Wednesday, January 26, 2011

10 Misconceptions of Inflation

I occasionally read articles by Jim Jubak of MSN Money when one of his articles is featured on homepage with a particularly intriguing title. Today, the catchy header on MSN was "Reasons to love inflation" [actual article titled, "10 reasons to love rising prices"].

No need to really follow the link, because I'll post his 10 reasons, along with rebuttals. In fairness to Jubak, about half of his ridiculous assertions are just silly--I guess his editor thought "10 reasons..." would entice more readers than, "A few reasons...." This article specifically addresses why Americans should love inflation, so he isn't pimping inflation for everyone.

1. Inflation keeps deflation from the door. Deflation can kill an economy (just ask the Japanese). With prices going lower every day, consumers have constant pressure to put off purchases because "it will be cheaper tomorrow." This is no way to run a modern consumer economy. Even the Chinese know it's a bad idea to discourage consumer spending. That's why savings accounts in China pay a negative real interest rate. Every yuan you save today is worth less tomorrow.

Sorry, Jim, I asked the Japanese and am waiting to hear back from the Chinese, but I'm still not convinced. You can't just make an integral assertion like this and then throw out a couple non sequitur non-points out to back it up. The reality is that deflation does not kill an economy, rather a decline in prices in necessary to correct prices that were driven up during boom conditions on speculation. The reality of the market is that people lose money when they make mistakes, deflation is one method by which this important liquidation occurs.

I will grant you that deflation is worse for people with low (or negative) savings, and since most Americans qualify in the category, deflation would hurt them. However, savings are the lifeblood of a healthy economy. That Americans are not prepared for economic reality, does not negate its necessity nor its inevitability.

2. Inflation gives us the illusion that we're making progress in our work lives. And that illusion provides critical grease for the economic wheels. Wouldn't a 5% raise feel good in 2011? Wouldn't it make you feel appreciated at work? You'd start to think that tomorrow you might be able to afford (fill in the blank). Even if that 5% raise was, once you subtracted inflation, equal to 0%, it sure would feel better than the honest-to-goodness 0% raises that many workers have received in the recent past. And workers who feel better -- even if as a result of an illusion -- are more productive (and less likely to throw a wrench at the servers).

Remember how I mentioned he was adding in fluff in order to come up with 10 reasons???

3. Inflation makes consumers feel richer, so they buy more. Policymakers are still trying to get the U.S. economy revving so that it produces more jobs. Waking up each morning knowing that your biggest asset, your house, is worth less doesn't make you want to strap on that American Express card and drive to the mall. (Don't give me this stuff about nominal versus real prices. We all live in a nominal world.)

The American economy suffered economic imbalances in conjunction with excess spending and debt which persist today. So naturally, the cure-all remedy for the mess is to drive people to spend more. This is absurd logic.

So what if policymakers are trying to rev up the US economy?--and by that, they are trying to induce spending and jobs, not fundamental economic growth. Just because policymakers are doing it doesn't mean it is correct policy. I thought this was an exposition to defend the policy of inflation, not to inform us of it and ask us to go along.

I also really love the deception involved here. 'Inflation will trick you cattle into thinking you have more wealth.' That, in and of itself is bad enough, but what's worse is that inflation doesn't just change the nominal wealth it redistributes the wealth in real terms. When all that new money comes into the economy, it doesn't magically appear pro-rata in everyone's bank out so that we all stay equally wealthy as before. The government and the lending institutions push that money out into the economy, primarily through politically targeted projects and big business. Wait, who am I kidding? I was being redundant; a politically targeted project usually is big business, in bed with government. In any case, that money isn't going to the middle class that policymakers are trying to trick.

4. Inflation makes consumers feel that saving is worthwhile. I've been trying to teach my kids to save. Do you know how impossible that is when banks pay 1% or less on the traditional passbook account? If it weren't for the free lollipop, there would be no way to get them to put a buck in at all. And we need inflation's help, not just in building a future generation of savers, but also in making the buy-on-credit-now versus save-to-buy-later decision tougher. Think there's any real incentive to save instead of just charging it when interest rates are so low? We need the whiff of inflation to push them higher.

This is hard to make sense of. I don't think Jubak is living in the real world or a free market fantasy land. You cannot save during periods of inflation. I cannot make that point clearly enough: YOU CANNOT SAVE DURING PERIODS OF INFLATION! Modest inflation like 2-3%, fine. But were talking inflation, not the standard year-to-year inflation we used to know. What drives inflation is low interest rates. In order to save your money, you put it away and earn interest. If the interest rates are low, though, and inflation persists, then you are saving your money in nominal terms, but you are losing wealth. (Remember how I mentioned inflation redistributes wealth?)

Then he argues that inflation will lead to higher interest rates. But this is just silly. We don't need inflation in order for this to happen. We need to remember that there is a true market for credit, just like everything else. We tend to forget this is the case because central planners have undermined this market through central banking. But interest is a charge for deferring consumption, and for incurring risk of loss/default. Savings are the supply. America has no savings so how can they have credit? You can't buy a product when there is no supply. Think about something really rare and ask yourself: does it cost a lot or is it cheap as dirt? A short supply of something, in this case savings, results in high cost of the product, in this case credit.

All the market fundamentals exist to justify massive increases in interest rates. But imagine someone with savings trying to get, say, 20% for his money. The bank is not going to pay it, they are getting money basically for free from the Fed because the Fed is printing money and lending it for nothing. Consumers won't pay the cost because the banks have all that cheap money that they can loan out for incredible profits at a low rate.

If you want high interest rates, why don't don't you try advocating for some sort of reforms in monetary control that will actually let the market determine fair and equitable interest rates in line with the economic conditions?

