Asymmetrical Information

It's also worth pointing out that a little bit of inflation encourages people to spend money now, rather than waiting for later when things'll be cheaper. That's why deflation's so bad, and why central bankers would rather err on the inflationary side if they're going to err at all.

And unless I'm mistaken, a lot of fuel costs are already in the price of the items that make up the core basket--at least as much as the producers can pass on. That should smooth out the short-term bumps and give us a better idea of the real effects of high energy.

I don't know this for a fact but it makes sense, no?

I imagine you meant "one splash is good

I'm looking forward to your "different post". As a non-economist, I always wondered if the power of the Fed is gradually slipping away as we move away from a cash economy.

Oh, boy, here's one of my favorite canards again, a "little bit" of inflation is good, because it "lubricates" the economy, keeps people buying stuff, etc., etc., etc. and etc.

Well, I guess a "little bit" of theft is good, too, because after all it keeps the fences in business and gives the cops something to do. Unless, of course, it was your property that was stolen and is never recovered, then that "little bit" of theft isn't so good after all. But who cares about that, right? Let's all encourage burglars to break into houses, in order to keep that "little bit" of theft going...

What is 'inflation'? It is the debasement of the currency. It is a policy that reduces the value of each and every token, thereby attacking one of the fundamental properties of money, the use of it as a "store of value". It forces interest rates to rise, in order to make it worthwhile to lend money. And it is a stealth tax upon anyone who deals primarily in cash...

A "little bit" of debasement of the currency eats away at the value of all investments, but is particularly hard on those foolish enough to try to save their money in the form of cash, including savings accounts. A "little bit" of currency debasement nibbles away at the living standard of anyone on a fixed income, and those earning the least elastic wages.

So that "little bit" of theft...er...counterfeiting...no, wait, sorry, "inflation" is just dandy, unless one is trying to save money in order to invest in something, working for lower end wages, living on a interest payments or a defined-benefit pension; those who don't bother to save anything, who work for higher wages and collect no interest no doubt find it just dandy.

I wonder how the economy managed to grow so stunningly from 1805 to 1905 without that "little bit" of inflation?

Hypothesis; Inflation is a mechanism by which those with higher income pass along their taxes to those with lower income. That is, inflation is in part a direct response by those with economic power to higher levels of taxation. Those with little economic power, are stuck with the bill.

Randy wrote:

Hypothesis; Inflation is a mechanism by which those with higher income pass along their taxes to those with lower income. That is, inflation is in part a direct response by those with economic power to higher levels of taxation. Those with little economic power, are stuck with the bill.

Ugh. As much as I dislike class-oriented analysis, there is something to this. Certainly the first individuals/institutions that get their hands on the latest print run in an inflationary environment are better off than the last ones to do so.

Too much inflation is very bad, but a few percentage points can lube the engine of commerce.

If three qualifies as 'a few', then you are perfectly happy with the purchasing power of money being cut in half every generation or so.

Regards, Don

Polemic aside, ellipsis, if the central bank aims for complete price stability, then we'll have periods of both inflation and deflation. I'm pretty sure most economists agree that a little bit of inflation is far better than a little bit of deflation.

Besides that, if prices increase because of a supply shock, like an increase in the price of oil, how do you expect to stop the price level from rising?

Ellipsis,

I really don't mean to make a class argument. Its just the simple mechanics of power. If the price of gas goes up, and I have the economic power to demand a raise to compensate, then I'm really not paying higher prices - but those with no such power are. That economic power tends to positively correlate with class is incidental.

"I'm pretty sure most economists agree that a little bit of inflation is far better than a little bit of deflation."

And this is precisely the problem. A little bit here, a little bit there, and those little bits accumulate into something big, as Don Lloyd points out. When you get right down to it, the difference is this: the pain from deflation is felt accutely and immediately, but the pain from inflation is far more dispersed and spread out over time. This means in effect that there's an incentive to just keep kicking the can down the road by cranking out more money once the pain from the original inflation starts to be felt, in addition to the other institutional incentives that bias the government toward inflation. Lather, rinse, repeat.

Deflation is no better or worse than inflation. Inflation is devaluing the currency by "creating" money and giving it to favored groups; deflation is upvaluing the currency by destroying currency (taken from unfavored groups by means of taxes).

Either one destroys wealth. Deflation is politically unstable because it has the gov't throwing away a major source of power; inflation is very politically stable because the favored groups will have financial power to work to ensure the continuance of the system that gave them power.

-Billy

Oh, about that first post: no, inflation isn't "good" because it encourages people to spend more. Rather, it's "bad" because it encourages people to save less and borrow more -- while making it harder to trust borrowers, because the money they'll be repaying you with will be worth less.

I put "bad" and "good" in quotes because neither the problem nor the solution is in inflation or deflation. The problem is manipulation of the currency; without that manipulation markets have a lot more reliable information about natural inflations and deflations.

Don't we have real interest ratesto fix these problems?

AT wrote:

Polemic aside, ellipsis, if the central bank aims for complete price stability, then we'll have periods of both inflation and deflation.

Ah, but that assumes the existence of a central bank, and there have been times in history when such monarchistic notions were viewed with distrust. Economies can and have functioned just fine without a king in charge of them. Andrew Jackson let the central bank disappear, for example, and the republic did not fall...

I'm pretty sure most economists agree that a little bit of inflation is far better than a little bit of deflation.

That may be, but so what? As others have pointed out, a "little bit" of depreciation of the currency halves the value of that currency well within a human lifespan. Thus that "little bit" chops a widow's bank account by 50% unless she can get an interest rate above the inflation rate (which currently is impossible), to pick one heart-string-plucking example. The writers of the Constitution, having had a rather poor experience with fiat money, wrote into it a clear stipulation that only certain things could be considered "money". That's why quite a few prices were essentially the same in 1905 as they were in 1825.

Besides that, if prices increase because of a supply shock, like an increase in the price of oil, how do you expect to stop the price level from rising?

Who says I'd want to control any price, when prices are a key signal within any economy?

Or to put it another way:
Why would I want to do such a silly and dangerous thing as to demand a centrally-planned economy, when history is littered with the wreckage of such bad ideas?

Maybe so ellipsis, but what's the alternative to a central bank? I know you're all gold standard people, so let's out with it.

AT asked:

Don't we have real interest rates to fix these problems?

Gosh, don't we? What's the current prime, what's the CPI been for the last 3 months or so, what's a typical interest rate on a savings account?

I saw the other day where if one plopped $50K into an account, the bank would pay all of 2% or so. Given the CPI has been near 3% for a while, what kind of deal is that? And then there's all the adjustments from seasonal to hedonic pricing that are buried in the CPI...

AT wrote:

Maybe so ellipsis, but what's the alternative to a central bank?

I'll rephrase the question:

"Maybe so, but what's your alternative to a king?"

Does that help?

I know you're all gold standard people, so let's out with it.

I like cowrie shells, myself, they are so pretty...

Randy wrote:

Ellipsis,

I really don't mean to make a class argument. Its just the simple mechanics of power. If the price of gas goes up, and I have the economic power to demand a raise to compensate, then I'm really not paying higher prices - but those with no such power are. That economic power tends to positively correlate with class is incidental.

Well, ok, that's accurate enough, thanks for the clarification.

I saw the other day where if one plopped $50K into an account, the bank would pay all of 2% or so. Given the CPI has been near 3% for a while, what kind of deal is that? And then there's all the adjustments from seasonal to hedonic pricing that are buried in the CPI...

