Three types of inflation

on Wednesday, August 24, 2011

We hear a lot about inflation, and mostly hear about the Fed or government being responsible for the dollar's decline in value over the years. This is a bit strange, and muddles a lot of conversations about the economy and the Fed. In my view there are three distinct, separate causes for inflation; good, bad, and "natural," inflation.

1. "Bad" inflation occurs when bankers "cheat" and print up new notes out of thin air. This is the only cause of inflation recognized by most conservative or libertarian economists, like Milton Friedman or Thomas Sowell. They consider inflation to be always and only a "monetary phenomenon," where the cause of inflation is always an excess supply of currency, relative to existing goods and services. In their view, the only way to inflate a currency is to use the printing press excessively, of which governments have historically been very fond.

This type of inflation is certainly possible, but is unlikely with the system that we have in the United States.  New dollars, created by the Fed, are used to purchase assets that are held by the Fed. At some point in the future, they will be resold on the open market. In order for those new dollars to be permanently inflationary, the currency must be deemed worthless.  A central bank that buys a brick of gold with new money harms no one if it sells the brick for the same money at a later date. It only temporarily lowers the value of existing dollars until it sells the gold. The only way to truly steal by printing money is by issuing a brand new currency, or by never selling the gold back to the market. As long as the Fed's assets are resold to the open market, no harm is done. The only effect is a temporary change in the value of currency.

Think of it this way. Imagine the Fed prints up endless amounts of money and purchases literally every asset on earth. It would hold all assets on earth, and the people would hold paper money. Now imagine it sells all of the assets back to the people, on the open market, and burns the dollars it receives. Are we not right back where we started? Has anyone been harmed? No, the only way they can hurt anyone is in buying up all the assets and then declaring the money held by citizens to be worthless.

2. "Good" inflation is a bit more complex. To understand this it is helpful to imagine that we are using a commodity as money, as was done in the past.  Imagine that we are still today using pigs as our medium of exchange, store of value, and unit of account. Everyone prices goods in "pounds" of pig flesh. Further imagine that many people are holding huge amounts of preserved pig-meat in their mattresses and basements for a rainy day. What would happen if suddenly, all of the hoarded meat were offered in trade on the open market?

The value of pig-meat would fall as its supply rises (relative to other goods). This would be an inflation of the pig-meat commodity-money, but has this inflation harmed anyone? No, the inflation of pig-money only makes it easier to acquire pig-meat, which most people enjoy consuming! The world becomes wealthier as the meat flies out of basements and onto the open market. Suddenly, it is ridiculously easy to eat bacon. The only people who do not benefit from the explosion of meat-money are those who do not consume pig-flesh. To them, the only use for pig-meat is as money (exchange, storage, accounting). They are pretty pissed off when everyone begins liquidating their pig-meat on the open market, because the value of the meat in their basement falls in value.

So this type of inflation is good for everyone except those who don't consume pig-meat. In the modern world, the only people that "consume" US dollars are those who use them to pay down bank loans, denominated in US dollars. When a bank accepts dollars in payment on a bank loan, the dollars are destroyed; removed from circulation in the same way that a slab of bacon is removed by a hungry citizen. Today, when people are encouraged to spend what they have saved, everyone with a bank loan finds that it is easier to repay his loan, just as people would find it easier to eat pork. This idea won't sit well with anyone who does not consider modern money to hold real value to people who are obligated to "consume" it by repaying bank loans.

(If this is you, you may want to take a quick three-part journey, beginning with The Curious Nature of Ownership. Next, you'll want to read What is Wealth? And finally you may end with Banking: A Picture Book. I don't expect a full realization from these essays, but it may be enough for you to at least consider a new viewpoint regarding the reason modern "fiat" currencies hold value.)

The reality is that most people don't hold very much wealth as paper money. Most people hold it in some type of investment, which is a bit like loaning out slabs of bacon to your neighbor, who uses them as furniture. If suddenly, because of some act of the Fed, congress or God, you are moved to liquidate your bacon holdings (spend money), you would remove the furniture from your neighbor's house, and move it somewhere else that looked better. Perhaps you'd trade it for a new car. This act would help the man with cars and hurt the neighbor with whom you had previously invested that pig-money. The net result is likely a lot of movement and very little productive action.

This is the type of intervention that is praised by some, because it creates a lot of economic activity, and bemoaned by others, because it encourages people to move assets from productive use (neighbor's furniture) to another, perhaps questionable use as a new car. It creates what they view as "malinvestements," that will later cause bigger bubbles, and bigger crashes, than would normally occur.

3. "Natural" inflation occurs when everyone is so rich they demand more in trade to do work. It’s easier to hire a poor man to clean your bathroom; Bill Gates might want $50 million per hour to do it, if he agrees at all. When everyone in the market is becoming richer and richer, labor prices naturally rise, and assets that involve a lot of local labor rise in price. As everyone accumulates more and more wealth through productive action and trade, they become less and less willing to do boring or difficult or dangerous tasks in exchange for money. The only way to avoid the price of unskilled labor rising is to introduce new workers, either through immigration or young adults entering the workforce, but even the children entering the workforce will be less willing to work because they will have been raised by richer families, and over time immigrants will require more and more in trade as they too become wealthier.

So in this way, whatever component of an asset that requires a human being to labor to produce it will become more and more expensive over time. Today, it requires an entire bedroom full of electronic equipment to motivate a minimum-wage earning teenager to work a summer job. Fifty years ago, the same labor would have produced a lot less.

In my view it is quite silly to talk about inflation as if there is always an immediately identifiable cause, or to assume that a change in the value of dollars is always a bad thing for our quality of life. As I briefly outlined above, inflation is almost never harmful unless a new currency is issued, or unless the Fed never sells its assets back to the open market. Higher inflation might be annoying, and might make it harder to do business because the future is uncertain, but it certainly doesn't always "steal" from anyone, per se, and it certainly is not "always and only" a monetary phenomenon.