I follow the general blog from the Adam Smith Institute mostly for philosophical commonalities, with the same being true with many other more libertarian organizations. The difference between us, however, is their more recent obsession with inflation. It’s quite curious, indeed; and so when I saw the resent post on inflation in the UK by Dr Eamonn Butler it seemed like a good straw man to use to tackle some of the popular myths.
******* Update regarding Dr. Butler – author of a book about Milton Friedman’s economics in 1985. How short memories are and how shocking of a switch.******
Headline inflation in the UK has fallen to 2.5% (from a peak of 5.2% a year ago), so there is great rejoicing. The monetary hawks (such as Liam Halligan) have been proved wrong, we are told – all the Quantitative Easing didn’t actually fuel inflation…
And the fact that prices are rising only moderately suggests that all the Bank’s quantitative easing is not actually having much effect on the real economy. It certainly seems to be keeping up asset prices, which is why the stock market is looking so healthy. But maybe it is not seeping into the everyday economy. Maybe it just replaced the collapse in the money supply when the banks found themselves caught in the headlights and stopped giving out loans any more.
The first problem I see is that headline inflation is the wrong measure on which to focus, if the idea is to venture into the realm of focusing on prices as a measure of economic performance that is the only thing that matters. Prices shouldn’t be the emphasis, and moreover, including the price of imports like oil in the equation for monetary policy acts like a commodity peg, so that higher spending on oil products means less spending on other things.
On the second point, that QE is raising prices only moderately and that means it isn’t working; considering that the BoE is inflation targeting with import prices included in the target, it probably isn’t working, even if the target is somewhat flexible, because inflation expectations are anchored around the target and there isn’t any promise to be irresponsible in the future. It’s a failure to manage expectations around a reasonable nominal target, such as nominal growth, or connect QE with some desired economic outcome that is failing to improve the UK economy, not a failure of QE in principle. But the expectation that prices have to rise by more than the target in order for QE to work is completely wrong because the output gap would have to be closed before inflation from QE would become an issue.
But as [sic] the deepest level, I still wonder why we should regard inflation of 2.5%, or the Bank’s central inflation target of 2%, should be remotely acceptable. At that rate, the value of our money halves in 30 years. Which is great if you are a big creditor [sic], like the government, because you are repaying your debts in devalued money. And indeed the government is charging us tax on the interest we get on our savings, even though these are negative in real terms. And as incomes struggle to keep pace with the inflation, more of us find ourselves drawn into the higher-rate income-tax brackets. And so on. It all favours the spendthrifts and punishes the savers.
There is so much wrong with this statement, it’s difficut to know where to begin. But I will break it down into sections and begin with this: paper money has no inherent value. It is a medium of exchange, no more, no less. What gives it a perception of value is the willingness to hold it and exchange it for things of value today. The value of your money will not half in 30 years. Today’s market value of a cash balance could half in 30 years if all things remained the same. But is it reasonable to have the expectation of stuffing paper money in a mattress with the assumption that it will have the same real value 30 years later when you’re aware of the likelihood it will lose value well in advance? Is meeting that expectation worth the kind of economic damage wrought on the economy of today with inflation targeting that includes imports in the target, complete with the opportunity cost to posterity? It doesn’t seem like rocket science to figure out that the expectation to hold a cash balance with real value retention is unreasonable, even if it were commodity-based, and the best thing one can do to “save” for the future is to invest; convert your paper money to something of value. Like baseball cards much?
Which is great if you are a big creditor [sic], like the government, because you are repaying your debts in devalued money. And indeed the government is charging us tax on the interest we get on our savings, even though these are negative in real terms. And as incomes struggle to keep pace with the inflation, more of us find ourselves drawn into the higher-rate income-tax brackets. And so on. It all favours the spendthrifts and punishes the savers.
I think “debtor” is meant here. But the entirety of what is said needs a bit of a reality check. What matters to economic health is stability in inflation because debts are issued in nominal terms, usually with inflation expectations baked into the contract. Now consider the collapse in nominal aggregates in 2008 leading to economic weakness and disinflation, and the effect that has on existing nominal contracts in real terms; it magnifies the real burden of debt because the real value of nominal debt contracts increase – one major way nominal shocks have real effects. Restoring inflation back to trend merely puts that burden back into equilibrium rather than resulting in a wealth transfer from creditor to debtor as suggested here. But since people only look at nominal values compared to current purchasing power and insist on a given price level even after a contraction, there is absolutely no political will to reverse that stealth wealth transfer from debtor to creditor. And to top it off, the same people insisting on low inflation everywhere, at all times and at all costs complain about the needed tax hikes for the government to pay down its magnified debt lest a debt crisis ensue. The rest of the problems of the persistence of weakness in the economy and associated negative real interest revolve around that same fixation on inflation and insistence that it remain low after it collapses, which is really an insistence on maintaining nominal disequilibrium. Perhaps some considerable thought toward what being part of the solution rather than the problem really means is in order.
Keynes figured that inflation is useful because of the downward inflexibility of wages. People don’t like pay cuts, but pay in declining industries can be cut in real terms simply if it does not rise as much as prices. So people are gradually eased into more productive jobs without any nastiness. Keynes, though, did not realise just how damaging inflation is to signals in the economy. When all prices are rising, it is hard to separate the ‘noise’ of generally rising prices from the ‘signal’ of prices that rise because demand is not being met. For years, people invested in houses because they saw house prices going up and up, without realising that, after inflation, the rise was much less. So you get bubbles in some places, and underinvestment in others. None of which helps competitiveness and employment.
Why does what Keynes thought about inflation have anything to do with current the economic problems? There is nothing here that establishes a connection. The claims here regarding wage cuts by having them grow at less than inflation are puzzling and difficult to reconcile with the complaint about stagnate wage growth earlier; and I find it difficult to understand why, with evidence all around that prices and wages are adjusting to some degree that confused price signals are a culprit in the current circumstances. There is no empirical evidence that inflation causes bubbles or confuses manufacturing. Anyone with supply chain management experience can attest that a stable general rise in prices does not cause them to produce more things than they can sell. What causes them to have excess inventory in a recession is a sudden the decline in demand driven by tightening by the central bank, and even then, the excess inventory problem is far less now than before advances in technology and management practices of the last few decades. What causes bubbles and “malinvestment” more than anything else is government interference in markets and central planning. The housing boom and crash is the perfect example of a regulatory boondoggle in action that was exacerbated by central bank tightening to comply with strict inflation targeting. But instead of the Adam Smith Institute focusing on that most serious example ever of why centralized planning is a really bad idea, as we would expect, we get to hear all about how inflation is the source of all evil. It’s completely ridiculous.
There is also an argument that it is wise to allow a bit of inflation because if by mistake we tipped into deflation things would be really terrible. With falling prices, why should anyone buy today what they could buy cheaper tomorrow? So business would grind to a halt, we’re told. But in fact, inflation is equally destructive – killing the incentives for saving and investment, encouraging false booms, diverting resources into the wrong places. Should it not be a key duty of the government to preserve the value of our money – not to let it lose its value at 2.5% or indeed on any scale at all?
Frankly, I can’t even make sense out of this last part of the complaint about inflation. If inflation kills incentive for investment, where do the “false booms” come from? And again, who or what “diverts resources into the wrong places”? Does this mean people can’t be trusted to do with their money what they will, so it’s better for them to not have it in the first place? If that is the logic behind the complaints, then I don’t really see the point in having any expectation for maintaining a reasonable standard of living, or why capitalism is a good idea.