Now you are on to something...a "little" bit of inflation encourages those with spare cash to invest in projects with higher returns on capital. If you have zero inflation or deflation, it lowers the demand for high returns. You cannot have high future economic growth without investors taking risks, and sometimes high risks. I am not saying the whole model falls apart with zero inflation or deflation, but it would certainly put a dent in higher-risk investing.

hammer

Hammer wrote:

Now you are on to something...a "little" bit of inflation encourages those with spare cash to invest in projects with higher returns on capital. If you have zero inflation or deflation, it lowers the demand for high returns.

Really? So I guess it was the hyperinflation of the 19th century that led to investors pouring capital into canals, railroads, telegraph lines, and other high-risk investments? Or going back a couple of centuries, the Dutch who pooled their fortunes to hire a ship that would sail to Sumatra and back, hopefully, they were motivated by inflation?

You cannot have high future economic growth without investors taking risks, and sometimes high risks.

And different investors have different tolerance for risks. The people that invested in the Erie Canal had a higher risk tolerance than those that bought the equivalent of Treasury bonds, and the expected return was priced accordingly. But inflation makes everyone chase higher returns no matter what their risk tolerance is, and leads to the absurdity of pension trustees investing in hedge-funds, retirees putting substantial amounts of money into riskier stock funds, and so forth, in order to try to get ahead of the depreciation that is destroying their capital.

And it only gets worse when the Fed stands ready to bail out the stock market or a big hedge fund by throwing liquidity at it..."Moral hazard" is not just a phrase, it really does mean something.

I am not saying the whole model falls apart with zero inflation or deflation, but it would certainly put a dent in higher-risk investing.

The history of investing over the last several hundred years tells me that the above statement is false.

Inflation is a mechanism by which those with higher income pass along their taxes to those with lower income.

Inflation hurts people with cash savings and benefits people with lots of debt. So how can it be an example of the rich benefitting at the expense of the poor?

A small amount of inflation is definitely a good idea, though. Ellipsis' parallel to "theft" is overwrought, since the effect of small amount of inflation is a net increase in average wealth. It is hard to see where the theft is if you're left with more constant-dollar wealth than you started with.

Kim Scarborough: As a non-economist, I always wondered if the power of the Fed is gradually slipping away as we move away from a cash economy.

Not really. The supply of money was detached from the number of circulating bills a long time ago (methinks when checking accounts were invented). Which is why we now have three measures for money supply (M1, M2, M3) instead of just one. And the Fed has a variety of ways to affect them (mainly buying and selling bonds in the open market).

As for the gold standard people, I've never understood the libertarian fascination with it. It strikes me as less libertarian because floating exchange rates allow the markets to decide the value of a currency. A gold standard means the government dictates the value they want a currency to be worth. And if the market considers a currency to be overvalued by the government, they will take advantage of this by exchanging the currency for gold, thus draining gold away from a country's reserves (the reason we got off the gold standard in the first place). Fixed exchange rates only make sense when the problems caused by currency volatility dwarfs these issues.

But I only have an undergraduate understanding of economics, so I could be mistaken somewhere.

For the record, I'm not a gold standard person. I'm a free-banking/competing currencies person.

It should be noted that inflation itself is taxed, altho less so than in the recent past. They call it "Capital Gains".

Dan wrote:

Inflation hurts people with cash savings and benefits people with lots of debt. So how can it be an example of the rich benefitting at the expense of the poor?

Well, first of all really rich people don't pay interest, they collect it. If they borrow money it is to invest in something that is supposed to throw off more money than the cost of debt service, right? And the rich have more options (tax free muni's, offshore accounts in other currencies, hedge funds) than the working stiff who socks $50/week into a savings account and buys a US Savings Bond once in a while. Note again that rich people generally don't pay interest, they collect it...

A small amount of inflation is definitely a good idea, though.

Why?

Ellipsis' parallel to "theft" is overwrought, since the effect of small amount of inflation is a net increase in average wealth.

Really? How does that work, please? Suppose that I issue a new currency; for every dollar you give me, I give you 1,000,000 NewDollars. In places where NewDollars are common, the soda machines dispensing bottles of drinks take 1,000,000 NewDollar notes...so how has the average wealth been increased?

Don't confuse wealth with tokens used in accounting...

It is hard to see where the theft is if you're left with more constant-dollar wealth than you started with.

If that were true, I'd agree, but since depreciation of the currency leaves persons holding cash with less and less constant-dollar wealth, the theft should be obvious. Take the just-retired person who has 5 bank accounts, each at the $100,000 maximum insured value. Interest on those accounts is probably all of a whopping 1.75%, while the depreciation of the currency is running at 3% or more. This person is really thrifty and lives off of the interest in the accounts (how that works I have no idea) but never touching the principal. In 24 years the money in those accounts will only buy $250,000 worth of goods and services; the now-old retired person has been robbed of 50% of the value of his/her savings!

The miracle of compounding can work for or against you, but it always works.

Randy wrote:

If the price of gas goes up, and I have the economic power to demand a raise to compensate, then I'm really not paying higher prices - but those with no such power are. That economic power tends to positively correlate with class is incidental.

Of course, if you have the power to demand -- and get -- a raise, you're not going to wait around for some silly little fluctuation in gasoline prices to do so. At least, I wouldn't.

Well, first of all really rich people don't pay interest, they collect it.

Which is why inflation hurts the rich and benefits the poor. Inflation hurts people who have lent money and helps people who have borrowed money. If I lend you $10 today and expect $15 back five years from now, fat lot of good that does me if $15 five years from now is only worth $9 in today's money. I've effectively paid you a dollar to take $10 of my money for five years and give me nothing in return.

Why? [is a small amount of inflation good]

For the reasons already stated; it helps the economy in various ways, lubricating the wheels of commerce as it were.

How does that work, please?

One obvious way is that it makes investment effectively mandatory for rational actors -- you have to invest in something, or you're guaranteed to lose money. Since the average investment pays off at much better than the inflation rate, this has the effect of forcing people to (a) help the economy and (b) get richer in doing so.

A second obvious way is that a low inflation rate reduces the risk of slipping into deflation. Having an inflation rate of exactly zero is impossible -- nobody has enough knowledge to pull that off. Deflation is far, far worse than inflation. It is therefore sensible to have a small rate of inflation, as an insurance policy against being pushed into deflation by economic fluctuations.

Suppose that I issue a new currency; for every dollar you give me, I give you 1,000,000 NewDollars. In places where NewDollars are common, the soda machines dispensing bottles of drinks take 1,000,000 NewDollar notes...so how has the average wealth been increased?

You do realize that that's not an example of inflation, right? That's an example of currency exchange. If you replaced all the money in America with 1,000,000 times as many NewDollars, the inflationary effect of that would be zero.

If that were true, I'd agree, but since depreciation of the currency leaves persons holding cash with less and less constant-dollar wealth, the theft should be obvious.

I'm sorry, but I don't think it counts as "theft" when (a) you know with absolutely certainty that you'll lose money if you do something and (b) you do it anyway. That's stupidity, not victimization. A person with substantial cash reserves should do the intelligent thing and invest his money instead.

On the topic of deflation... I think there is a distinction here...

On the one hand you can have demand side deflation, a decine in prices in an attempt to chase insufficient demand. I think we can all agree this is good.

