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Price Movements Cut Through Circular Economy Talk

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Tired of the long, drawn-out debate on future economic growth? You're in good company. It's a necessary debate, because our individual livelihoods depend on it. But it's a frustrating one, because there's little agreement, and the arguments are oftimes circuitous -- even those made by the "experts." Is there a way out of the analytical quagmires that we are currently up to our axles in?

Economists come by circular thinking honestly. Prominent in the first few pages of first-year textbooks is the circular flow diagram. It posits that the economy is a continuum, with a simultaneity of activities that make it difficult to determine beginning or end.

You get a job, you get paid, you buy stuff that wasn't being bought before, firms increase production, they hire more people who then consume more, and so forth. In the mean time, governments levy taxes and re-inject funds at some other point on the continuum. Similarly, imports leak money out of the system, but exports bring money back in. Simple, right? When things are functioning well, yes. But slowdowns mess things up -- this circular flow is so tight that it can be extremely difficult to actually see the key sources of weakness.

Some don't really care, suggesting that weakness is the time for governments to step in, borrowing if necessary to get the economy going with spending injections. That's where context is important. In this latest go-round, the economy entered the down-cycle vastly over-stimulated.

Global government intervention, as significant as it was, proved akin to curing the hangover with vast amounts of liquor, postponing the inevitable. It bought us time, but little else except a mountain of debilitating debt.

Others advocated that other key public policy lever, interest rates. Low rates were aimed at getting the wheel going more quickly. The resulting flood of cash did convince us that money was available, preventing bank runs. Low rates were nice, but nobody -- not firms, definitely not consumers -- were in a borrowing mood. Lots of the liquidity ended up just sitting around.

The subsequent three years of slow motion have ignited the debate about what really gets an economy going. Everywhere, pundits are picking their point on the circular flow diagram, certain that "it will start here." Others suggest that it won't start anywhere; growth is permanently slower, for a variety of structural reasons. Can we make any sense of the circle, or is it, by its very structure, a mystery?

To some, the answers lie in psychology. Even here, the growth and decline triggers are nebulous, making for even more tightly circuitous reasoning. What we are really left with is the frustration that against all efforts to the contrary, the economy still experiences cycles, and not just small ones.

Globalization, innovation, fiscal wizardry and gutsy monetary experimentation haven't been able to stave it off. If growth and decay are inevitable, it then becomes essential to understand in real time what point of the business cycle the economy is at. That's a tall order. Is it possible?

Embedded at the core of economic activity is a key signal: prices. By their ups and downs, they illustrate moments of plenty, of shortage, of weak purchasing or red-hot demand. They catch the interplay of these. But they are no mere output of the system; they also influence supply and demand.

This is where deflation can be so debilitating. Firms faced with excess product slash prices to move their goods and services along. When this becomes general habit, and persists for a long time, folks get used to it, and they delay purchases as long as possible. It's a conundrum we find ourselves close to now, and we only need look to Japan to see how debilitating deflation can be.

The bottom line? The debate on growth will likely be circuitous well beyond the start of the next growth cycle. In all the banter, it's critical that we not forget the role of prices, and that in the current context, a little inflation may not be a bad thing at all. And remember, of the two ills of pricing, it's the one that central banks really know how to cure.