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Samizdata quote of the day The downside of zero inflation is that it does nothing to erode the value of debt, much of which is denominated in money terms. If your mortgage is £100,000 and the price level doubles, its real value has fallen to only £50,000. The world is still burdened with excessive debt, which is a worry for policy-makers. But a low inflation world forces them to confront this issue honestly, and not try to evade it by using the subterfuge of inflation.
– Paul Ormerod
Of course it is only a ‘downside’ if you are in debt, it is an upside if you are a saver and lender.
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Living within your means is easy once you’ve got your shit together.
But zero inflation will not assist with the euthanasia of the rentier, which Keynes was so keen on.
Sadly savers are being cheated by artificially low interest rates – wild government monetary policy designed to keep the Credit Bubble (“broad money”) economy going a bit longer.
If your mortgage is £100,000 and the price level doubles, its real value has fallen to only £50,000.
Is he talking about the value of the house has reduced, or the value of the mortgage (to the lender) has reduced? Surely “price level” affects everything?
Clearly the value of the debt to each of the parties.
The lender, naturally, prices in the expectation of inflation when setting terms for his loan. So, although it seems like the borrower is getting a deal, persistent inflation (the kind we have had for the last umpteen years in the western world) is really corrosive for both borrowers and lenders.
It would be both simpler and more economically desirable if the purchasing power of currency remained relatively static over long periods of time, but it would be much less politically desirable to the populist vote-buying class.
Although Omerod’s heart seems to be in the right place, he has a number of things wrong. First and foremost (and he’s not alone in this, of course) is that he conflates price increases (generally measured by CPI) with inflation. That was once true, in the days of hard money, when the only time you saw significant inflation was after the discovery of large quantities of gold (such as after the Spanish conquest of South America). But inflation is always and ever a monetary phenomenon, and in these days of fiat currencies and overbearing central banks the correlation between prices and inflation is grossly distorted. (This ignores, of course, the government’s systematic manipulation of the CPI measurement which, while annoying, isn’t really important to the points I want to make here.)
Omerod points to the deflation of the early 30’s, which he attributes to the collapse of demand, and that’s partly true. He also notes that over the last 150 years zero inflation, and even periods of deflation, were the norm, which he attributes to competition. Again, he’s partly right. Those periods of mild “secular deflation” (to use Schlichter’s term) were the consequence of a growing economy and a relatively constant monetary base. Broadly decreasing prices are a good thing; they are the reward to a society which maintains honest money and an economic/legal structure conducive to healthy growth.
Today we have neither. Our money has been debased beyond salvation, and our tax and regulatory environment stifles economic activity at every turn. Our central banks are manufacturing money at a terrifying rate, and the only reason we haven’t seen massive inflation is that most of it is bottled up in excess reserves at the Federal Reserve and on banks’ balance sheets. The economy is so weak that banks aren’t lending, so the only thing preventing hyperinflation is an anemic economy. And the only reason we aren’t seeing deflation on an even greater scale than in the 30’s is because some of that newly-printed money is “leaking” out into the broad economy and is offsetting the effects of the significant decrease in the velocity of money. In other words, by itself central banks’ reckless printing of money should have engendered hyperinflation; and by itself the moribund economies of western nations should have resulted in massive deflation; but in combination the two phenomena have largely offset each other. However, that delicate (and lucky) balance can’t last forever, and once it starts to tip in either direction it will start a cascade effect toward either hyperinflation or economic collapse. And in either case the ultimate result will be collapse.
Laird:
I’m particularly interested in your final paragraph. One of the things that has bothered me about the last few years is that, by my simplistic understanding, we should be experiencing massive price increases by now, because of massive increases in the money supply. But we’re not. We’re experiencing price increases as low as they’ve ever been in my lifetime.
If I understand what you’re saying, the U.S. dollar isn’t falling in value because the excess currency is stored here and here, and some similar places. That explanation does seem to fit the facts. But what is it that this situation — presumably, the result of “quantitative easing” — is intended to do? Is it merely to keep banks and financial institutions on some kind of life support by making their balance sheets look good?
“The lender, naturally, prices in the expectation of inflation when setting terms for his loan. So, although it seems like the borrower is getting a deal, persistent inflation (the kind we have had for the last umpteen years in the western world) is really corrosive for both borrowers and lenders”
Not quite, because tax. Inflation subsidises corporate borrowing, to the benefit of both lenders and borrowers. Lenders can put a lot of their loans in a tax free environment – eg offshore – and pay no tax on the lending. (Not every lender but a serious amount, you only need to look at figures for the money stashed offshore.) Corporate borrowers get a deduction. In a zero inflation environment with interest rates at 2% say, the subsidy is small. With 10% inflation and interest rates at 12%, the subsidy is sextupled – you’re getting a tax deduction for paying off the capital of your loan.
Now we shouldn’t whine about this too much. It’s not a subsidy as such, it’s only a reduction in corporate taxes, which is a good thing. But it’s a stupendously bad way of reducing corporate taxes, introducing a huge distortion into corporate balance sheets. Much better to cut the rate.
This dumb bogan is of the opinion that inflation from money creation by central bankers is that the money is in Chinese bank vaults from cheaper manufactured goods that have had detrimental effect on European and American manufacturing. The Central bankers have kicked an own goal.
Tedd, it’s a little more complicated than that. The excess dollars are also stored here, and on foreign central bank’s balance sheets. That latter point is important because the dollar remains the world’s reserve currency (although perhaps not for too much longer), so foreign banks find it necessary to stockpile large quantities of them. And that helps maintain the dollar’s value vis-à-vis other currencies while simultaneously helping put a damper on the inflationary effects of money printing.