On the other hand you can have supply side deflation. This is a situation where due to a variety of reasons (mostly productivity growth) the cost of providing goods and services declines and competition lowers consumer prices to match. I would maintain that supply side deflation is a wonderful thing. We've had it for decades in some of the healthier parts of our economy (tech) and it seems to have been a good thing for both suppliers and consumers.

Thoughts?

Pardon, above should have been:

"On the one hand you can have demand side deflation, a decine in prices in an attempt to chase insufficient demand. I think we can all agree this is not good."

Using gold as money is all well and good... except when the supply of gold drops relative to demand. Then you get lots of deflation.

And sometimes your country's explorers go west and bring back scads of gold. Then you get lots of inflation.

A good central bank will keep prices more stable than the fluctuations imposed by the supply of gold.

One day we can ditch money entirely and use wirelessly networked computers to do all our trading. Till then, we'd like some sort of stable money supply, and we definitely want to avoid deflation.

The bad thing about deflation is that people can make profits just by sticking their money in their matress and pulling out more valuable money later. This discourages people from doing things like lending out money; if the best deal lenders can get involves lending out dollars and getting fewer dollars back, it's better to hold onto those dollars and make even more profit. Similarly, if the best an entrepreneur can do is to invest dollars into an enterprise and get fewer dollars out of it than he put in, he's better off putting the money into his mattress.

So deflation tends to discourage lending and investment, which is bad for people whose livelihood depends on borrowing money or holding jobs.

Dan,

Re; "Inflation hurts people with cash savings and benefits people with lots of debt. So how can it be an example of the rich benefitting at the expense of the poor?"

Those with little economic power have neither cash savings nor debt. They are simply stuck with wages that do not increase with inflation. Inflation doesn't hurt those who have the ability to adapt to it. As ellipsis pointed out, this doesn't need to be a class argument. But generally speaking the rich aren't hurt by inflation while the poor are. My thought is that the underlying cause of inflation is not money supply, but excessive taxation. That is, the economy responds to excessive taxation with inflation. The government responds to inflation by altering the money supply. A vicious cycle. Turns out there is no free lunch.

So who actually pays higher taxes? - the people handing in the checks? - or the people who actually get hurt?

Aric,

Re; "Of course, if you have the power to demand -- and get -- a raise, you're not going to wait around for some silly little fluctuation in gasoline prices to do so."

Good point, but many raises are based on CPI, and the ability to get such raises is a function of economic power.

Dan wrote:

I wrote:
Well, first of all really rich people don't pay interest, they collect it.

Which is why inflation hurts the rich and benefits the poor.

I can tell that someone has never lived through a period of inflation while working for the minimum wage, or lower. The lowest wages are the last to react to depreciation of the currency, the very last.

Inflation hurts people who have lent money and helps people who have borrowed money.

Up to a point, this is true. But people who lend money quickly demand a premium in order to try to keep up with the depreciation of the currency. If they can't get it, then they stop lending money and turn to other investments. This happened in the 1970's, when stocks and bonds were poor vehicles, people turned to tangibles. People working for low end wages do not have that option, they find that more and more of their income is required to buy the same basket of goods. Those who are saving find it harder and harder to do so.

People workiing for midrange wages, who do a lot more borrowing than rich or poor, could be said to benefit from inflation in this sense. But aside from their debt, they suffer as well, just not as obviously.

If I lend you $10 today and expect $15 back five years from now, fat lot of good that does me if $15 five years from now is only worth $9 in today's money. I've effectively paid you a dollar to take $10 of my money for five years and give me nothing in return.

And that's why you'd demand a higher interest rate once depreciation of the currency becomes embedded in the economy. That higher interest rate won't have a stimulating effect on things, right? For example, back when the prime rate was around 20% were there a lot of loans made, or hardly any?

I asked:

Why? [is a small amount of inflation good]

For the reasons already stated; it helps the economy in various ways, lubricating the wheels of commerce as it were.

No, that's not an answer. I could just as easily say that by encouraging misallocation of capital it hurts the economy. I'd be right, of course, but need to at least show why. Show me why degrading the currency is good for anyone; if a little inflaction of 3% is good, shouldn't more be better, for example? How about 10% per year, wouldn't that really lube up the economy and get it roaring? Better still, let's try for 100% per year, that'd really make things rock, right?

I asked:
How does that work, please?

One obvious way is that it makes investment effectively mandatory for rational actors

Not all humans are rational actors. Some are never rational actors, some are rational some of the time. If all humans were rational actors all the time, then bubbles like the dotcom mania would never happen. Since such things do happen, humans are not rational actors. It is not a good idea to make economic decisions based on a false premise.

-- you have to invest in something, or you're guaranteed to lose money.

And even if you do invest in something, you may well lose money. That's why "investing" is different from "saving", there is a higher risk.
But inflation, by robbing the currency of value, makes all investments more risky, because the return must be so much higher than the rate of inflation.

Since the average investment pays off at much better than the inflation rate,

Where can I find this average investment, please?

In the 1970's the Dow underperformed inflation for almost 10 years, the bond market was pretty much always behind the curve, and so forth. Right now the average investment seems to pay less than the inflation rate; the Dow has been stuck around 10,000 for several years, any stock that pays a dividend is returning less than 5%, bonds are priced very high, with returns less than half of the official CPI -- the only thing that is doing well is real estate, if one can buy and then flip a house or condo, there's a tidy profit. Gee, I wonder why there's a housing bubble...

With the current official inflation rate of 3%, show me an average investment that is throwing off at least 6% per annum and will continue to beat inflation by at least 3% no matter how high inflation goes...and be specific.

this has the effect of forcing people to (a) help the economy and (b) get richer in doing so.

But if the average investment is returning less than the inflation rate, then people are forced to (a) invest in ever riskier vehicles while (b) losing money in the process. I argue that is happening right now, as it has happened before.

A second obvious way is that a low inflation rate reduces the risk of slipping into deflation.

The dangers of deflation are overrated, in my opinion, due to the dramatic deflation of the Great Depression. Said deflation followed the
large inflation of the period 1918 - 1929.

Having an inflation rate of exactly zero is impossible -- nobody has enough knowledge to pull that off.

Please explain how it is that many commodity prices in 1905 were essentially the same as in 1825, then. Yes, there were panics, periods of inflation ("greenbacks"), and periods of deflation in the 19th century, but prices generally remained stable in the long run. How awful for businesses, to have to plan in an environment of stable prices! Surely they'd benefit from not knowing what their costs are going to be in a couple of years?

Deflation is far, far worse than inflation.

Why?

More sensible for central bankers and their cronies, perhaps, more sensible for a government that administers taxes on income, but not more sensible for business.

I wrote:
Suppose that I issue a new currency; for every dollar you give me, I give you 1,000,000 NewDollars. In places where NewDollars are common, the soda machines dispensing bottles of drinks take 1,000,000 NewDollar notes...so how has the average wealth been increased?

Reply:
You do realize that that's not an example of inflation, right? That's an example of currency exchange. If you replaced all the money in America with 1,000,000 times as many NewDollars, the inflationary effect of that would be zero.

Yes, I realize that, I was merely challenging the notion that changing numbers on the notes somehow increases wealth. Inflation does not increase wealth!

I wrote:
If that were true, I'd agree, but since depreciation of the currency leaves persons holding cash with less and less constant-dollar wealth, the theft should be obvious.

Reply:
I'm sorry, but I don't think it counts as "theft" when (a) you know with absolutely certainty that you'll lose money if you do something and (b) you do it anyway.

