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Inflation Goggles.

Posted by Gonzalo Schwarz
May 31, 2011

What is the true cost of inflation?  It causes so many problems and distortions that it is almost impossible to pin down.  The most obvious part of the cost is seen in the form of price inflation.  The general understanding is something like this: if a certain “basket of goods” would have cost X last year but now costs 1.05X, then the difference is price “inflation.”  The difference between that increase of 5% and any increase in your wage not due to increased productivity or hours worked (e.g. overtime), is the “cost” to you.  Of course, due to the nature of the way the new money is brought into the economy, to the extent that some incomes rise more slowly than prices in general, there are others that rise more quickly.  This is the sense in which the inflation is merely “redistribution,” because your loss is someone’s gain.

If it served some noble purpose, agreed upon voluntarily by all users of the money, this aspect of it would not be quite so objectionable.  If a society wanted the money supply to grow, whether to keep up with population growth, to match productivity growth, or for any other reason at all, they could simply institute a policy of choosing the amount of new money to create each year, dividing it by the number of 8 year old girls, and sending a check to each one.  The money would spread out through the economy at a fairly regular and predictable rate and by the time the effects of the injection had worn off, there would be a new crop of spenders waiting in the wings.

The first and most obvious objection to a plan such as this would be that it is unfair to subsidize big oil companies in this way, followed closely by alarm at being overrun by ponies.  Every year on Inflation Day sales of little plastic dolls would shoot up, and because the plastic in the dolls is made of petroleum byproducts the oil industry would see a spike in profits like clockwork every year.  Because this will draw more capital to the oil industry than would otherwise have occurred, it becomes obvious that money is not neutral, even in the long run; the creation of money has real effects on the economy even after the effect on relative prices has worked its way through.  If banks create money you will see a larger banking sector, and if money is mined out of the ground you will see a larger mining sector.

As long as princess dolls and ponies remain popular the distorted economy will lumber on with the new structure.  And having presumed that this is a voluntary transfer on the part of the society, there is no problem.  But what if tastes were to change, or if the transfer was not voluntary?  If princess dolls and ponies were to suddenly go out of style, or if the society decided to bestow its largess on 14 year old boys instead, the entire doll and pony show would come crashing down, along with industries closely related to the business of making and maintaining dolls and ponies; and if the transfer was not voluntary it would be quite obvious on its face that it was theft by fraud, pure and simple.

The destruction of wealth and the sowing of social strife are but the visible and obvious costs of inflation, however.  Another cost is the destruction of the knowledge that the planners running the inflation game need to accomplish their own goals on their own terms.  Assuming the benevolent goals of maintaining general price stability, full employment (or the natural rate of unemployment), and stable macroeconomic growth, the central bankers still need accurate and timely information to tell them which way to shift the levers.

An example of this is when economists talk about the threat of inflation coming when the economy begins to heat up.  This is a non-monetary explanation of price inflation and is logically impossible across the whole economy – more money spent on some goods necessarily means less spent on others. What they are saying is that more consumers out buying is bidding up prices, but what they are actually describing is monetary expansion through the credit market hitting prices and outpacing productivity gains (in fact, holding all else constant, improvements in technology and productivity would, over time, have the effect of lowering the prices of goods subject to these advances).  In some cases the needed information is just not available or subject to quantification; in all cases the relevant information is subject to varying time lags.

Worryingly, when something happens that clearly contradicts sound economic reasoning (an increase in productivity leads to prices rising), a well placed time lag can seem more impressive than logic, and you might end up with rules designed to cause havoc in an economy.  Economist Frank Shostak points out that “following the yearly rate of growth of industrial production lagged by 19 months… suggest[s] that the growth momentum of the core CPI is likely to strengthen,” seemingly suggesting that increases in productivity will induce more consumption and raise prices!  In fact, it is only the impact of the loose monetary policy making its way through the economy.  A slight increase in economic activity stimulates a flurry of credit creation through printing and fractional reserve banking; this increase dwarfs the productivity effect leading to higher prices.

Following policies, however well intentioned, that inevitably lead from miscalculation to miscalculation, is a recipe for disaster.  Key data and assumptions used by central bankers are misleading and dangerous to the economy and “contrary to popular thinking, the recent strengthening in some key US economic data such as employment doesn’t reflect economic strengthening but is simply a response to the strengthening of bubble activities that are setting in motion another economic bust.”