Now or never

In the Great Debate over inflation, where are the moderates?

Reading newspapers, or watching vitriolic newscasts, you may feel caught between Scylla and Charybdis:  Either inflation will run riot tomorrow or it will never come.  Conservatives contend that excess money must quickly raise prices in general.  Liberals counter that since 2009, when central banks ‘round the world printed money ‘round the clock, inflation has remained muted.

Neither position is respectable, even for a straw horse.  let's consider the conservatives' claim first.  Yes, an increase in money supply may raise demand for a nation's production.  We all like to spend.  But in an   economy with excess capacity, the additional spending may raise output rather than prices.  Today most national economies are not producing as much as they can, so they are able to step up production without driving up unit costs and prices.  A worker won't demand a pay raise if two of the unemployed are waiting to take his place.

In addition, the slowdown since 2009 has been unusually severe, and people aren't sure what will happen next.  Until the smoke clears, they may hoard cash rather than spend it.  This may be particularly likely in Tajikistan, which relies heavily on the earnings of its emigrants.  The demand for immigrant labor is more volatile than that for native workers.     

Now turn to the liberal claim.  Inflation depends not only on the money supply but also on the credibility of the central bank, since this shapes public expectations and therefore prices.  If a reliable bank vows to soak up excess money before prices begin to rise, then people may act accordingly.  They won’t demand pay hikes for anticipated inflation – hikes that themselves would generate inflation.  The expectation of stable prices will fulfill itself.        

In the United States, the governor of the Federal Reserve in the late Seventies, Paul Volcker, established the Fed’s credentials as an inflation fighter by creating a recession -- the worst, at that time, since the Great Depression of the Thirties.  Volcker demonstrated that the Fed would sometimes accept higher rates of unemployment in exchange for lower rates of inflation.  The next two governors, Alan Greenspan and Ben Bernanke, benefited by his bitter medicine.  Their monetary expansions created little inflation, partly because people didn’t expect them to. 

(In this light, the National Bank of Kazakhstan may have trouble controlling inflation, because its volte-face on devaluation early this year destroyed its credibility.  If the Bank feels free to renege on the exchange rate, how likely is it to keep its promise of low prices?)   

Brother, can you spare a car?

This doesn’t mean that the Fed can cash in on the Volcker cure forever.  Perhaps the most widely accepted premise in macroeconomics is that a national economy tends over time to produce at full capacity, since workers and capital owners cannot profit by remaining idle for long.  When the U.S. economy finally returns to full production, any Fed prodding of additional spending will raise prices, since the additional output will burden the factories and so prove costly.

The absence of inflation since 2009 is not evidence of its demise.  We’ve seen this movie before.  In the early Forties, to finance World War II cheaply, the Fed printed money and the government controlled prices or quantities.  When the government liberated the economy after the war, prices surged – although economists had predicted that they would collapse.  

(Their idea had been that as folks become richer, they will spend a smaller share of their income.  Economic recovery must end in sustained stagnation and low prices.  Economists had overlooked the public’s demand, pent up during the war, for such durable goods as automobiles.  When the war ended, consumers scrambled to make up for lost time.  Even after this splurge, consumption did not drop sharply, because it depended in the long run on long-run income, which is slow to change.)              

What’s wrong with inflation?  The consumer’s usual answer is that higher prices reduce the amount that she can buy with her paycheck.  Eventually, she will persuade her boss to give her a pay raise, since the high prices of his output increase his revenues.  Meanwhile, her standard of living will fall.

The standard error

Another problem is that inflated prices mislead us.  In principle, the price of a bag of potato chips reveals to us the cost of producing the bag as well as its value to the consumer.  If the price is 30 tenge, then the bag could not have cost more than that to manufacture, or the factory would not have provided it; and the consumer could not have valued it at less than 30 tenge, or she would not have bought it.  By raising the price, inflation deceives us about the bag’s value.  The producer, observing the price hike, may conclude that the demand for chips is rising, so he will produce more.  Only eventually, after noting price increases throughout the economy, will he realize that the price of chips rose because of inflation rather than an increase in the demand for treats.  To correct his error, he will scale back production – firing workers and paving the way to recession.

Most public critiques of inflation focus on extreme cases in which prices rise by millions or billions of percent.  Clearly, hyperinflation destroys the economy by disabling the price mechanism, which is as vital to markets as an engine to an automobile.  The classic example is Germany in 1923, where hyperinflation cleared the path for Hitler, who vowed to use his storm troopers to prevent alleged price increases by the Nazis’ usual suspect, the Jewish merchant.  Such textbook discussions imply that inflation is rarely destructive.  In truth, even modest inflation can damage.  Though the distortion in the amount produced of a particular commodity may be small, a national economy includes hundreds of thousands of goods and services.

Inflation is not always pernicious.  John Maynard Keynes, who was more critical of high prices than non-economists realize, pointed out that we may prefer slight inflation to slight deflation.  One reason is that the agent of economic growth, the entrepreneur, must borrow in order to build his innovation.  When prices are rising, the real cost of a 500,000-tenge loan will fall since those tenge, now returned to the lender, will buy fewer products than they did when the entrepreneur took out the loan.  Conversely, when prices fall, the real cost of the loan to the borrower will rise.  This will discourage attempts at innovation. 

This may help explain why the European Central Bank has targeted an inflation rate of 2%.   Inflation of 7%, the going rate in Kazakhstan, may be a bit harder to justify.  –Leon Taylor, tayloralmaty@gmail.com           

Good reading

John Maynard Keynes.  A tract on monetary reform.  Online.  1923.  Keynes was a monetarist, urging controls on money supply, well before he became a Keynesian.  Of his books on economics, A tract is his most readable.