The example I gave was intentionally simple in order to demonstrate the corrosive effect of depreciation of the currency on simple savings. It is not, however, unrealistic; as people get older, their tolerance for risk changes and they are less willing to risk losing capital, because once you stop working for money, it is harder to get more. Therefore they tend to move out of things like stocks, and to move in to things like bonds. A fixed interest rate bond suffers from inflation in the same manner as the bank accounts in the example above.

That's stupidity, not victimization. A person with substantial cash reserves should do the intelligent thing and invest his money instead.

What's the inflation rate going to be next year? How about in 2010? You don't know, I don't know, no one knows. If you or I arrange investments today predicated on an inflation rate of 3% and in a couple of years it is actually 5%, does that makes us stupid, because we failed to plan for the higher rate of inflation?

Suppose that you did not have any income stream except from investments. Would that make you more prone to put your capital into places where the chance of a loss was higher, or into places where the chance of a loss was lower? I'd suggest that it would result in a large portion of capital in something with a very low risk of loss, a medium portion in higher risk investment and only a tiny part in really high risk (and thus potentially high return) vehicles. But that's me, and I have a higher risk tolerance than someone who is retired.

Supply-side deflation is, as noted above, common in some industries. $1,500 more or less bought a midrange computer in 1988, 1993 and even in 2000. The difference between a 286 with 640K of RAM, a Pentium I with 32 Meg of Ram and a Pentium 3/ Athlon with 128 Meg of Ram is quite significant. Calculators are essentially free, in constant dollar terms. In fact, this particular form of deflation is being used to manipulate the CPI via "hedonics".

Supply side deflation is what we are seeing in manufactured goods, because of the ongoing industrialization of China; if it can be "made in China", it likely will go down in price for some time to come. This is good, if you are a buyer, and not so good if you are a manufacturer trying to compete.

Demand side deflation is the boogeyman that everyone fears, and is willing to tolerate inflation to avoid. Yet we have seen it happen over and over in recent years; any time a housing market gets overbuilt, deflation occurs sooner or later. Some people get hurt badly, others get hurt a little bit, some don't get hurt at all. But it is hardly the end of the world when a housing bubble pops; Phoenix, Ariz. has gone through multiple boom/bust cycles in housing since WW II, and the place is still standing. Deflation doesn't go on indefinitely, eventually price equilibrium is restored and life goes on. I'm guessing that the horror people have for deflation is still a product of the 1930's depression.

Deflation arguably is the proper response to inflation; by destroying the excess liquidity created in the inflationary period, deflation as such it is the natural "cure" for an inflationary episode. The alternative we have seen since Bretton Woods collapsed is for endless depreciation of the currency in a fiat money environment. The problem is, every previous example of such a system in human history has collapsed eventually, as the value of the fiat token converges to zero. The deflation that is required to accomplish this is eye popping, and the social and economic effects can be very serious. It took Europe a long time to recover from John Law's bubble(s), for example. The Wiemar hyperinflation in Germany during the 1920's had some unpleasant socio-political results, for another example.

One of the things that I find alarming about the 2001 "recession" is that it wasn't a recession, there was no cleaning out of inventories, no failure of marginal businesses, and so we still have many of the same distortions in the economy. The "hot" money is still sloshing around the globe, looking for the next high return. Eventually we will see a turn to tangibles, and then watch out! Central bankers get alarmed with the price of gold starts rising; at the peak of the inflationary episode of the 1970's IIRC gold was at $800/ounce. That doesn't seem so bad today, but adjusted for inflation it would be, hmm, $1200/ounce? Maybe more?

Suppose that the alternative to deflation was not inflation, but a hyperinflation, then what should be chosen?

Ellipsis - good post. Especially that part about money shloshing around the globe. I read somewhere that what we are seeing is really a lapse in innovation. The wealth created by the last great surge in innovation in the early 90s was just looking for somewhere to go by 2000 - first equities, then real estate - neither of which is really capable of storing the value of so much wealth. What is needed is something worthwhile to invest in.

Who knew that a a topic so seemingly mundane as inflation/deflation and central banking would turn much of the Jane Galt commentariat's right-ish wing into multiloquent, hyperbolic class warriors?

Theft, schmeft. It's one way of doing things and it has both advantages and disadvantages; but this much is obvious to any observer, it hasn't exactly sent the US to purgatory in the past hundred years. Way to stick a fork in an otherwise thought-provoking analysis, ellipses :-/

anony-mouse wrote:
Who knew that a a topic so seemingly mundane as inflation/deflation and central banking would turn much of the Jane Galt commentariat's right-ish wing into multiloquent, hyperbolic class warriors?

Try raising the issue of central banking, fractional reserve banking, inflation and deflation at a Libertarian party meeting some time, and see what happens. This is tame.

Theft, schmeft. It's one way of doing things and it has both advantages and disadvantages; but this much is obvious to any observer, it hasn't exactly sent the US to purgatory in the past hundred years.

I guess if I were to buy some product from anony-mouse and paid for it with counterfeit notes there'd be no objection, no complaint of theft?

Inflation isn't just "one way of doing things", it's a dangerous way of doing things, and every time it has been tried it has failed. The US hasn't been on a fiat system for the last 100 years; the Federal Reserve didn't even exist 100 years ago, for a start, and ties to gold limited the dollar until 1971. The fact that the dollar has lost over 90% of its value since the creation of the Fed, and much of that in the last 40 years, ought to give a little pause to fans of inflation.

Way to stick a fork in an otherwise thought-provoking analysis, ellipses :-/

Shrug. I calls 'em as I sees 'em. Wanna discuss the income tax, instead?

ellipsis seems to be missing a very basic point that the other people are assuming but not quite explicitly stating. So I'll state it explicitly:

Having a bit of inflation in the system will result in the economy growing faster such that even accounting for inflation, real wealth will increase more than it would if you tried to run a zero-inflation economy. In other words, so what if inflation is 2%, if nominal wealth increases at 6%, vs. having inflation at 0% but nominal wealth only increasing at 1%.

Now, it's certainly valid to debate whether or not having a bit of inflation in the system really does goose things enough to make the economy better off after accounting for that inflation. But ellipsis doesn't even try to go there and simply stops at "inflation bad".

ellipsis-

I think what anony-mouse means when he says that inflation "is just one way of doing things" is that one way of doing things is to tolerate small amounts of inflation, rather than attempt to eradicate it. If that is the case, then your assessment that "every time it has been tried it has failed" is incorrect. Also, I find it unclear what your the point you are trying to make is by citing America's transition from the gold standard to fiat. Perhaps you could elaborate?

QM,

If a little inflation does in fact lead to greater productivity, then it could be said that a little inflation is a good thing. But how would we know? It seems to me that the fact of inflation existed before the theory that inflation is okay - which causes me to doubt the theory.

And of course there is also the problem that inflation is obviously not good for everyone. Is the possibility that it is good for some, a justification for naming it an unqualified "good"? Or is it conceivable that the people calling it good are simply the people it is good for?

So now fractional reserve banking is bad? Fine, let's just start doing business in ducats and florins.

AT,

Well, Mises thought it was bad. Seems to me that the continued success of fractional reserve banking depends on the public never understanding just how shaky it is. Makes me think twice about the desireability of educating the public in economics.

It should also be noted that a little bit (or a lot) of inflation is good for those holding leveraged real assets (like Real Estate.) Any politician that came out against Real Estate (either by allowing deflation or removing the mortgage interest deduction) would be hung from the nearest yardarm. Given those political realities, I think inflation will be with us as long as the Fed can make it happen.

