Saturday, June 12, 2010

Understanding Inflation

Understanding Inflation

Paul Krugman keeps telling us that we need to keep stimulating the economy in America and Europe. What he rarely says too loudly is that there is a limit to how much this can be done by borrowing. The only possible source of money for that stimulation is to print it. [Of course it isn't literally printed: it is all just numbers in computers.]

When GFC/I hit, then banks did start printing money. They called it "Quantitative Easing". They used the printed money to buy bonds, and they promised that they would later unprint the money by selling the bonds. Printing money is criticized for causing inflation. Commentators seem to have no trouble saying this with a straight face when the reality in America and Europe is damaging deflation. We can certainly agree that unprinting money at this time will add to deflation.

So why is everyone so hysterical about inflation? We are usually pointed at Germany's bout of hyperinflation in the early 1920s as a lesson in the bad things that can happen. But hang on: After their burst of hyperinflation sorted out their economy, Germany got its act together, and only 15 years later they nearly conquered the whole of Europe. Meanwhile their victorious opponents who were also basket cases in the early 1920s didn't have inflation and they were still basket cases 15 years later. So we need to understand what inflation does that is helpful. But first a foray into politics.

Listen to the debate between the stimulators (led by Paul Krugman) and the deficit-reducers (led by right-wing parties everywhere, with the left too nervous to criticize). You would think that this was a purely technical debate about how best to run the economy in the national interest. Nothing could be further from the truth. When governments act they produce winners and losers. This has the unfailing effect of bringing out the engines of disinformation on both sides. And inflation makes losers of the most powerful people on the planet: lenders and people with cash in the bank.

Inflation makes it easy for borrowers to pay back their loans. This means that borrowers come to fully own the real physical assets that were the collatoral for the loan. They then lavish care and attention on those assets and make them as productive as they can be. Consider on the other hand what happens when the economy is weak and there is also deflation. The borrowers know that they can never repay that loan. They squeeze as much value as they can out of the assets without the ability or incentive to properly maintain them. The employees who know how to operate the equipment leave. Eventually the lenders get the assets but the value of those assets is substantially reduced.

So who wins from deflation and loses from a bit of inflation? Hardly anyone. Except that this misses some important human traits. One is that we hate seeing other people get something for nothing, and there is no doubt that debtors get that with inflation. Also humans see gains and losses in relative terms: we like to do better than others, particularly our neighbors. That's why increasing standards of living don't increase happiness. So the lenders rightly see inflation as transferring real wealth from them to debtors. And the lenders are the most powerful people on the planet.

So how much inflation do we need? Our main experience since WWII is that economies run well with about 3% growth and 2% inflation. This means about 5% growth in the nominal economy (the size of the economy in dollars, without taking into account the decline in the value of the dollar). It seems likely that this applies whatever the growth rate. If the real growth rate is 10% then a 5% deflation rate won't cause any problem. On the other side of the ledger, if the economy is declining at 2% for some reason, then you need 7% inflation to keep the wheels of commerce moving. [Note that we should be taking population change into account, so that the required growth in the nominal economy is probably 3% per head of population, assuming the added people are statistically similar to the existing population. But I'll ignore this subtlety.].

Why do we need this nominal growth? Without it then people who just sit on their money, and don't try to use it to generate wealth, do nearly as well as, or perhaps better than, the people who are trying to move the economy along.

Many people think the world would work better if money was a store of value as well as being a medium of exchange. That wouldn't work. Still there is merit in society storing valuable commodities to prepare for difficult times ahead. The government could sell certificates representing a basket of stored commodities. This would act as an additional sort of money that was a store of real world value. It would be similar to the gold standard back when you really could change your notes for gold, but it would not be based on a single commodity. Certificates would be cashable for money at any time for the current market value of the commodities. When the government has less certificates than stored commodities it would sell the commodities to restore balance.

The basket of commodities would be chosen (and adapted over time) to reflect the manufacturing and direct consumption needs of society. As such it would not be a distortion of production. Compare this with people that want to restore the gold standard. This would take monetary policy out of the hands of people trying to make the economy work, and place it back into the hands of miners, alchemists and conquistadors.