5. By eroding the value of money, inflation reinforces the value of concrete assets. That's important in a world that needs to do a lot of investing in finding and developing new supplies of commodities such as oil and copper. Anything that works to lower the relative cost of capital for these projects is a plus in industries with current supply/demand imbalances.

I can't make much sense of this statement at all. He may be suggesting that low interest rates, linked with the inflation, make financing capital investment cheaper so that oil can be sought out, drilled and refined. But, what about that whole thing he said a minute ago about inflation bringing about higher interest rates, which would have the opposite effect on capital investment? I can only hope this is not the point he wishes to make--except that this is frightfully the most coherent of the possibilities.

Furthermore, when credit isn't based on a pool of savings, but on the whims of the gurus in the ivory towers, low interest rates result in viable economic projects competing for funds while non-viable projects. Thus, essential capital that should be allocated to vital oil exploration and ore mining will be siphoned off by retail and service ventures that seem profitable due to the incorrect market signals being sent to entrepreneurs by the interest rate. At least when all that inflation leads to high interest rates, it will make only the most essential ventures profitable--unfortunately, those profits will come on the backs of high prices.

6. Inflation is essential to ending the slump in the housing markets. Cheap mortgage money isn't enough to get buyers into the market when they're afraid that the price of the asset is about to slump. We need inflation's help to get us back to the good old days when homeowners could count on their houses being worth more (in nominal dollars, I know) every year. Inflation can make home ownership a no-lose investment again.

The slump in the housing markets is essential to correcting the mistakes that were made in the last bubble. Propping up bad investments is not a sustainable economic policy. People made mistakes, and they will lose money. The faster these mistakes are behind us, the sooner we can move on.

And once again, Jubak refers to tricking people into thinking or feeling that they are richer, or their assets have appreciated by simply putting a bigger number on their assets without actually having market conditions change to bring true value to the investment. Apparently inflation is good for Americans like sugar pills are great for serious medical conditions. Real medicine not required, a simple placebo will do.

7. And while we're at it, we need inflation to make debt loads more affordable long term. How? By shrinking the real value of that debt every year. Owing $450,000 on a mortgage is much easier if inflation is eroding the value of that debt every year by 3% or so. (Yes, inflation pushes up the price of credit, but as long as your own debt carries a fixed interest rate, you don't really care about the higher rates future debtors will pay.)

I'm reminded of a joke: two economists are walking down the street when one of them sees a $50 bill on the ground and says, "Look, $50!" The other man replies, "There can't be $50 there, someone else would have picked it up already."

In other words, you can't just rip off your creditors by riding a wave of inflation, they already jumped on that wave too. Prices reflect forecasts into the future, including the price of credit, interest.

8. Without inflation we have no hope of containing the U.S. national debt. The U.S. government needs inflation to reduce the real value of its debt even more than strapped homeowners do. As of January 20, according to the very frightening U.S. debt clock, the U.S. national debt was $14.1 trillion. That's roughly $45,000 in debt for every U.S. citizen (which is almost as big a burden as the $52,000 in personal debt per citizen). That doesn't count the unfunded liabilities for programs such as Medicare. Think there's much chance that burden will be sustainable in the long term without some help from our friend inflation?

Inflation is not an increase in wealth, it is an increase in figures. You can't afford more stuff just by inflating the currency. Any manipulation of the currency is really going to be a default. I don't think we should even call it a national debt anymore. It is not going to be paid. Either the Debt will be restructured, which although it is a default is at least honest. More likely, the money will just be printed and worthless dollars will repay creditors for the valuable savings they sacrificed. Jubak is arguing a case for fulfilling the accounting figures of the financial obligations, but I hardly see that as an issue. What good is balancing the accounts when the value has been squandered. If and when it comes time to crank the printing presses in order to liquidate the debt and many of the entitlements, accounting is going to be the least of our problems.

9. Inflation is also crucial to restoring personal and national financial discipline. At current interest rates, money is simply too cheap for the U.S. federal government and Congress to pay much attention. At current interest rates, the payment on the U.S. national debt comes to just $3.5 trillion a year (or $11,310 a year per U.S. citizen). That's a ton of cash, but it's not enough to crowd out spending on crucial government programs. Inflation pushes up interest rates so that Americans can't afford to build that lame weapons system in some congressperson's district. Then, whammo, we have a crisis on our hands. And we all know we're not going to fix this problem without a crisis.

This is the same fallacy Jubak has been falling for throughout his article. The interest rates create the inflation! Asking for inflation to cure low interest rates is asking for low interest rates. It's silly. It's like a dieter saying, "I hope I get full soon, because I want to stop eating." Just put down the knife and fork and have some restraint!

10. Best of all, inflation makes it easier to tell stories that begin "When I was your age . . . " Try this one for fun: "When I was your age, I used to pick beans in the hot sun for a whole day to earn just $1." That sounds pretty good, at least until your kids are old enough to figure out that a $1 in 1958 would be worth about $7.60 today. (Here's an inflation calculator they could use. Don't let them near it.)

I was worried we weren't going to get any more fluff, but he managed to squeeze one more in there. Jus tfor fun, I'll disagree with Jubak on this as well. What do old people say? "I used to walk 10 miles in the snow, uphill, against the wind, both ways, to get to and from school." Old farts don't want to tell their grandkids about the candy bars that were "only a nickel". That sounds like grandpa was living in a utopia of free-flowing chocolate and jolly rancher raindrops. No, grandpas should be rooting for free market currencies and the consequent deflation. When our grandchildren are at the store buying 50-cent Mars bars, we can tell them about how Mars bars were $1.25 in our day, and we can throw in , just for good measure, "you youngins don't know how good you got it!"

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