These should be the glory days for economists. With all of the good news accompanying this economic expansion -- low unemployment, steady growth, and low inflation -- you would expect to hear loud rejoicing from the nation’s economists for the success of their models. Instead, there is mystery in the air. Prices, which were supposed to skyrocket under tight labor markets, have remained steady, or have fallen. Fed Chairman Alan Greenspan, has repeatedly testified before Congress that the dual occurrence of low inflation and low unemployment is a great puzzle. Despite the economy’s healthy growth rate, inflation remains a non-event.

Why hasn’t demand overwhelmed supply this late in the expansion? The Keynesian model which Mr. Greenspan relies on for insight, offers no explanation outside of asserting that the statistics are not telling the true story.  One explanation, for example, is that the economy has been adding factory capacity more rapidly than was previously thought. Another explanation is that productivity is rising more rapidly than the data would have us believe. Such explanations are necessary because in the Keynesian model, prices generally rise when you have low unemployment and economic growth. After all, isn’t that when society’s demand for scarce resources rises?

Yet, in the Supply-side model there can be zero inflation, regardless the productivity gains, even if the economy is growing at double digits. Accordingly, a society’s increase in the demand for scarce resources cannot, by itself, cause the price level to rise. Increases in aggregate demand relative to aggregate supply do affect the relative price of output -- the amount of time it takes to produce an additional market basket. But this does not mean the price level will rise. In fact, it may fall.

When an economy has grown to the point that full employment and complete factory utilization are being reached, workplace inefficiencies are bound to occur. For example, if jobs are growing faster than the growth in tool shops or computer workstations, (depending on whether the output under discussion is high tech or low tech) production bottlenecks will inevitably arise. And though, most economists would begin warning policymakers of imminent demand-pull inflation, this fear would be misplaced.

If anything, additional output to the system while a fixed supply of money is maintained, translates into less dollars chasing more goods and, therefore, cause falling prices. This is because an increase in the demand for money due to an expanding economy will drive up the purchasing power of the dollar and drive down the price level of goods and services. Put differently, with more goods in the system, but the same amount of money, the price level is bound to fall unless more money is added to restore the previous goods/money balance. Far from being inflationary, growth, in all cases, here and everywhere, is innately deflationary. The whole idea of demand-pull inflation is nonsensical under a fixed money supply.

Key in this understanding is the distinction between the relative price of output and the nominal price of output. The relative price of output is the time used up in production of all goods and services in an economy. The nominal price of output is the amount of currency required to buy a market basket. Changes in the relative price of output do not signal where the price level itself will be.

Mr. Greenspan and his colleagues are having difficulty envisioning the deflationary consequences of this economic growth because as they draw their picture of inflation, they try to fit too much information into one diagram of aggregate demand and supply, when two separate diagrams -- one that establishes the time-price of output, output’s relative price, and another that establishes the price of money, its purchasing power -- are needed. Essentially, they fail to see the connection between both the money market and the real goods market. Monetary shocks can cause shocks in the market for real goods and services, via an unindexed tax code, which can cause variability in the level of output and the time price of output, just as fiscal shocks, such as tariff and/or tax changes, can cause the value of a currency to vary as when a change in output causes the demand for money to rise or fall independently of Fed policy.

Once the distinction between relative prices and nominal prices is integrated into the macro model, certain historical economic situations -- recognized as technically impossible in the Keynesian model -- are rendered conceivable, if not necessarily commonplace. For example, the Keynesian model cannot explain how the price level may rise when productivity increases during a period of either economic decline or zero growth. Nor can it account for a falling price level that occurs simultaneously with slowing productivity and an either stagnating or restructuring economy.

From this perspective we can readily explain the posssibility of a low productivity, low inflation, sustained growth economy. The absence of sufficient additions to the capital stock while jobs have been added is the principal explanation for sustained growth and low productivity. In today’s economy, many of us are working more hours and more jobs, perhaps because our taxes and perceived liabilities are higher. (To a tired workforce this could be a political issue, but so far has not become one.) The problem is that we lack the extra tools and technology that we need to give us the choice of substituting leisure for work. Meanwhile tight money, relative to rising demand for money, is causing the purchasing power of the dollar to rise.

One gets the sense that Mr. Greenspan understands something terribly wrong with his Keynesian explanation of what is going on in the economy. This is unnerving to markets. One minute we have the pleasant circumstance where the Chairman of the Federal Reserve is governing monetary policy with a steely focus on the price of gold like a hard money supply-sider. The next minute he is testifying before Congress like he’s a dyed-in-the-wool Keynesian, worried as he is about the limits of economic capacity. In which camp will he pitch his tent if economic conditions change?

Mr. Greenspan must recognize when the dollar is becoming too strong, just as he must recognize when it is weakening. Although deflation keeps effective taxes at statutory levels on the sale of capital assets and understates profits, and, therefore lowers taxes at capital intensive companies, via depreciation schedules, deflation can be, nevertheless, every bit as destructive as inflation. Forcing creditors to work either twice as hard to pay off their debts or, otherwise get forced into bankruptcy because their dollars will not stretch far enough to meet their fixed monthly obligations, serves no purpose whatsoever. Nor does it make sense for employees to have to find out the hard way, via lay-offs, that their nominal wages were too high given falling prices everywhere else in the system.

Supply-side economists have long preached that the dollar price of gold is the best proxy in the marketplace for determining the true purchasing power of the dollar. Gold’s price adjusts immediately to changes in the balance between the supply and demand for money, while other prices, often governed by long term contracts, can take far longer to adjust. If there were a better harbinger than gold for future changes to the general level of prices, then, by all means, that one should be used. In the meantime, gold remains the standard bearer.