A Primer on Inflation

John Taylor of Stanford was a guest on Econtalk.  Unique among most economists, Taylor has a widely-known rule named for him.  The Taylor rule provides guidelines on how to handle inflation.  He developed the rule in the midst of the Stagflation of the late 70s and early 80s.  Basically, Taylor proposes that the federal funds rate - which is set by the Federal Reserve - should rise with inflation (that is a gross simplification for which I apologize).  Oftentimes, there is guesswork to try to keep the rate low enough to encourage borrowing - which provides capital for investments - and high enough to tame inflation.  Taylor holds that the Fed has done an excellent job with the interest rate for most of the last 40 years.  However, the current rate of near 0% is entirely out of step with the inflation rate.

Much of the discussion is just a primer on what is inflation, how do you measure inflation (consumer price index), what are the causes of inflation, what are ways of countering inflation, and what are the consequences of not countering inflation.  Runaway inflation leads to barter economies.  Taylor was conservative on his estimates of the inflation rate and proposed that the Federal Reserve should be raising the nominal interest rate to fight inflation.  He proposed that they should have taken action in summer of 2020.  Russ asked about fiscal policy, but Taylor did not delve into that subject beyond saying that big deficits are not ideal.  It is better to have smaller deficits.  Way to take a stand.  He is a monetary economist and more interested in interest rates.

It reminds me of lectures from college. Recommended.

Inflation, the Regressive Tax

"Inflation is always and everywhere a monetary phenomenon."

Milton Friedman

Let us assume the economy has 100 dollars.  There are 10 people in the economy, each with $10.  The government levies a 20% tax.  Now, everyone has $8 and the government has $20.  Simple.

Let us suppose the government would like to spend more than $20.  The majority of the ten people in the economy don't want to pay more taxes.  Efforts to raise taxes are voted down.  What to do?

"I have an idea!" the Federal Reserve declares exuberantly.  "Let's increase the money supply."

"Won't that just reduce the value of money?"

"Yes, but government will have the money.  If we print an additional $20, we will have $40 to spend.  By the time the people realize that the money supply has expanded, we'll already have spent it."

In this simplified scenario, the citizens held 80% of the money while the government held 20%.  After the government printed another $20, the citizens now only had 67% of the money while the government had 33%.  Effectively, government has implemented a new tax rate of 33%.

Of course, the government is going to spend its newly minted money by giving it to citizens for goods, services, or entitlements.  When the inflation works out of the system, the division of the $120 economy will $12 per citizen, which will then be taxed by 20% ($2.40).  The new balance will be $9.60 per person and $24 for government.

"Gee, it was fun spending all that money," Senator Spendthrift declares.

"Quantitative easing?" The Federal Reserve suggests.

Another $30 are printed, giving the government $54 to spend.  And on and on it goes.

The thing about inflation is that it hits lower income people harder than higher income people.  If you own stocks or property, they appreciate in value.  A stock that was worth a dollar before government poured that $20 into the economy will now be worth $1.20.  After the second inflow of cash, it is worth $1.50.  This is also true of real estate.  That $100,000 home will require more devalued dollars to buy it.  Skyrocketing home prices are great for homeowners, not so great for would-be home buyers.  It is particularly bad for renters.

Bad governments love inflation.  Inflation is a tax that the populace can't avoid.  Inflation happens when the money supply grows faster than the economy.  The Fed knows what it is doing.  This is intentional.

The Money Illusion

Some months ago, I heard Scott Sumner (PhD Economist) on a Podcast I follow (EconTalk with Russ Roberts) and was intrigued.  He kept arguing for growth in Nominal Gross Domestic Product (NGDP), which is denominated in current dollars which may be less valuable than last year's dollars.  Thus, NGDP can be different from Real GDP.  One can have nominal growth simply by printing more currency even in an economy with RGDP of zero.  This seems somehow wrong to me.  It's like he wants to trick the economy into thinking there is growth even when there isn't.  Nonetheless, I found his blog and have followed it since then.  He says the darnedest things and makes a surprisingly good case.

Sumner holds that the Federal Reserve should have a targeted NGDP, assuring that the economy is constantly expanding.  I have long thought that money was supposed to be a reliable store of value but Sumner is proposing to forever decrease its value through this constant rate of inflation.  I was long a supporter of the gold standard but that is unrealistic since the supply of gold is not growing at a rate equal to the growth of world economies.  As such, the gold standard would effectively shrink the money supply.  Likewise, it is difficult to target fiat money to the actual growth rate and that might, in recessions, prove to be a problem by again shrinking the money suppy (as happened in the Great Depression).  So, I find myself in agreement with much of what he has to say but still find the idea of constant, planned inflation disagreeable.

Some other things Sumner has declared have also grated on me.  For instance, he proclaims that we have a very tight money supply, which seems impossible with all the Quantitative Easing.  How can you pour cash into a stagnant economy and not have inflation?  He has explained but that bit has yet to make sense for me.  Still, he keeps me coming back and has surely changed some of my thinking.  He may yet win me over to his NGDP targeting and I don't think I will forgive him if he does.

Check out his blog here:

http://www.themoneyillusion.com/

End the Fed

Ben Bernanke, Chairman of the Federal Reserve, had the first ever press conference in the nearly century history of the institution. He said not to worry about inflation and that unemployment should slowly decline over the next two years. I beg to differ. Sure, employment should improve but inflation is coming. Look at the price of gold: it was going for $880/oz. in Jan. 09 but is currently trading at $1540/oz. Silver has gone from $11/oz. to $49/oz. in that time. Gas and food are also climbing. Oh, the government will assure you that gas is going up because of speculators and greedy oil companies. Never mentioned will be that with each new dollar that is printed, the ones in your wallet become less valuable.

The primary purpose of the Fed was originally to keep the money stable, make it a reliable store of value. Inflation is anathema to that. However, governments love inflation. Inflation is a tax. Inflation allows government to continue spending or to pay off debts with devalued currency.

None of what I say would come as a revelation to Bernanke. So, he knows inflation is coming. He knows that to rein it in will require a rise in the interest rate which will choke off job-creating investment. None of this is new. He, better than most, knows where these policies have led in the past. What is he thinking? He didn't explain it in his unprecedented press conference.