Friday, September 26, 2014

Inflation, UNH! AH! What is it good for? Absolutely..... a few things actually.

Oh, inflation, you bane of existence.  You Weimar Zimbabwean destroyer of worlds, bringing terror into the souls of central bankers.  Why can't you be vanquished by our modern economy?  Well, the reason is that we (meaning not crazy people who study economics) want moderate inflation.  You may have heard talk of the Federal Reserve targeting 2% inflation and thought "why don't they target 0% inflation?  inflation is terrible".  And in fact so had I wondered in the past.  The reasons are complicated (as macro economics generally is, despite what some might tell you about it being just like a household budget.  it's not.), and as a non-economist I only have a limited understanding of them all.  But I'll try to run through the basics here based on my limited knowledge.First off, what is inflation?  Via Wikipedia: " inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.[1] When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy."

One of the great knocks on inflation is it degrades buying power. And of course this is true, and out of control inflation can cause severe price instability and lots of secondary economic problems and governments can get caught in an inflation spiral trying to print their way out of the crisis.  But in modern times and advanced economies this just hasn't happened in close to a century.  That's why the ever fearful inflation hawks have to point back to the Weimar Republic of the 1920's and war torn, third world, Zimbabwe to support their ever present screams of "HYPER INFLATION IS
COMING"!  To ignore the past is to be destined to repeat it.  But to ignore present realities leaves one living in the past instead of dealing with current reality.  The fact is the Fed and the rest of the major central banks around the world understand monetary economic theory, act mostly independently of short term political influence and have kept inflation well controlled for decades through many economic cycles and disruptions.  We're simply not living in a world where the USA needs to live in fear of hyper-inflation.  And of course the facts on the ground, despite the tearful cries from the Wall Street Journal and various other right wing, supply side economists, bear this out.  If you listened to them the last 6 years, and bet on soaring inflation and worthless treasury bonds, you'd have lost a lot of money.

But I digress.  Let look at why low to moderate inflation is desirable.  First off, consider a bank that's made a loan, such as a student loan.  With 0% inflation, the value of the loan payments in terms of purchasing power are constant of say 20 years.  As a net lender, the bank likes this.  If there's some inflation, the bank is losing real value on it's asset.  But remember, for every lender there's a debtor.  The student who took the loan graduates, gets a job and starts paying.  Inflation means this new worker is likely to get raises every year that meet or exceed inflation.  So for the young worker, real purchasing power stays stable or grows while debt service shrinks.  This is good for the debtor.    Now you might think "ok, so it's a wash.  one side wins, the other loses".  In a microecon sense this is true, but in a macro econ sense it is not necessarily true.  The debtor and lender are in different economic positions.  A young single college graduate is going to be constrained balance sheet constrained in their spending due to large college debt, while a bank very likely is not so constrained.  Particularly in a weak economy, such as now, banks and other large institutions are awash in cash with no place to spend it.   So in terms of effect on spending and GDP, helping a balance sheet constrained individual vs a lending institution with a strong balance sheet will lead to a better macroeconomic outcome.

The second reason why inflation is useful, especially during a demand driven recession, is it can pull spending forward.  Meaning, if the real value of your money is going to decrease over time, you are incetivized to make purchases today.  So I buy a car and GM builds a new production plant this year instead of next year when it will cost us both more.  This is particularly true for buyers who are holding under utilized cash, which is exactly the people you want spending in a recession which can otherwise lead to hoarding resources out of uncertainty.

Third, when economies try to adjust to a recession there are two "stickiness" problems.  First there's downward wage stickiness and the Zero Lower Bound on interest rates.  Downward wage stickiness means that both employees and employers are very resistant to wage cuts, even in a negative inflation environment where technically a nominal cut would equal no change in real compensation (people are not rational economic actors and anyone who tells you different is wrong).  The ZLB refers to situation when the short-term nominal interest rate is at or near zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth.  In other words,the Fed's monetary policy loses efficacy because they can't cut rates below 0%.  Inflation solves both these problems, allowing wages to adjust without nominal cuts and the real interest rate ( nominal rate - inflation) to go negative. 

Now, I'm probably missing lots of things and failing to explain or even understand some of the intricacies on this, but that's as good as it gets from me.  If you want a more professional opinion, go read a not rambling drunk.

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