Friction Inflation
Belgium (Brussels Morning Newspaper) As early as November 2000, economists in a conference organized by the ECB argued that a continent-wide inflation rate of 0-2 percent would increase structural unemployment in Europe’s arthritic labour markets by a staggering 2-4 percentage points.Â
Akerloff-Dickens-Perry concurred in the aforementioned paper. At zero inflation, unemployment in America would go up, in the long run, by 2.6 percentage points. This adverse effect can, of course, be offset by productivity gains, as has been the case in the USA throughout the 1990’s.
The new consensus is that the price for a substantial decrease in unemployment need not be a sizable rise in inflation. The level of employment at which inflation does not accelerate – the non-accelerating inflation rate of unemployment or NAIRU – is susceptible to government policies.
Vanishingly low inflation – bordering on deflation – also results in a “liquidity trap”. The nominal interest rate cannot go below zero. But what matters are real – inflation adjusted – interest rates. If inflation is naught or less, the authorities are unable to stimulate the economy by reducing interest rates below the level of inflation. This has been the case in Japan and in the USA.
A central bank, having cut rates aggressively and unless it is willing to expand the money supply aggressively may be at the end of its monetary tether. An assertive monetary expansion is what Paul Krugman calls “a credible promise to be irresponsible”.
Inflation is exported through the domestic currency’s depreciation and the lower prices of export goods and services. Inflation thus indirectly enhances exports and helps close yawning gaps in the current account.
But the upshots of inflation are fiscal, not merely monetary. In countries devoid of inflation accounting, nominal gains are fully taxed – though they reflect the rise in the general price level rather than any growth in income. Even where inflation accounting is introduced, inflationary profits are taxed.
Thus, inflation increases the state’s revenues while eroding the real value of its debts, obligations, and expenditures denominated in local currency. Inflation acts as a tax and is fiscally corrective but without the recessionary and deflationary effects of a “real” tax.
The outcomes of inflation, ironically, resemble the economic recipe of the “Washington consensus” propagated by the likes of the rabidly anti-inflationary IMF. As a long term policy, inflation is unsustainable and would lead to cataclysmic effects. But, in the short run, as a “shock absorber” and “automatic stabilizer”, low inflation may be a valuable counter-cyclical instrument.
Inflation also improves the lot of corporate – and individual – borrowers by increasing their earnings and marginally eroding the value of their debts (and savings). It constitutes a disincentive to save and an incentive to borrow, to consume, and, alas, to speculate. “The Economist” called it “a splendid way to transfer wealth from savers to borrowers.”
The connection between inflation and asset bubbles is unclear. On the one hand, some of the greatest fizz in history occurred during periods of disinflation. One is reminded of the global boom in technology shares and real estate in the 1990’s.
On the other hand, soaring inflation forces people to resort to hedges such as gold and realty, inflating their prices in the process. Inflation – coupled with low or negative interest rates – also tends to exacerbate perilous imbalances by encouraging excess borrowing, for instance.
Still, the absolute level of inflation may be less important than its volatility. Inflation targeting – the latest fad among central bankers – aims to curb inflationary expectations by implementing a consistent and credible anti-inflationary as well as anti-deflationary policy administered by a trusted and impartial institution, the central bank.
Deflation and the Value of Cash
Traditional economics claims that deflation actually increases the value of cash to its holder by enhancing its purchasing power in an environment of declining prices (negative growth in the average price level). Though highly intuitive, this is wrong.
It is true that in a deflationary cycle, consumers are likely to delay consumption in order to enjoy lower prices later. But this precisely is what makes most asset classes – including cash – precarious and unprofitable.
Deflationary expectations (let alone actual deflation) lead to liquidity traps and zero interest-rates. This means that cash balances and fixed-term deposits in banks yield no interest. But, even zero interest translates into a positive yield in conditions of deflation. Theoretically, this fact should be enough to drive most people to hold cash.
Yet, what economists tend to overlook is transaction costs: banks charge account fees that outweigh the benefits of possessing cash even when prices are decreasing. Only in extreme deflation is cash with zero interest a profitable proposition when we take transaction costs (bank fees and charges) into account. But extreme deflation usually results in the collapse of the banking system as deleveraging and defaults set in. Cash balances and deposits evaporate together with the financial institutions that offer them.
Moreover: deflation results in gross imbalances in the economy: delayed consumption and capital investment and an increasing debt burden (in real, deflation-adjusted terms) adversely affect manufacturing, services, and employment. Government finances worsen as unemployment rises and business bankruptcies soar. Sovereign debt – another form of highly-liquid, “safe” investment – is thus rendered more default-prone in times of deflation.
Like inflation, deflation is a breakdown in the consensus over prices and their signals. As these are embodied in the currency and in other forms of debt, a prudent investor would stay away from them during periods of economic uncertainty.
At the end, and contrary to the dicta of current economic orthodoxy, both deflation and inflation erode purchasing power. Thus, all asset classes suffer: equity, bonds, metals, currencies, even real-estate. The sole exception is agricultural land. Food is the preferred means of exchange in barter economies which are the tragic outcomes of the breakdown in the invisible hand of the market.
(To be continued)
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