Saturday, February 4, 2012

Misconceptions concerning inflation

We want a positive rate of inflation in order to keep the unemployment rate at tolerably low levels. We want a low rate of inflation in order to minimize relative price distortions due to price stickiness. Most importantly, we want a stable rate of inflation in order to facilitate intertemporal transactions (for example, almost every financial transaction). Occasionally, we may want a higher than normal inflation rate (now is one of those times) in order to lower real interest rates when nominal interest rates are stuck at zero. Normally, however, a low, positive, and stable rate of inflation is what we seek, and ever since Paul Volcker broke the back of unstable, double-digit inflation during the early '80s, the central bank of the United States, the Federal Reserve System, has more or less delivered on those inflation objectives. Why, then, do some people worry so much about inflation, and insist upon monetary regime change in order to contain an inflation problem that exists only in their own minds?

Misconception #1: Inflation hurts those who save. Recall the lending example in my previous post. If I naively lend you my savings, without taking inflation into account, then I will end up getting back less than I was expecting. If inflation is stable, however, I need only adjust the interest rate I charge you for the rate of inflation in order to get back exactly what I was expecting. In general, so long as inflation is stable, savers need not fear it, for they may simply demand higher interest rates to compensate them for it, which is what savers in fact do. (This is why high inflation is correlated with high interest rates, low inflation with low interest rates, etc.) The only savers that stable inflation hurts are those who save by hoarding cash (by stuffing it under their mattresses, for example). These people, however, have nobody to blame but themselves. Even in the context of perfect price stability (0% inflation), the rate of return on cash is inferior to equally safe alternatives (e.g., Treasury securities). And if you're really concerned about inflation, you can always buy TIPS (Treasury inflation-protected securities), which adjust Treasury yields for CPI inflation. The reality is even the most insecure people typically don't stuff a lot of cash under their mattresses; instead, they stick their cash in government-insured bank deposits. And banks, of course, adjust their interest rates for inflation. Savers have nothing to fear, therefore, besides unpredictable inflation, but everyone has a stake in keeping inflation predictable, not just the savers.

Misconception #2: Inflation raises people's cost of living. Inflation is any rise in the general level of prices. Hence, the more inflation we experience, the higher the price of gas, right? The higher the price of gas, the higher your cost of living, right? Not quite. Inflation does show up in higher gas prices, but it also shows up in higher wages. Much like savers adjust interest rates to compensate for inflation, workers adjust wages for the same reason. Even though gas prices are higher, so is your income, which means gas is just as affordable now as it was when gas prices were lower. The same reasoning applies to other commodities. Inflation raises the prices of the things you buy, but it also raises the amount of money you have with which to buy those things. It has nothing to do, therefore, with your cost of living. What does determine your cost of living? One word: scarcity. The less stuff there is, the more expensive it is to buy. If higher gas prices raise your cost of living, it is not because the Fed is printing too much money. Rather, it is because there's not enough gas out there to support the previously lower price of gas. Unfortunately, Dr. Bernanke is not known for his oil drilling skills, seeing as the only way he may lower gas prices without also lowering your wages is by drilling for more oil.

Misconception #3: The gold standard is the best recipe for keeping inflation in check. This is probably the nuttiest idea out there. The gold standard is a monetary regime in which the money supply is adjusted over time in order to keep the money-price of gold fixed. The idea is that gold's value is inherently stable, and thus the value of money would be thereby stabilized. Here's the problem: suppose miners in South Africa unexpectedly discover enormous reserves of gold. Such a discovery would sharply depress the goods-and-services-price of gold, but in order for the money-price of gold to remain fixed, the goods-and-services-price of money would have to fall sharply, too, generating a sudden burst of inflation. Sound stable to you? Or consider a historical example: just before the Great Depression, France began hoarding lots of gold, for reasons unknown to the rest of the world. This raised the goods-and-services price of gold dramatically, which under the gold standard meant that the good-and-services price of money had to rise dramatically, too. The result was that France imposed catastrophic deflation on every country on the gold standard, triggering the Great Depression. How do we know this? Countries like China and Spain, which were not on the gold standard, suffered only mild recessions, and essentially no deflation, because of the collapse of their trading partners. Every country on the gold standard plunged into depression, in the midst of historically rapid deflation. But here's the best part: the timing with which countries began to recover from the Great Depression is precisely the timing with which countries abandoned the gold standard. Here is US industrial production at the beginning of the Depression:

Guess what happened right at the trough in early 1933? FDR took the US off the international gold standard. For serious.

The last few decades show that determined central banks are perfectly capable of keeping inflation at low, positive, and stable rates, without surrendering monetary policy to the random forces at play in the gold market. Why, oh why, does anyone want to go back on the gold standard?

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