I've been thinking about inflation a lot lately. Some time ago, I realised that I had no understanding of what inflation was all about, and I was somewhat embarrassed by this knowledge gap. Since then, I've tried to build a model of understanding for inflation, and it goes something like this...
Inflation verses CPI
Generally, the inflation rate is reported in terms of the consumer price index (CPI), which is the amount that baskets of goods rise in price over time. This is misleading, because it leads to the belief that the price of the basket of goods is rising, rather than that the purchasing power of the money being used to buy the basket is falling. So, rather than focus on the CPI, which is one possible consequence of inflation, let's look at what inflation actually is.
Inflation is an increase in the money supply. Pure and simple. An increase in the money supply generally leads to increases in prices, but can also have other consequences as well.
Historically then, inflation generally occurred when a boat load of money arrived from lands elsewhere, in the form of gold, silver, rum, or whatever happened to be the currency of the day. As this new money filters it's way through the town, the price of the town's goods & services generally rose.
Nowadays, money gets created in different ways. Firstly, through the direct printing of fiat currencies, in either physical or digital form. Secondly, through fractional reserve banking systems. Banks are allowed to lend out more money than they have in capital, which, for any other company, would be an insolvent position, and only need to maintain a capital reserve ratio of about 15%. Thus, every time a bank loans money, most of this "loan" money is actually new money, which, by definition, is inflation.
Central Bankers Role
The only problem with the fractional-reserve-banking system of money creation is that it's not a one way street. In the same way that the net issuing of loans causes money to be created, the net paying-off of banking loans causes that money to vanish, which is, by definition deflationary.
Now, governments, central banks, and banks all love inflation, and hate deflation, so they try and prevent deflation at all costs. So, when the CPI starts getting "too low", generally at less than 2%, the central banks lower interest rates to encourage more bank lending, more new money creation, more inflation, leading to higher CPI. Similarly, when the CPI starts getting too high, the central banks raise interest rates to discourage new banking lending, stemming the new money creation, which is less inflation, leading to lower CPI.
The Problem
Ignoring the fraudulent aspects of "money creation", there is a fundamental problem with this system - of having central banks targeting CPI of 2-3%. Working backwards, targeting 2-3% CPI, implies targeting 2-3% inflation, which implies targeting 2-3% new money creation, which implies targeting 2-3% net loan creation, which implies ever increasing amounts of consumer debt.
So, what you end up with is a massively indebted population trying to escape the rat race by speculating on the next asset bubble (another regular consequence of new-money inflation).
Until the crash point, and the start of the deflationary cycle of debt reduction.
Until the central bank "fix" the problem using inflation, through lowing interest rates.
Until interest rates hit zero, and the "fix" turns into direct money printing, QE1, QE2..
Until fiat money becomes meaningless...
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Inflation is not the rise in the supply of money.
ReplyDeleteIf money supply rises at the same rate as available goods and services in the economy then prices will stay the same. Eg, more money is available to buy bread, but there is more bread, so they cancel out.
Clearly if the money supply rises faster than the amount of goods and services in the economy then you will get inflation.
And another point: a 2 to 3 percent inflation does not imply overall loan growth of 2 to 3 percent. The government can just print 2 to 3 percent more cash and spend it on cultural awareness training for public servants or something .. problem solved!
While stealing 2 to 3 percent of the value of everyone's money every year (by printing more) might be irresponsible and immoral, it's not clear that it will necessary collapse.
Fiat money is like Tinkerbell. Every time someone says that fairies don't exist, a fairy dies! Fiat currency is backed by nothing but a belief in the integrity of goverment. As Elsworth Toohey said "I trade in the currency of men's souls. And I sell short!" .. or something like that.
Sorry .. I'm ranting again.
If the money supply is rising then you have inflation. If the supply of goods is rising faster than that, then you have a very rare scenario where inflation does not cause rising CPI.
ReplyDeleteRegarding your other point. In modern western economies, the vast majority of new money creation comes from the fractional reserve banking system. Hence, in modern western economies, the 2-3 CPI is caused by the increase in bank loan book sizes, ie, consumer debt.
Without fractional reserve banking, the only "money destroyed" would be the physically destroyed money, and "bad debt write-offs". Because of fractional reserve banking, "money destroyed" also includes "good debt paid back".
Hence the debt-deflation cycle that Steve Keen talks about.
Hence the anti-deflationary responses from central banks...
Wikipedia on Inflation, sentence one:
ReplyDeleteIn economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.
Roger N. Waud "Economics" Glossary of terms pp776
Inflation: A rise in the general level of prices of all goods and services; this rise causes the purchasing power of a dollar to fall.
QED.
Excessive increase of money supply may CAUSE inflation,
but increasing money supply is neither a pre or post condition for inflation.
