Along with the physical economy that produces goods and services, there is a paper economy that produces claims on those goods and services. The uncontrolled growth of the paper economy is largely responsible for today's extraordinary interest rates and for the very difficult task of permanently reducing inflation.

The paper economy is far broader than traditional definitions of the money supply. It includes money, credit, pension rights, social security entitlements and all other present and future claims on the physical economy's output of goods and services. Focusing on the paper economy leads to conclusions very different from those arrived at by the monetarist school of economics.

Monetarists believe that the path to lower inflation lies through controlling the growth of the narrowly defined money supply. The currently popular definitions of the money supply they want the Federal Reserve to control are cash, checking and savings accounts (including NOW accounts) and some portion of money market mutual funds.

By reducing the growth of this definition of money down to the real growth potential of the physical economy, monetarists believe that permanent price stability can be achieved with only a moderate amount of recessionary pain.

From the standpoint of the paper economy, the monetarists are focusing only on the tip of the iceberg. When the vast amount of other paper claims in the economy are considered, two very different conclusions emerge which monetarists neither anticipate nor appreciate.

The extraordinary high interest rates of the last two years were neither predicted nor welcomed by most economists, monetarists or otherwise. The few analysts who did predict soaring interest rates did so by looking beyond the narrow definitions of the money supply to the broader supply and demand for credit.

Economists such as Solomon Brothers' Henry Kaufman correctly predicted record interest rates, but not by focusing on the monetarists' definitions of money supply and its growth. They concentrated instead on the broader demands for credit such as bonds, mortgages, commercial paper and other financial claims on goods and services. They recognized that large federal deficits create demands for credit that compete with strong credit demands from an expanding private sector.

Public and private competition for credit sent interest rates soaring, but that was a competition the federal government was certain to win. The losers in the competition for credit include the housing industry, the auto industry and business capital spending.

The distinction between money and credit may seem academic at first, but that distinction is the heart of the problem. Monetarists define money only in terms of what can be used in transactions: Cash can be used to buy groceries and a checking account can be used to pay the utility bill, for instance.

Since credit instruments such as five-year Treasury notes can't be used at the local supermarket, monetarists exclude them from their definitions of the money supply to be controlled.

Plausible as the distinction between money and credit seems, it breaks down in practice. U.S. capital markets are so efficient that virtually any credit instrument can be turned into cash by taking it to a securities broker. Stocks, bonds and even second trust deed mortgages can be transformed from credit instruments into money at the option of the owner.

Even access to credit such as credit card lines and overdraft protection offered by banks can be transformed into money quickly and easily.

Whatever can be transformed quickly into money in fact is money, academic distinctions to the contrary. Brokerage firms are vehicles to transform credit and equity instruments into money, and it is no accident that the few economists who correctly predicted the rise of interest rates are employed by brokerage firms.

The practical experience of transforming credit into money and back again gave them a perspective that their fellow economists in government and academia did not have. By viewing money and credit together rather than as separate entities as monetarists do, economists at brokerage firms were able to see the bulging public and private demands for credit that led to new records in interest rates.

Combining money and credit helps predict interest rates, but it does not begin to approach the outer limits of the paper economy. The paper economy includes not only money and credit, but pension rights, Social Security entitlements and all other claims on the future goods and services produced by the physical economy. In the long run these other paper claims may be even more of an obstacle to controlling inflation than the current growth of money and credit.

At first there seems no connection between today's inflation and a worker's pension right or Social Security entitlement due in 20 years. The pension right can't be spent at the local supermarket and can't be converted into money through the nation's capital markets. Despite its lack of current liquidity, that distant pension right has both short-term and long-term inflationary impact.

The short-term inflationary impact arises from workers' diminished need to save for their own retirement. Instead of saving a large portion of current income for the later years, they feel free to spend it now under the comfortable assumption that their employer and the federal government will take care of them.

This "spend it now" attitude adds more demand to today's demand-induced inflation while it lowers the nation's savings rate on which capital formation and future economic growth depend. In monetarist terms, bank deposits--which once were true savings--become transactions balances to be spent, thus increasing both inflation and the velocity of money.

This short-term inflationary impact of pension rights and Social Security entitlements pales beside their long-term significance. As time goes by, those distant rights and entitlements become current demands for cash to be paid by former employers and by the federal government.

Those claims for cash will add enormous pressures on inflation, except where the pension plan is fully funded; in that exceptional case existing pension assets will be paid out to satisfy pension liabilities and no increase in the paper economy will take place.

The problem is that neither private nor public pension plans are fully funded. The unfunded deficit of private pension plans is measured only in billions of dollars, far smaller than the trillions of dollars of unfunded federal pension claims and Social Security entitlements.

Those unfunded federal obligations are a legacy of members of the "spend and elect" school of politics, many of whom are still in Congress. They bought votes by generously passing out claims on future federal dollars. It all seemed so painless at the time because passing out future entitlements did nothing to increase the federal deficit in the year the votes were bought.

Yesterday's painless purchase of votes is now today's painful process of budget cutting. Despite the difficult budget cuts already enacted, the narcotic growth of entitlement payments propels federal spending upward without any matching increase in federal revenues.

President Carter thought that his reforms fixed the Social Security system for the next decade, but already it is in financial trouble again. That trouble translates into ever-widening federal deficits unless more painful budget cuts or tax boosts are enacted.

This prospect of widening federal deficits illustrates the essential unity of the paper economy. Future entitlements become present federal expenditures, leading to yawning federal deficits. Those deficits are financed either by printing money, which is directly inflationary, or by creating new credit instruments such as Treasury bonds. When those new credit instruments reach the nation's capital markets they can be transformed into money, thereby creating new inflationary pressures with only a slight delay.

There is little hope of reducing inflation for good without halting the growth of the paper economy and extinguishing the excessive unfunded claims on future goods and services. Since no one wants to see his or her claim to enjoy goods and services extinguished, the war against inflation is never fought with an all-volunteer army. Other nations and other generations conscripted soldiers in the fight against inflation in one of two unpleasant ways.

Depressions wipe out paper claims in the most painful way possible. In the Depression of the 1930s, the paper economy went into reverse as the money supply contracted, securities such as stocks and bonds became worthless, and depositors lost their accounts in banks which closed their doors. When the paper economy contracted, the inflation of the 1920s turned into outright deflation.

The other way to wipe out excess paper claims is by a burst of unexpected hyperinflation, such as the one in Germany in the early 1920's. That hyperinflation destroys the real value of paper claims fixed in dollars such as mortgages, bonds and bank accounts. After 15 years of accelerating inflation, most U.S. investors have learned to avoid locking up their money at fixed rates of interest, so the hyperinflation option is unlikely to be as effective in the future as it was when people actually trusted the value of the U.S. dollar.

Depression and a burst of hyperinflation are both unpalatable, but history offers no other suggestions about how to stop inflation by extinguishing excessive paper claims on the physical economy's output of goods and services.

Logically, however, there is a third way. If the nation's output of goods and services grows fast enough, then perhaps all those paper claims can be met in a non-inflationary fashion. That is the essence of the supply side school of economics and is the hope of Reagonomics. If that hope is not realized, then the other two solutions to inflation are bleak.