Sometimes, inflation IS evil

August 15, 2011

In his latest NYT column, Floyd Norris joins a rising tide of pundits in pushing for higher inflation. There are two main lines of argument for higher inflation. Firstly, the economy is too leveraged, many people have underwater mortgages and cannot spend, therefore decreasing the real debt burden will boost the economy. Secondly, deflation is bad for the economy, therefore inflation must be good. The premises of both lines of argument are true, but the conclusion may well be false.

The fundamental problem is a failure to consider the costs of inflation alongside the benefits. Yes, increasing inflation will likely lead to an uptick in real estate prices, which may lead to fewer underwater mortgages. But will this really lead to a recovery in consumption? What other effects might inflation lead to? Do you really think rich asset holders simply sit tight and let the central bank erode away their wealth? The most benign effect of inflation will be to raise home prices. There are a variety of other much more adverse side effects. For example, rich investors can snap up farmland as an inflation hedge, and then demand increasing farm rents to offset inflation erosion, resulting in rising food prices. Wages, I expect, has no chance of rising with the current sky-high unemployment rate, which would result in lower- and middle-income classes getting squeezed, and maybe abandoning all other discretionary luxury purchases. There could be increased capital flight from the US, leading to a decrease in productive investment. By pushing investors into deploying their cash, the economy as a whole may see all their real assets further concentrated in the hands of the moneyed classes, which can then just sit on their assets and demand rents from the rest of the economy. On balance, I think that the possible distortions brought on by inflation will probably outweigh the benefits. Paul Krugman has also recently pointed out that there is good inflation, and then there is bad inflation. It is far from clear what type of inflation will be stoked if one just prints more money.)

In a modern efficient capitalist economy, financial factors, such as an appropriate amount of money in circulation and a financial sector that allocates capital rationally, cannot in and of itself CREATE economic growth. At some point, capital flow is as lubricated as can be, and increasing the size of the financial sector past that point just creates a source of instability. Simply printing money will just cause people to shuffle money around the various asset classes without actually increasing the stock of economic assets. What we need now is joint financial-government action, with the central bank keeping interest rates low so that the government can borrow cheaply and invest in increasing the stock of economic assets, and the central bank also printing money to match the increased stock of economic assets so that deflation doesn’t occur. Avoiding deflation is critical, but that does not mean that one should advocate for inflation. In other words, it is time for the government to step up.

 

More on this topic (What's this?) Read more on Inflation at Wikinvest

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