Sunday, August 28, 2011

Higher Inflation Displays Bad Economics

Friday provided an interesting litmus test for Bernanke’s views on further monetary stimulus and the market’s perceptions of his comments. Leading up to the statement, I warned that expectations were very high with markets awaiting a repeat of Jackson Hole 2010. When the first headlines hit, claiming no new stimulus, markets dropped 2 percent in a matter of minutes. As individuals parsed through the speech, a report from the Wall Street Journal’s Jon Hilsenrath, who often “speaks” for the Fed, suggested that Bernanke had all but guaranteed QE3 in September. An enormous surge of buying reversed the losses and by the end of the day equity markets were up 1.5-2%.

Using history as a guide, the next few weeks could very well see further gains in equity markets and commodities (especially oil and gold), while the dollar weakens further. If expectations were high for Jackson Hole, it appears they will be even higher for the next FOMC meeting. At the last meeting, Bernanke faced a rarity in three dissenting members. Considering inflation is already within the Fed’s target range, a surge in oil and food prices similar to 2010 is unlikely to encourage further support inside or outside the FOMC. Despite the failure of QE2 to positively impact the real economy, markets are now expecting QE3 and we must prepare for the potential consequences of such a policy.

Although I remain skeptical of the power of monetary policy in this current environment, several economists on the left are calling for further monetary stimulus through higher inflation targets. The idea behind this theory is that higher inflation will reduce the real value of debt, encouraging consumers to stop saving and increase consumption. Witnessing a pickup in demand will then spur businesses to build up inventories and hire more employees. These actions result in a self-fulfilling cycle that sparks higher GDP growth and speeds up the timetable for reclaiming trend line growth.

While this notion of higher inflation targets as a panacea for growth sounds promising in theory, the policy makes a critical error common to economics, highlighted by Frédéric Bastiat many years ago. (emphasis mine)

“In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause--it is seen. The others unfold in succession--they are not seen: it is well for us if they are foreseen. Between a good and a bad economist this constitutes the whole difference--the one takes account of the visible effect; the other takes account both of the effects which are seen and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, at the risk of a small present evil.”

Bastiat, Frédéric (2005-05-31). Essays on Political Economy (Kindle Locations 485-491).

Earlier, I mentioned that inflation is already within the Fed’s targeted range but several economists are suggesting initiating higher targets. Before delving further into this discussion, ask yourself, why do we have inflation targets at all? Why is inflation desirable? These questions are rarely discussed in today’s society but were frequently debated by renowned economists in previous decades and centuries. Many of the economists, including Bastiat, concluded that inflation was a prime example of a policy whose “immediate consequence is favourable, [but] the ultimate consequences are fatal.”

Understanding this view of inflation requires initially dispelling a frequent misconception. Most discussion of inflation these days tends to remark at the increasing price of goods. In reality, inflation is the devaluation of money. Although this may seem like unnecessary semantics, the difference is actually substantial. The critical difference stems from recognizing that the change in comparative values stems not from any difference in the supply or demand for goods, but rather from an increase in the supply of money. As Milton Friedman stated, “Inflation is always and everywhere a monetary phenomenon.”

Regarding inflation as a monetary phenomenon allows us to recognize some misconceived ideals relating to value. Although value may be thought of in terms of money, the truth is that money is only valuable based on the amount and kind of goods a given quantity can purchase. An individual earning $10,000 per year in the 1920’s would certainly have been much better off than someone earning the same amount today.

Returning to the concept of inflation, it should now be clear that a higher rate of inflation means increasing the supply of money, not the demand for goods. The most obvious effect of inflation is therefore to make people feel richer, despite the truth that a collective peoples’ wants can not be satisfied any more than previously. If individuals all started with an equal amount of money and goods, the consequences of inflation would not be so severe. However, this is obviously not the case and the unseen effects of inflation have very serious distributional consequences.