Randy, how could banks lend money without fractional reserves?

I believe Paul Krugman, back in the days when he was a good economist instead of a bad pundit, wrote on this subject a number of times. I'd always understood his argument to be that deflation was a bad thing because it encouraged hoarding, which removed resources from the economy, which slowed economic growth. A moderate amount of inflation, in contrast, discouraged hoarding, which stimulated the injection of resources into the economy, which increased economic growth.

As far as I know, everyone who believes in a small amount of inflation to stimulate economic activity agrees that large amounts of inflation are a bad thing.

"If a little inflation does in fact lead to greater productivity, then it could be said that a little inflation is a good thing. But how would we know?"

Technological progress demands sustained work, uninterrupted by economic busts. If a company could only get, say, 80% of the way toward a cure for the most common type of lung cancer before being bankrupted by a deflationary cycle, then the expected return on investment for that research is negative and will not be funded. It is the success of technical progress that primarily determines the real value of retirement funds and the like. No amount of gold bullion can make up for not being able to buy an artificial pancreas at any price.

I guess if I were to buy some product from anony-mouse and paid for it with counterfeit notes there'd be no objection, no complaint of theft?

Are you presently subject to an overdose of antihistamines, or are you just being irrelevant and flippant for fun?

You cannot peg a large, complex system -- especially one as big as the US economy -- at '0.' Moreover, you cannot guarantee that your best intentions will completely prevent an extreme swing from occurring. Suppose there is no fed and no structured inflation to keep a stimulus on investment and reduce the pressure on borrowers, and currency reverts to a gold standard.

Now suppose a deflationary swing occurs and gains enough momentum to become self-reinforcing. How do you propose to get us out of that, short of yet another huge rash of social programs, and Europe generously offering to start a third world war?

ellipsis
Really? So I guess it was the hyperinflation of the 19th century that led to investors pouring capital into canals, railroads, telegraph lines, and other high-risk investments? Or going back a couple of centuries, the Dutch who pooled their fortunes to hire a ship that would sail to Sumatra and back, hopefully, they were motivated by inflation?

I never said inflation was the ONLY motivation for higher returns, I said it was a motivation for high returns. By the way, I said a little bit of inflation (

But inflation makes everyone chase higher returns no matter what their risk tolerance is, and leads to the absurdity of pension trustees investing in hedge-funds, retirees putting substantial amounts of money into riskier stock funds, and so forth, in order to try to get ahead of the depreciation that is destroying their capital.

Inflation makes every chase higher returns no matter their risk tolerance? Is that why with the 2% inflation of the late 1990's people started pouring money into tech stocks and with 10% inflation of the 1970's people socked money away in that high growth commodity gold? Maybe we both are overestimating the rationality of people, because it seems people often chase returns based on the latest fad.

The history of investing over the last several hundred years tells me that the above statement is false.

In periods of deflation since 1900, the stock market had low returns. Of course, in prolonged periods of low inflation, the stocks markets tended to form a bubble. I guess you pick your poison. I do agree with your demand-side/supply-side deflation argument. Well said.

hammer

Ellipsis seems to be ignorant of TIPS and I-bonds. For example:

http://www.publicdebt.treas.gov/sav/sbirate2.htm

AT,

Re; "how could banks lend money without fractional reserves?"

That is a truly interesting question. Because the question underlying it is, how could we live without debt? Simpler lives, no doubt. I picture a world where people build their own homes - like my father did, and his before him. A world with fewer cell phone, computers, and cars. A world where people save more and spend less. In short, a much different world - though not necessarily a worse one.

Banks could still lend, they would just have to lend money they really have. People could still borrow, but borrowing would be expensive, and they would have to limit their borrowing to leverage - avoiding debt for the purpose of living beyond one's means. So how much of our current debt is leverage and how much is living beyond our means? Could lending of real money support the part that is leverage?

What is happening now is that banks loan fake money, people borrow and spend fake money, and as long as everyone believes that the fake money has value, then everything is fine. Belief has always been a primary component of money. Gold is no different - it has value because people believe it does. The problem with an ever expanding supply of fake money is that it is inevitable that at some point people will stop believing. We are living the good life with our fake money. But we are beginning to see that we are not only borrowing against our own futures, but our children's futures as well. There is no such thing as a free lunch.

Randy:

If a bank has to keep 100% of its deposits in reserve, it simply can't lend money, "real" or otherwise. Wouldn't banking revert to the 15th century and merely be trading of banknotes and letters of credit? The whole point of a financial intermediary is to allocate capital where it's most productive. Your propose that everything will be funded with securities offerings or groups of rich guys lending money on their own? Sounds a bit inefficient to me. Perhaps you could build a house by yourself and show us how easy it is to do?

Oh dear -- the anti-inflation, anti-central bank crowd have finally gotten to the argument that all this economic growth doesn't really make the world a better place. Can dark mutterings about the Rothschilds, the Freemasons and/or the Trilateral Commission be far behind?

AT,

Yes, banking would revert to the 15th century, when the Medici would loan money to customers to enable them to do business. But the Medici assumed 100% of the risk on these loans, for which they received an appropriate interest payment. Today it is the depositors who take the risk - without any idea that they are doing so. They give their money to the bank, thinking it will be there for them when they need it, when in truth the bank has simply passed most of it on to someone the depositor doesn't know and has no reason to trust. Of course the government insures the depositor - doesn't it? Sorry, but no. The FDIC is nothing but a security blanket given to depositors to keep them from losing their faith. If the FDIC is ever really needed, the only place the government can get the money to cover the deposits is from the depositers in the form of taxes.

Am I suggesting that we should require 100% reserves tomorrow? No, that would be as stupid as the fed raising the interest rate to 25% tomorrow - it would bring on the crash it is trying to avoid. But yes, I do think a gradual tightening of the reserve requirement is a good idea.

As for building a house on my own, yes I could do it. I helped my father build his - though certainly building codes make this much more difficult today. Today it is easier to just borrow fake money, and give it to someone else to do the building for me.

DRB,

Your assumption is that growth is a product of inflation. It isn't. Growth is a product of innovation and productivity. Inflation is a product of living beyond our means. Is a little inflation a "good" thing? Sure, if we enjoy living beyond our means. The question is, who is going to pay?

Randy,

My assumption is not that growth is a product of inflation. My assumption is that inflation -- in small amounts -- helps to stimulate growth by discouraging hoarding (which tends to retard growth). I am also making an assumption that economic growth is a good thing. You may disagree, but in that case I don't think we're going to have much to say to each other -- I consider this more or less axiomatic.

The notion that we are "trying to live beyond our means" appears to be an enthusiastic embrace of the Lump of Wealth fallacy. This is the fallacious concept that there is a fixed amount of wealth in the world and that we are in some fashion "using it up" through our economic activity. In fact, our economic activity creates wealth.

DRB,

This is new territory for me. AT brought up an interesting idea and I'm exploring.

I agree that growth is a good thing. And debt, in the form of leverage increases growth. But debt in the form of having lots of trinkets, a bigger house or nicer car than I can really afford, or social programs that only the next generation can possibly pay for, are all forms of living beyond our means, and they are the cause of inflation. They run counter to that part of the debt which is truly leverage. They hold back growth. It isn't a lump of wealth argument. It is an argument that living beyond our means is putting the breaks on growth.

Randy,

First, I'm having trouble understanding the distinction you're making between debt and leverage. Appreciate it if you could explain what you mean when you draw that distinction.

