Wednesday, September 24, 2008

Why inflation is appropriate

Is inflation really so bad? One argument that gets thrown around a lot is that growing the money supply is an insidious and immoral form of wealth redistribution. The reasoning goes something like this: to see why inflation is redistributive, consider what would happen if the money supply were increased by the government issuing an edict saying all dollars were now worth twice as much. Clearly this would not affect anyone's real wealth, and prices would quickly adjust to the new amount of currency in the economy. But this isn't how increase in the money supply occurs. When the Fed makes an open market purchase and injects new currency into the economy, that money goes first to the banks and the people they loan to, then to wherever they spend the money, and so on. These people who receive the new money first get to spend it before prices have adjusted to the new supply of currency - as they spend it, prices start to rise. Meanwhile, people holding cash or whose wage is a certain cash value find their spending power starts to diminish. Effectively, they have transferred some of their wealth to the people who received the newly generated currency.

This is the argument, but now let's imagine the alternative of a fixed money supply, where the number of units of currency in circulation is fixed. Suppose you become very rich in 1970 and come to have under your control 1/10th of the total number of dollars in circulation. At the time (1970), with the GDP being whatever it is, this 1/10th of the total dollars has a certain real value. Now say you keep these dollars in a vault for 40 years. Fast forward to 2010 - society is a lot wealthier and more productive now, has a much higher GDP, etc. It would not make sense for the money you kept in the vault for 40 years to have appreciated in value - your dollars sitting in a vault should not be generating wealth out of thin air.

Another way to think of it is if you used your money from 1970 to buy a bunch of 1970s goods, then transported these goods instantly to 2010 and sold them, they would be worth a lot less. We can do things more efficiently now, at lower (real) cost than we could in 1970 - that's the nature of economic growth! An inflating money supply therefore just reflects the reality that new wealth is being created over time. It therefore makes perfect sense that as the economy grows, exisiting cash assets decline in real value and prices therefore rise.

Therefore, the argument about inflation being redistributive is missing the point. If you take out a loan and pay it back, it means you have generated new wealth which did not previously exist. Of course you (and the bank that loaned it to you) receive the benefit of that new money moreso than others - you are generating an amount of wealth equal to the loan amount plus interest. With more overall wealth in the economy, it makes sense that everyone else's existing stored wealth in the form of cash is devalued slightly.

Now think about the money sitting in a bank vault for 40 years. In a fixed currency, that money will become more valuable just by sitting there. If that money is generating real value out of thin air, it must be the case that others are indirectly subsidizing this growth. And the people subsidizing it are all those people who actually do generate new wealth over the 40 year period and have to pay higher real interest rates because of a deflating currency (which is the inevitable result of a fixed money supply and a growing economy). Compare this to the more fair situation now, where if you want your cash to gain in value, you need to either use it yourself to generate wealth, or provide capital to somebody else who is doing that. A fixed currency is actually the opposite of what is truly fair!

So, the money supply should grow as new wealth is created. The next questions are: can the Fed really grow the money supply in step with the creation of new wealth? And what are the consequences of not growing (or shrinking) the money supply at the appropriate rate?

1 comment:

Anonymous said...

"Clearly this would not affect anyone's real wealth, and prices would quickly adjust to the new amount of currency in the economy."

I don't think this statement is correct. Prices of goods may adjust but all liabilities such as loans, pensions, fixed income investments do not adjust. In addition, wages are slower to adapt than prices, or may even not adapt at all. So clearly there is a wealth transfer from pensioners / bank account holders / employees to employers, those in debt and heavily leveraged.