Second, let us consider the effects of inflation on possession of goods versus money. Inflation is caused by an increase in the supply of money. An individual holding savings in cash or money therefore loses real purchasing power over time as those holdings are devalued. On the contrary, an individual possessing non-perishable goods will experience an increase in the real value of their holdings, which could be exchanged for a greater sum of money. Further, those individuals owning the necessary supplies and means for production of goods will benefit as well.

From these examples it should be apparent that inflation encourages the accumulation of debt and benefits those possessing and producing goods. The reverse also holds true as inflation discourages saving by either delaying consumption or not accepting debt. Provided these insights, it becomes obvious that inflation also promotes poor investment of capital.

So why are many economists arguing for higher inflation targets? When initially implemented, an inflationary policy should create a debt financed and consumption led burst in economic growth. This economic stimulus marks the immediate and seen portion of the policy. Over time, however, poor investment and a lack of savings prove insufficient to maintain aggregate demand. The resulting excess supply of goods causes falling prices and corresponding losses on investment. If this outcome only resulted in prices falling back to normal levels, one might concede the merits in creating inflation. Unfortunately, over the entire cycle, a lack of accumulated savings and misguided investment results in less goods being produced by society and therefore lower economic growth. It is these consequences that are ultimately fatal and too often not foreseen.
The other reason economists may argue for higher inflation is due to excess household debt that currently restrains demand. On the notion that household debt is excessive and provides a headwind to economic growth, I certainly agree. What I cannot condone is the use of inflation to remedy this problem. It is important to remember that for every debt there must be a corresponding credit. An inflationary policy hurts those individuals who have wisely saved or been careful in their investments, while helping those who lived beyond their means or invested poorly. Not only does inflation unfairly impair certain groups of individuals, but it encourages a continuation of the past actions that resulted in the current economic malaise. If debt reduction is desired, a better plan would involve enacting policies that allow debt to be written off. Principal reduction on home mortgages offers a reasonable example. In this case, the losses would fall on banks or mortgage lenders that made the poor investment (provided the loan). This policy largely constricts the consequences to those parties directly involved and should discourage similar practices going forward.

One other consideration that seems often overlooked is the distribution of individuals within an economy and how inflation affects the varying classes. As mentioned earlier, the groups benefiting the most from inflation either have excessive debt, significant non-cash assets, or the means for production of goods. Although excessive debt may often be thought of in relation to lower income groups, I think this idea may be incorrect for our consideration here. Wealthy individuals often appear to pose the least credit risk and are therefore able to obtain loans at low interest rates. Due to the cheap cost of debt, wealthy individuals frequently accept significant sums of debt to expand investments. On the opposing end of the spectrum, many lower income households likely experience difficulty obtaining loans, constraining the amount of outstanding debt they can acquire. From this perspective, at best, it seems inconclusive that one income class benefits more than another. As for the latter two groups, it seems fair to say that households with significant non-cash assets or owning the means for production, largely fall in upper income classes. Based on this assessment, one could reasonably suggest that inflation benefits the wealthy class at the expense of less wealthy households.

A final consideration of inflation must consider the effect of such policies on the government’s finances. During much of U.S. history, the federal government has run budget deficits. Despite no longer being necessary to finance spending, since removal of the gold standard, the federal government still sells debt in the form of Treasury bills and notes. By instituting an inflationary policy, the federal government ensures that the real value of it’s future debt burden is reduced. Inflation therefore allows the government to hide the real value of its expenses and slowly capture a greater share of wealth over time.

For decades the Federal Reserve has maintained a mandate for generating inflation, which is now being questioned with regards to whether the target level is high enough. As Bastiat warned, it appears several economists are falling into the trap of only noticing those consequences which are seen and failing to acknowledge those which are not. Better policy making requires attempting to foresee those effects that are not immediately visible. While a higher inflation policy likely creates an initial debt-financed expansion, the ultimate consequences are almost certainly reduced long-term growth and greater inequality.

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