are raised to levels that dampen business investment and consumer spending, the economy slows or even slips into recession. It's really that simple.

Without substantial economic growth, unemployment rates could rise even higher than today's current rates, and more of each country's budget will be required to support the growing ranks of the unemployed.

It is scary. But easy-to-understand. The U.S. may be unable to create enough jobs to match its population growth, which is expected to rise by almost 30 million from its current 2012 level of 313 million to 342 million by 2020.

That's why many economic models predict unemployment rates will increase. Increased population growth and increased taxes are two key explanatory variables fueling this prediction.

The cost of unemployment, as we've all figured out by now, includes lost growth, the price of unemployment benefits, health costs, and a population that increasingly becomes demoralized, frustrated, and embittered.

What are we saying? Printing money and/or raising taxes to pay for runaway government spending leads to inflation which, in turn, leads to decreased consumer spending, increased unemployment, and possibly civil unrest.

This is not a new insight. It's not original or profound. Countless history books have validated this assertion. We have just, hopefully, cleared away all the fancy talk about the situation we face.

Inflation will get us in the end

We've all witnessed that any attempt at cutting entitlements––or even slowing their growth––is bitterly resisted. But the middle class really has no choice. Entitlements (benefits) will be cut in all developed countries––like it or not.

The only question is by what method. The least painful way is to do it openly––for instance by raising the age at which Americans get full Social Security benefits.

Said Peter F. Drucker: "If this is not accepted, middle-class entitlements will be cut by inflation, that is, by destroying the purchasing power of middle-class incomes."

To repeat: the only way the government can pay for ever-increasing entitlements–– without extraordinary economic growth––is by printing money and raising taxes. Now, try to explain this to a friend. Make the linkage between entitlements and inflation.

Hint: The more we borrow for entitlements, the more money we need to pay back creditors. And the EASY WAY to get that money is to print more money and/or raise taxes. That creates inflation.

Inflation reduces the purchasing power of middle-class families. And that gives them less discretionary or disposable income. That causes them to buy less and probably dip into their savings just to keep up with the essentials. And that creates diminished sales for many businesses which, in turn, leads to more unemployment.

To pay for Increased unemployment, government may have to print more money and increase taxes even more. It's a never-ending cycle.

"But this is nothing but Economics 101," most readers will protest, and they are right. It is nothing but elementary economics.

To start out with the results of printing money without corresponding increases in the supply of goods and services, with the notions of demand-pull and cost-push inflation, with the empirical evidence of the inverse relationship between rising taxes and consumption – this is what economics is all about.

But why, after all this time preaching economics, teaching economics, professing knowledge of economic thought, so few government leaders are willing to follow successful and tested prescriptions in developing viable economic policies, we cannot explain.

The fact remains that so far, any country who is willing to use the teachings of Milton Friedman, James M. Buchanan, Peter F. Drucker, Frederich Hayek, Douglas North, Joseph Schumpeter, George Stigler, and others as the basis for creating sound economic policies is likely to acquire economic growth and economic dominance in world markets fast and almost without risk.

Government economic policy decisions to restore economic growth

There's lots of talk among policymakers about what can be done. Some prescribe austerity programs, others promote more stimulus, and still others advocate a mix of both. But nothing seems to happen.

So until they decide what to do it's impossible to predict the rate of economic recovery. But those of us on the corporate battlefield cannot wait.

We have to live with the consequences of inaction. We even have to live with decisions - or really just good intentions – that are not converted into action.

Thankfully, there's a time lag between today's economic policy decisions (or lack of them) and tomorrow's economic results. It's the time lag that gives us a window of opportunity to thoughtfully and thoroughly figure out what to do.


For further reading see the accompanying article series: Drucker Series on managing in turbulent times or download the full series compiled in this mini e-book: Managing in turbulent times: 4 Drucker strategies for weathering the economic storm