Second, could you explain how buying more stuff, a bigger house, or a nicer car causes inflation? Inflation is what occurs if you have to pay more this year to buy a nicer car than you did last year. But I can't figure out what relation the decision to buy a nice car has to do with inflation.

Third, could you please explain how people buying more stuff actually *reduces* growth? From where I'm sitting, growth would decline if people decided to buy less stuff. I honestly am having trouble following your thought process here so appreciate any help you could provide.

DRB,

You're having trouble following my thought process? Me too :)

But I've been doing some reading on the history of central banking. Interesting stuff. I think I might be on to something here, but it isn't clear enough to keep posting. Don't mean to waste your time - your questions are good. I'll get back to you the next time this comes up.

New train of thought. This came to me in the shower last night, but I think its worth getting down.

Let's step away for a moment from whether inflation is good or bad, and talk about what inflation does. What it does, is destroy the ability of money to act as a long term store of value.

So what happens when money loses its ability to store value over time? What replaces it?

Nothing! There is no way to store value over time if money can't do it. No, not even investments. Excluding other factors, investments will lose their value at exactly the same rate as money because investments are valued in terms of money.

So what does this mean? It means I have to keep working! More precisely, the only wealth I can count on is the wealth from the value I am currently creating.

Now, is this good or bad? It depends entirely on your perspective. If your interest is macroeconomic or socio-political, then keeping people on the job is good. From the perspective of a person who would rather not work till the day I die, its not so good. Its the work ethic on steroids.

Finally, why is a little inflation good but a lot of inflation bad? Because a little inflation destroys only the ability of money to act as a long term store of value, but a lot of inflation, by destroying the ability of money to hold even short term value, destroys also its ability to act as a medium of exchange. A little inflation leaves no option but work, a lot of inflation breaks the system down entirely.

I wrote:
"I guess if I were to buy some product from anony-mouse and paid for it with counterfeit notes there'd be no objection, no complaint of theft?"

Anony-mous replied:
Are you presently subject to an overdose of antihistamines, or are you just being irrelevant and flippant for fun?

I'm asking simple, basic questions. How about another? The First Bank of Ellipsis is now open. All deposits accepted. Interest rates will vary from 0% to 6% per annum. A fee of 3% of all deposits will be collected once per year. Now, how many takers do I have for accounts?

Hmmm. Nobody seems to want to give me 3% of their principal every year, but it's just fine for the Fed to take the same chop, how strange....

You cannot peg a large, complex system -- especially one as big as the US economy -- at '0.'

This once again assumes that I think it's a good idea to have someone setting interest rates for the entire country. Well, why stop there? Why not have the Secretary of Energy issue a decree that sets the price of a barrel of oil, the Secretary of Agriculture declare exactly what the price for a bushel of wheat should be, Secretary of Transportation decide how much airline tickets should cost...

I mean, you're already on record supporting a centrally planned economy, so why stop at just interest rates?

Moreover, you cannot guarantee that your best intentions will completely prevent an extreme swing from occurring. Suppose there is no fed and no structured inflation to keep a stimulus on investment and reduce the pressure on borrowers, and currency reverts to a gold standard.

Ok, but under such a situation I would expect some other institutions to come into being; there were banks that issued notes into circulation, for example, in the 19th century.

Now suppose a deflationary swing occurs and gains enough momentum to become self-reinforcing.

How exactly does that work, please?

How do you propose to get us out of that, short of yet another huge rash of social programs, and Europe generously offering to start a third world war?

Looking back at periods when such events actually happened, I'd say that at some point price equilibrium is restored and the economy begins to expand again.

But the premise above is clear: that social programs and a war ended the Depression of the 1930's. If one actually looks at the data, what seems to have ended the depression was a restoration of price equilibrium due to the gross excess of credit created in the 1920's having finally been 'worked off', and this happened despite the further gross distortions introduced by social programs. In fact, if you look at the records you see that the Depression was really multiple recessions on top of each other, the later ones being caused by the Roosevelt "cures" for the first one.

Rick MacAlexander writes:
ellipsis-

I think what anony-mouse means when he says that inflation "is just one way of doing things" is that one way of doing things is to tolerate small amounts of inflation, rather than attempt to eradicate it.

But this is a false dichotomy. Attempting to eradicate inflation would lead to merely more attempts at managing the economy via monetary methods, which is what I object to in the first place. The 19th century period when there was no central bank in the US saw periods of both inflation and deflation, but no inflation as bad as the 20th century nor any deflation as bad as in the Great Depression, either. There is a nasty habit of unconsciously thinking of an economy as some kind of machine; push this button, pull this lever, and the desired results pop out. This view is utterly wrong; machines don't grow and shrink on their own, they don't pinch off parts into extinction while expanding other parts; that's what living things do. An ecological view, with different niches, changing resources, changing populations, and so forth is a better view. Think of an economy as big lake...

If that is the case, then your assessment that "every time it has been tried it has failed" is incorrect.

Name a fiat currency from the past, and tell me what happened to it. John Law's paper money, the Assignats, the Continental, the Greenback, the experiments in China...all of them in time reverted to zero value. Inflation is a monetary phenomenon caused by an increase in the medium of exchange, right? Fiat currencies facilitate inflation; because inflation (depreciation of the currency) is a stealth tax, in which the government gets to buy goods and services with cheaper tokens, it is apparently irresistable to governments in the long run. Unfortunately, it gets out of hand in the longer run and the fiat token value converges to zero -- at which point even a lender of last resort cannot step in -- and some new kind of currency, with some sort of built in restraint (like a gold standard, but there are others) is created and stability is restored.

Also, I find it unclear what your the point you are trying to make is by citing America's transition from the gold standard to fiat. Perhaps you could elaborate?

Under the gold standard America had price stability, which made planning by business much easier. It wasn't perfect, inflation and deflation were still possible, war was still possible, businesses could still fail, but it was a heck of a lot easier on the populace. Note that a whole lot of government intervention in the economy, from low-cost loans to business (SBA) and individuals (FannieMae, etc.) to tax breaks and so forth are intended to "level the playing field". But none of these efforts were needed to grow the US from a small country to large one in the 19th century; a stable currency seems to have served many of those purposes.

I'm surprised how many posters to a libertarian web site seem to have an abiding faith in a centrally planned economy...

QM noted:

ellipsis seems to be missing a very basic point that the other people are assuming but not quite explicitly stating. So I'll state it explicitly:

Having a bit of inflation in the system will result in the economy growing faster such that even accounting for inflation, real wealth will increase more than it would if you tried to run a zero-inflation economy. In other words, so what if inflation is 2%, if nominal wealth increases at 6%, vs. having inflation at 0% but nominal wealth only increasing at 1%.

Well, that's quite an interesting assumption, and frankly I have never seen it stated in that way before. How one would go about proving it is a problem.

On the face of it, this seems laughable to me. There's a lot of huffing and puffing in the conservative press right now about recent numbers claiming a 3.8% growth rate in the economy in the latest quarter; however the inflation rate is at least 3% and may be as high as 4.7%, depending on the numbers one looks at. The 'fever' of inflation may well increase some economic numbers, but the cost of inflation is distributed across the economy and is pernicious.

More likely, in my opinion, is that 6% "growth" rate is accompanied by a 5% inflation rate, for a true growth of 1%. If inflation rises to 7% and "growth" hurtles to 8%, what's been gained? Well, a lot of debt...

Now, it's certainly valid to debate whether or not having a bit of inflation in the system really does goose things enough to make the economy better off after accounting for that inflation. But ellipsis doesn't even try to go there and simply stops at "inflation bad".