The massive decrease in the velocity of money can be seen here. This is an artifact of the anemic economy, and ordinarily would result in deflation were it not for the offsetting inflationary effects of Quantitative Easing. I think you are correct that one of the intended purposes of QE is to make banks’ balance sheets look good. The other is to prop up the stock and bond markets, which is where some of that money is flowing. That’s why we’re seeing record highs on the equities averages and records low (even negative) bond yields. But that’s just my opinion; I’d be interested in reading others’ thoughts on this.
There is an interesting discussion in the comments above, particularly between Laird and Tedd, also with Lee Moore chipping in.
IMHO, the reason we do not have extreme inflation, given current central bank base rates is because the broad money supply is not increasing. This is through the following reasoning.
The broad money supply is determined by several factors. Central banks (eg BoE) emphasise the importance of their control by setting bank base rates; however, they are currently almost powerless on that front. The reason is that commercial bank money creation (of broad money) depends on both the supply of base (narrow) money and the effect of commercial bank loans. But, after a significant period of loosening of constraints on commercial bank loans (up to 2007) has rendered banks, and the world economy, too risk prone – hence the 2007/08 crash. Thus, since then, there have had to be major readjustments to more constrain commercial bank lending (increased bank capital and liquidity requirements through Basel III). This has led to major constraints on the broad money supply – though these greater constraints have had to be applied somewhat gently and gradually. Without increasing the base money supply (through extensive quantitative easing, QE), there would have been a massive shortfall of broad money, leading to some sort of collapse in the world economy.
I strongly suspect that the current mismatch between inflation (low) and interest rates (very low) will continue, along with need for some further QE, until the ‘somewhat gentle and gradual’ readjustment of commercial bank financial stabilisation has been completed.
Best regards
I think the immediate question is why is the erosion of debt supposed to be a good thing? If you borrowed it, pay it back. If you got paid enough to buy a small car, you should be able to stick the money in your mattress and ten years later, pull it out and buy a small car (subject to genuine market fluctuations, of course). Anything else is theft.
It’s hard to see why there is any inflation at all, apart from governments’ monetary policy. Factor productivity is constantly rising so pretty well everything is becoming cheaper in real terms. If anything, wages should be falling in relation to production as the resultant reduced demand for labour* works its way through markets. So what we should have is constant gentle deflation with only things aren’t affected by innovation – land prices for instance – maintaining monetary value.
*Not saying it necessarily would of course, overall. For as we become richer (prices falling) we find new things need doing.
Laird:
Thank you for that further explanation, which I think I basically understand. We’re not seeing increasing prices because the new money being printed is either out of circulation in reserves or its effect is attenuated by the decreasing velocity of money. Is this explanation broadly accepted, or is the explanation itself contentious? In other words, do neo-Keynsians accept that this is the correct explanation but argue that it’s a good strategy, or do they reject this as an explanation for why quantitative easing hasn’t led to price increases?
BIS, that’s exactly correct (in my not-so-humble opinion!). The phenomenon is what Detlev Schlichter calls “secular deflation”: with a stable monetary base, economic growth (and increased productivity) naturally results in a gradual decline in prices on a macro basis (recognizing that pricing on individual items is also subject to various other factors). Which is precisely as it should be, if government were not stealing our wealth through the “stealth tax” of inflation. The effect can be seen graphically here, if you select US Consumer Price Index (the first box) and use the years 1800 to 1920. Over that period (which was largely dominated by hard money) CPI was generally stable or declining except during periods of war (1812 and Civil War). In 1913 the Federal Reserve was created and started printing money (and of course WW1 occurred shortly thereafter), and the CPI has seen a more-or-less steady increase since then. And once Nixon closed the gold window in 1971, thus removing the last constraint on money printing, it really took off. (Incidentally, you get basically the same results if you use the UK Retail Price Index.)
Tedd, I don’t know the answer to your question. I find reading neo-Keynsian bilge, such as that from Paul Krugman, so infuriating that I can’t get through it enough to really know their position on this. Perhaps someone else can answer that.
Richard Thomas, the reason mainstream economists believe that the erosion of debt is a good thing is that it reduces the real cost of government borrowing. I don’t think they really care that it reduces the real cost of consumer borrowing as well; that’s just an ancillary effect. They also believe that it provides an incentive to investment, since if you just put your money under the mattress after a few years it will have lost purchasing power. The only way to keep up is to invest it in something which produces a return greater than the rate of inflation. Which, incidentally, gets right back to the benefits to government, since it taxes those gains even if they do nothing more than offset inflation. So it’s a win-win for government (which is effectively who pays most economists).
An additional governmental benefit to inflation comes from its effect on wages. If prices go up 5% and you get a 5% raise in salary to compensate, that extra income is taxed (and might even push you into a higher bracket). However, if secular deflation effectively increases your purchasing power, there is no practical way for the government to tax that other than to increase nominal tax rates, which is politically difficult. Which is why governments hate deflation (regardless of what other arguments they may use).
The entire concept of a rate of inflation is bizarre. The first IBM PCs cost as much as a flat. Look at housing prices and computer prices over, say, the last 40 years.
Actually, inflation makes no difference to either. What makes a difference is *unpredicted* inflation. If people can accurately predict price levels, then the inflation is priced into the interest rates, and it’s a wash.
But interest rates are completely rigged, so…
Alsadius, what also helps is when you’re close to the government and get to “predict” those price levels ahead of everybody else.