"The semantic revolution which is one of the characteristic features of our day has changed the traditional connotation of the terms inflation and deflation. What many people today call inflation and deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates. This innovation is by no means harmless. It plays an important role in fomenting the popular tendencies toward inflationism"
ReplyDelete"it is obvious that this new-fangled connotation of the terms inflation and deflation is utterly confusing and misleading and must be unconditionally rejected".
Ludwig von Mises.
Let's be clear ..
ReplyDeleteWhat you are saying is that if the economy grows by 100 percent (ie there are twice as many goods being sold), and the supply of money increases by 1% over the same period, then we have inflation .. even though prices have dropped by nearly 50%?
This is simply not the definition that people (economists or otherwise) use in the modern age. The term may have been hijacked by pre-Keynesians a hundred years ago, but give it up, it's gone.
In all living memory, inflation refers to the _value_ of money, not the _supply_. Too many economics text-books have been written over the last hundred years defining it in terms of _value_ to take it back.
There no point declaring somewhere a sacred site if people have built houses and factories over it. No amount of protesting will get the buildings torn down - it's gone.
Likewise there's no point inventing a language which only has one user - it can't be used to communicate.
I'm not saying for a moment that I think increasing the money supply is a good thing, that's a separate argument. For another time. After a good night's sleep.
Actually one more point about inflation: prices are sticky. People are reluctant to decrease prices. Imagine me going to my employees and saying 'I'm going to decrease your wages by 2% because that's how the market has moved'. Even if there had been 3% deflation (by the modern definition) in that time, there would be outrage! People wouldn't understand that they would actually be 1% better off than before. However 3% inflation allows me to quietly lower their wages by 3% per year, and quietly reduce the wages of those employees that I would rather lose.
Not that I ever had any .. :)
There is an interesting article on this here:
ReplyDeletehttp://blog.mises.org/16955/just-what-is-inflation/
Thanks, good link. It seems that this language has at least a few users. And, just when I was starting to think that - perhaps - I'm delusional.
ReplyDeletePrices are sticky, but I think largely because rising costs are highly likely in an inflationary world. In a non-inflationary world, with stable money supply, costs of goods and services tend to decrease as a result of productivity gains. If the price of people's standard basket of goods tended to fall every year, they would be far more amiable to a wage cut..
This conversation has reminded me of a chapter in "Economics in one Lesson" (1946) in which Hazlitt criticizes inflation. It was a mystery as to why he bothered to do this (isn't it given that inflation is a bad thing?)
ReplyDeleteI will have to re-read the chapter now. Was he talking about increasing supply of money or decreasing value of money? I kind of suspect he was talking about the latter but even so, it's an interesting angle.
Most people are (were?) so ignorant that they see inflationary pressure as increasing the number of dollars they get paid every week and think they are richer. This is the same ignorance that lets a reluctant employer gently lower wages without the reluctant employee (reluctant to any productive work that is :) being able to do anything about it.
Ah yes - that excellent book - available online here: http://www.hacer.org/pdf/Hazlitt00.pdf. I recently read it for the second time, thus disproving the title :-)
ReplyDeleteHazlitt doesn't directly define the term "inflation", and rarely uses the term - likely to try to avoid any confusion - but in my reading of it, he does use the term "inflation" to refer to the quantity of money, rather than the value of money.
Perhaps one should give more credence to the quality of economists that use ye olde definition of inflation, rather than the quantity? :-)
If money is being created by banks through the fractional reserve banking system at a particular rate, then as this money is paid back, the "created" money is vanishing. So, where does interest come into it? Interest payments is real money, but not "created" when the original loan was drawn-down. So, this must mean that the fractional reserve banking system must rely on adjustments through bankruptcy (forceful taking on ones assets post default event). Cant help but think its like musical chairs - for interest to exist, someone will be losing that money in the system.
ReplyDeleteHi Oscar, You are correct in that when the money that the banks loan out is eventually paid back, that money vanishes.
ReplyDeleteThe bankruptcy argument doesn't necessarily follow. With a capital reserve ratio of, say, 10%, that means that the the bank has 10$ of customer deposits for every $100 in customer loans. The interest that the bank pays out to depositors (or wholesale funding) is therefore only 10% of the income generated by the interest on the customer loans (mortgages).
So who does lose out? In the "growth" phase of this scheme, where net debt is growing, and monetary inflation is occurring, it is the savers of dollars that lose out, as their savings are getting diluted. In the "debt deflation" stage, it is the holders of the assets whose prices are deflating that are losing out - that is, those that have recently bought houses with a mortgage, that will soon find themselves in negative equity - ie, having to work to pay the banks to get back to having zero equity...