Necessary Inflation[Note that this is a based on earlier posts. The last two paragraphs have some new stuff.]
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 central 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. Maybe not. 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.
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 real 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.
To understand why money isn't, and can't be, a store of value, it is important to understand that you can't move wealth into the future through money. This seems like a strange statement when we do it every day. We put money in the money box and much later we get it out and spend it. But what really happens is this. When we put money in our money box we reduce the amount of money circulating. There is less money chasing the same amount of goods and services. So each bit of circulating money can get a bit more than it could before. There is a very small amount of deflation. When you get the money out of the money box to spend, then there is more money chasing the same amount of real stuff. So this reduces the value of all the other money circulating at that time. That's how the value gets back into the money that you kept in the money box. We need to understand how our economy might work if it is declining instead of growing, and to do that we need to think clearly about how money works. The important point here is that individuals can move wealth into the future through money, but society as a whole cannot. Society as a whole needs to move wealth into the future to prepare for difficult times, but it does this by storing non-perishable commodities and by building productive infrastructure.
If, as I and many others now believe, oil production rates have reached a plateau and will tend to decline from now on, then we need to change the fundamental infrastructure of society. This will lead to economic decline while we switch infrastructure. We need to understand how to run a declining economy to be as productive as possible. And we need to direct that production as much as possible to the infrastructure switch: electrification of transport, heating, farming and everything else, and the production of cheap electricity. Yes we need stimulus, but not random stimulus. Let's use the stimulus to make capital investments now, like electrified rail, that will protect us from the economic decline in the future.
To help us understand the issue, consider what Paul Krugman has recently written in his blog (http://krugman.blogs.nytimes.com/2010/07/17/more-on-deficit-limits/) "there’s also no question that right now, the proposition that the government can 'create wealth by printing money', which some other commenters call absurd, is the simple truth: deficit-financed government spending, paid for with either debt or newly created cash, will put resources that would otherwise be idle to work." By "right now" he means the American situation with high unemployment and zero interest rate. What he writes would be true in the situation that existed through most of the 20th Century where workers and working infrastructure were the only constraints and energy was cheap. But now we have infrastructure that is geared to oil use, and oil production can not be raised significantly at any affordable price. So when we stimulate we create activity that needs oil. This raises the price of oil, which negatively impacts other activities. So the Right's claim that government activity, particularly stimulus, steals from the real economy is correct in our oil-constrained world. However the Right's assumption that the free market will get us where we need to go will only be correct in the long run. We can't afford to be trying to electrify transport when oil production is actually declining, which will be happening in 10 years. Government needs to steal from the rest of the economy to force the transition to an electric economy as soon as possible. That's why stimulus should be used for energy use change and energy production infrastructure, and not for anything else.
Another recent blog post by Krugman (http://krugman.blogs.nytimes.com/2010/07/14/nobody-understands-the-liquidity-trap-wonkish/) explains why the America and Europe can't easily prevent deflation by just printing money to buy bonds. Governments need to print money and spend it. They could alternatively send it to the voters to try to restart Business As Usual, but that would be a mistake in our current oil production constrained situation.