Shrug. It is a bad thing. It's bad for people who save (and "savings" are the things that banks are supposed to lend out, right?), it's bad for people on fixed incomes, it's bad for people on low wages, it distorts the economy by keeping marginal companies and marginal projects going long after they should have been closed.

It represents deliberate interference in the economy for political reasons; that alone ought to be enough to justify opposing it, to a libertarian...

John Allred pointed out:

It should also be noted that a little bit (or a lot) of inflation is good for those holding leveraged real assets (like Real Estate.) Any politician that came out against Real Estate (either by allowing deflation or removing the mortgage interest deduction) would be hung from the nearest yardarm. Given those political realities, I think inflation will be with us as long as the Fed can make it happen.

Now that is a cogent point. Inflation is good, in a sense, for some debtors, and if they have sufficient political pull, they can demand it. But now we aren't in the world of "the Fed managing the economy for the best of all", no, we are now into "the Fed manipulates interest rates for political gain", a far cry from "a little inflation is a good thing".

Of course, if enough people overseas decide that the value of the dollar is declining too fast, they can always decide to get rid of their dollars and buy something else. The central bank of Russia recently lowered its reserves from 90% dollars to 70% dollars, for example. The Chinese seem to be intent on recycling their dollar holdings into other things - oil companies (oops, didn't work), a strategic oil reserve, and who knows what else? Getting rid of fiat currency in favor of a tangible object, such as a commodity, is not a good sign for fans of inflation...

Posted by John Allred at

DN stated flatly:

Technological progress demands sustained work, uninterrupted by economic busts.

I guess that's why the 19th century had no technological progress, or the first half of the 20th, then?

If a company could only get, say, 80% of the way toward a cure for the most common type of lung cancer before being bankrupted by a deflationary cycle, then the expected return on investment for that research is negative and will not be funded. It is the success of technical progress that primarily determines the real value of retirement funds and the like. No amount of gold bullion can make up for not being able to buy an artificial pancreas at any price.

So thanks to inflation, we have the incredibly stable biotech sector, where no companies ever go broke or otherwise fail?

Hammer pounded away thusly:

ellipsis
Really? So I guess it was the hyperinflation of the 19th century that led to investors pouring capital into canals, railroads, telegraph lines, and other high-risk investments? Or going back a couple of centuries, the Dutch who pooled their fortunes to hire a ship that would sail to Sumatra and back, hopefully, they were motivated by inflation?

I never said inflation was the ONLY motivation for higher returns, I said it was a motivation for high returns.

Ok, tell me which is the higher return: 5% per annum in an economy with a stable currency, or 10% per annum in an economy with inflation at 9%?

By the way, I said a little bit of inflation (

"A little bit" of inflation has a habit of becoming a little bit more, and pretty soon you're talking real numbers...

I wrote:
But inflation makes everyone chase higher returns no matter what their risk tolerance is, and leads to the absurdity of pension trustees investing in hedge-funds, retirees putting substantial amounts of money into riskier stock funds, and so forth, in order to try to get ahead of the depreciation that is destroying their capital.

Hammer replied:
Inflation makes every chase higher returns no matter their risk tolerance? Is that why with the 2% inflation of the late 1990's people started pouring money into tech stocks,

You mean, the tech stocks that were "sure things", because it was a "new era" in investing, where it was only a matter of time before the Dow would hit 30,000 and "stocks for the long run" are investments that "never go down"?

Greed is a part of the human condition...

and with 10% inflation of the 1970's people socked money away in that high growth commodity gold?

People turned to gold as a last resort. First they chased stocks; the "Nifty Fifty", to be specific. When that failed, some turned to bonds and got burned, some turned to tangible assets and finally to the last resort, gold. But on the way there, people bought into all sorts of mutual funds (some of which no longer exist) and other schemes that offered high returns. If you choose to look, you can see it now; ordinary people turning to hedge funds, for example.

Maybe we both are overestimating the rationality of people, because it seems people often chase returns based on the latest fad.

I'm not overestimating rationality, I'm mostly reciting history. History can be a dreary subject with the same mistakes over and over again...like fiat currencies and inflation...

In periods of deflation since 1900, the stock market had low returns.

Yes, and so what? Holders of many bonds had adequate returns. As the excess debt/liquidity was worked off, pricing returned to an equilibrium and the economy began to expand...so?

Of course, in prolonged periods of low inflation, the stocks markets tended to form a bubble.

Uh, what periods are you referring to? The 1920's stock market bubble was funded by a huge (for the times) increase in liquidity created by the Federal reserve in an attempt to end the recession of around 1919-1921. Eventually they took the punchbowl away, but too late. The stock bubble of the late 1960's seems to have been fed by the guns 'n butter inflationary policies of Johnson. The 80's saw no stock bubble. So what's your point?

I'm not saying that a stable currency brings Nirvana, there's no such thing as a perfect economic system, or a perfect government, or a perfect society so long as humans are involved. But there are clearly some situations that are worse, much worse, than other situations...and inflation is clearly worse than stability. Since we haven't really had genuine prices stability for generations, none of us really can appreciate it in a personal fashion.

I guess you pick your poison. I do agree with your demand-side/supply-side deflation argument. Well said.

Now that's interesting! So clearly we should all be investing in stuff that can't be "made in China". Hmm, I think I pick -- oil stocks!

ErikR noted:

Ellipsis seems to be ignorant of TIPS and I-bonds. For example:

http://www.publicdebt.treas.gov/sav/sbirate2.htm

Thanks for reminding me of the inflation adjusted bonds. It will be interesting to see how they calculate interest rates, and if those things continue to exist, in years to come. Frankly, with all the "adjustments" to the CPI introduced in the 1990's I don't believe it is very accurate anymore.

Hedonics and substitutional pricing alone make it questionable.

Ken wrote:

Using gold as money is all well and good... except when the supply of gold drops relative to demand. Then you get lots of deflation.

First of all, there's no such thing as a perfect economic system. However I'm at a loss to understand how the above happens.

And sometimes your country's explorers go west and bring back scads of gold. Then you get lots of inflation.

That's what happened to Spain, certainly. They came to be known as the "mouth of the world", and everyone rushed to sell stuff to them. Good thing we have central bankers, so that can't happen now, right? Say, what's the US trade deficit, again?

A good central bank will keep prices more stable than the fluctuations imposed by the supply of gold.

Assuming, of course, that one can find a "good central bank". The track record is at best rather mixed, when it comes to this particular remnant of the era when Kings had a Divine Right to rule (and thus a Divine Right to determine what the money supply should be).

One day we can ditch money entirely and use wirelessly networked computers to do all our trading.

Maybe. But I'm not going to hold my breath on that one, it reminds me too much of the "paperless office" predictions I read in the 1980's.

Till then, we'd like some sort of stable money supply, and we definitely want to avoid deflation.

Hey, I'd like a new house with a big garage to put about 10 cars in, too! But I don't see any of these "likes" being taken care of any time soon...

The bad thing about deflation is that people can make profits just by sticking their money in their matress and pulling out more valuable money later. This discourages people from doing things like lending out money; if the best deal lenders can get involves lending out dollars and getting fewer dollars back, it's better to hold onto those dollars and make even more profit. Similarly, if the best an entrepreneur can do is to invest dollars into an enterprise and get fewer dollars out of it than he put in, he's better off putting the money into his mattress.

So deflation tends to discourage lending and investment, which is bad for people whose livelihood depends on borrowing money or holding jobs.

However it tends to encourage savings, which are needed for proper lending, it tends to end marginal businesses, which is needed in the long run for an economy to function. Deflation is simply the period in which excess debt is liquidated. At the personal level, a person with too much debt lives below their income level, in order to clear away that debt and ultimately be free of debt service. It stinks to eat at home all the time and drive an older car, but it's worse to live at a level where all available discretionary income goes into debt service, because in the long run you can't save (and therefore can't invest) in that condition.

At the macro level, when a business is pouring most of its receivables into debt service, it's time to stick a fork in it.

Deflation is part of the natural ebb and flow of an economy, frankly. It's only when a central bank starts goosing the money supply in order to "manage" the economy that we get really bad, deep deflation -- like the 1930's -- and that always follows what monetary phenom? Inflation...

DRB wrote:
I believe Paul Krugman, back in the days when he was a good economist instead of a bad pundit, wrote on this subject a number of times. I'd always understood his argument to be that deflation was a bad thing because it encouraged hoarding, which removed resources from the economy, which slowed economic growth. A moderate amount of inflation, in contrast, discouraged hoarding, which stimulated the injection of resources into the economy, which increased economic growth.

Well, I haven't had any respect for Krugman for some time, but this is the first time I had any inkling he was a Socialist...."hoarding"?

Wow, this conjures up visions of the Eastern Bloc or something; guys with crates of light bulbs smuggled in from the West, stashed in their garage, selling to their friends at midnight.

So it's "hoarding" if I choose not to bring something to the market now, because I expect a higher price later on? A rancher who looks at the futures market, considers his experience, and decides not to sell his cattle this month -- is "hoarding" cattle? A professional person who is in the market for a new car, but decides to wait until the prices go down, is "hoarding" her cash? Grain farmers that leave their crop in the silo for a while, watching the market for a better price, they are "hoarding" as well?

Y'know, Lenin had a problem with the farmers. They didn't want to sell their crops for basically nothing to the Soviets. So Lenin fixed that right up; he labeled uncooperative farmers as "Kulaks" and had 'em shot! By golly, I bet that brought about a market revolution back in the 1920's, didn't it? Wonder why Krugman hasn't thought of it yet?

"Hoarding"? What next, "from each according to his resources, to each according to his means"?

As far as I know, everyone who believes in a small amount of inflation to stimulate economic activity agrees that large amounts of inflation are a bad thing.

Ok, but why do they believe that?

Well, I'm beginning to see where this notion of "a little inflation is good" may come from. It seems that back in the early 1950's the inflation rate was on the order of 1%. Many 20-year home mortgages had interest rates of 4%. An inflation rate of 1% to 2% would take a long time to halve the value (or double prices); 72 years in one case, 36 years in the other case. The pernicious effects would be extremely muted. Economists of the '50's were still scared green of deflation from the 1930's, looked around at the prosperity of the 1950's and perhaps concluded "a little inflation is a good thing".

Then, of course, came the 1960's, higher inflation rates as the deficit spending kicked in, the value of the dollar declined.

Which reminds me, when the value of the dollar dropped notably back in the late 60's/early 70's, eventually the Saudis noticed it was taking more and more dollars to buy the same Mercedes/jets/yachts/white-slaves. So they jacked up the price of oil per barrel to a level they thought matched the depreciation of the currency, and price increases rippled through the world economy.

There's a lot more princelings to support over in Saudi nowadays, and the dollar's value keeps sinking...

Inflation is another word for TAX which is created by the FED.

I have read all the post here and yet nobody here has tapped into the root cause for inflation.

Inflation is caused by the "fiat monetary system"
Simply put each time money is created from nothing which banks do every time each and every one of you decides to borrow from the bank. This process dilutes the very wealth of each and every dollar that is in the economy. It's akin to pouring water into the soup, it ultimately dilutes and its flavour dissipates. This dissipation is referred to as inflation. The central banking cartel (FED) has an enormous amount to answer for our deterioration in savings and wealth. Inflation usurps us of our hard earned income and ultimate wealth. Explain to me the fairness in receiving a 2% return on savings where the dollar is weakening at 12% per year in actual purchasing power over the past 3 years. You are 10% per year worse off per year. Where is the justice and credence in that type of banking behaviour? There is none. Simply put it is government endorsed theft. The banks supposedly lend you money. That’s not true they never do. They loan you “nothing money” or “fiat money” which is magically created upon your loan approval and have the veracity to charge you interest on nothing.

This is the monster we are all contending with each and every day, its name is Fiat and this medusa money serpent needs to be slain. The system has no accountability to the public and serves only one purpose which is to further cement the FED and it’s central banking cartel as the richest and most dominant owner of the planet, far more than any government could ever wish for. The FED has it’s hand firmly on the lever of the “fiat” money making machine and has the ability to push and pull whichever way it feels to protect itself and it’s unimaginable wealth.

Right about now I can hear some of you saying this person is sounding kinda like a kook and needs to be taught a lesson in money systems. Bring it on but remember to turn down the SAM index. SAM index? Smokes and Mirrors. No jargon terms that are made up to protect the rich. I am a small fish in this huge pond as I am sure all of you are too. The money system is no different to an automobile engine. It is a machine with moving parts but at the moment it is an inefficient V12 that drives the wealthy in comfort and emits plumes of carbon gasses for the rest of to choke on.

I urge you all to read the book The Creature from Jeckyll Island by G. Edward Griffin but if you have no time to read you may want to listen to a synopsis of it at the following URL just copy the url and paste it into your browser.

http://americaondebt.com/
audio is on the far right hand side.

Obi Wan intoned:
This is the monster we are all contending with each and every day, its name is Fiat

I used to wrestle with one of those on a regular basis. It only caught on fire one or two times, but after the front wishbone welds failed it wasn't safe anymore...

The money system is no different to an automobile engine.

Negatory. The monetary system is closer to the bottom of the food chain in an ecology. Say you have a pond, and you dump fertilizer in it; pretty soon you have a nice crop of algae. Any algae-eating fish will thrive, and other fish won't. Eventually your pond populations will be hugely distorted by the constant, artificially high input of food; so much so that when it is taken away, there will be a population crash...

But I do like the idea of a monetary system based on Italian sports cars...

ellipsis wrote: But I do like the idea of a monetary system based on Italian sports cars...

It's gotta be better than a system based on nothing my friend.

little history. Before Smokey the Bear, the idea of fighting wildfires did not exist. Nature took it's course, the forest burned and rejuvinated itself ( fire's have done that for milennia ). About the same time as old Smokey got us into the "fires are evil, we must stop them" mode, the idea of stopping that "evil deflation" came into being.
There is an analogy here, and it is that trying to controlling natural forces, may work fine in the short/medium term, but eventually there's a price to be paid. In the case of our forest "management" policy, it's the catastrophic wildfires that destroy forests, rather than cleanse them as nature's cyclic fires had done. In the case of financial ecosystems, the risk is that deferring the payment for the excesses of the economic cycle into the distant future, will create an economic firestorm when things really do go bad. The whole system is predicated on trust. Loose that trust, and the system collapses, and tens of millions will starve or be eating out of garbage cans because they won't have the knowlege or means of survival. I don't mean this in an apocolyptic or predictiive way, just pointing out what the stakes are. I pray we never go thru that. Remember the crash of 1987 by all logic and odds should have NEVER occured. That is did shows that one should have too much faith in any system, however much we want to believe in it.

KBP

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