Would inflation hurt or help the economy? (And other questions)

Great Debates
1

I’m going to start the OP with a confession of ignorance: I know only enough about national and international economics to embarrass myself. However, unlike many of whom this is true I freely admit it, so my purpose is more to help educate myself than to participate.

You see talking heads discussing the “fixes” to the economy on all the news channels every night and posing everything from the left’s Soak-the-Rich to Cain’s 9-9-9 to the oldies-but-goodies like legalize and tax pot and other drugs to throw lots and lots more money at it to leave it alone. A minority of economists interviewed though, both on the conservative and liberal shows, favor deliberate inflation.

As I understand it the argument goes like this:

Billy owes $100,000 on a house that is worth $95,000, he has $4,500 per month in total expenses on a net pay of $4,200 per month, he owes $10,000 on credit cards, and he has only $1,500 in savings.

With inflation Billy’s house would soon be worth $125,000 which puts him back in black, and his paycheck would soon be $5,200 per month allowing him to meet his liabilities with a small cushion left over and that $10,000 he owes on credit cards would be easier to pay back with inflated money since the $10,000 remains the same numerically but the money he’s bringing in would go up numerically. I realize this is super simple, but… I think it’s the jist.

So questions:

1- In your opinion/based on what you know would this hurt or help the economy and why or why not?

2- Regardless of whether it would help or hurt the economy, how would the government achieve intentional inflation?

3- What would be the worst effects of inflation?

2

I can answer 1 and 3.

1 - Overall, it would help. The housing bubble was the biggest cause of the recession, and inflating away the loss of equity would go a long way to fixing it.

2 - Nobody knows. We had several months of deflation in 2010, even while the government handed out money like halloween candy to banks and car manufacturers and the unemployed. The government is doing EVERYTHING it can to promote inflation, with stimulus spending and near 0% interest rates and treasury returns that are actually NEGATIVE. None of it is working, and inflation is still chugging along at less than 1% more often than not.

3 - If inflation began in earnest, the biggest problems I foresee would be huge interest rates lenders would have to charge in order to profit. Peoples’ savings (hah!) would be eroded, but in my opinion that’s a good thing! Money in the bank doesn’t do any good for the economy. Severe inflation (in the 10%-plus range, at least for awhile) would encourage people to seek investments outside of just burying their money in treasury bonds, or an empty mayonnaise jar in the backyard.

In summary, I lost 170,000 dollars of equity on my house. I could use some good old fashioned inflation right about now.

3

Reasonable inflation as a result of real economic growth is a good thing in general. It hurts people on a fixed income, but interest rates would hopefully rise as utilization of the money supply increased. People on government programs with a truly fixed income would suffer some if cost of living increases did not keep up with inflation.

4

Low, predicable interest rates are good at spurring investment because any money not invested in something is losing value. If money was deflating, it would make burying cash in the back yard a profitable investment strategy.

5

“Inflation” is an ugly word. Nobody wants an increase in prices for its own sake. So let’s talk about money first, and then talk about inflation later. After all, inflation is caused at core by an increase in the effective money supply.

To rephrase the question: Would more money bouncing around more quickly improve the economy? The answer is absolutely yes, it would.

Why?

Because there are resources that are standing idle at present. We have bountiful resources that we are inexplicably not using, most notably a significant portion of our population that is currently out of work. So let’s say we increase the effective money supply: we increase the supply of money, and in addition, we increase the speed with which it bounces around the economy. Where does the money go?

One option is that the money can seek to bid up the prices on already existing goods and services. That is to say, there would be a bit of inflation. That’s one result, and that would definitely happen. But is that the only thing that would happen? No, because there is an enormous bargain going on in the economy right now, a gigantic killing to be made with the much cheaper resources that can be bought up. Rather than bidding up the prices of already existing goods (inflation), the majority of the new effective money bouncing around would start buying up cheap idle resources: idle workers and factories and equipment and real estate and so on. More money would go to put people to work.

We have more than a century of economic data on this, and a robust theory to explain it. If we increase the effective money supply, then there will be price increases, but the majority of the money will go to real production.

Achieving an increase in the effective money supply should be the easiest thing in the world.

You go to the printing press. You find the big green start button. You push the big green start button. You let it run for a good long while. You then take that money and put it in the economy. The end.

In modern terms, this would mean going to the computer terminal at the Federal Reserve, and hitting the big green MAKE MONEY button on the monitor. When pop-up box asks you how much money you want to create, you start hitting the zero button on the keyboard bunches of times. The actual process of getting that new money into the economy is a bit convoluted, but the essence of it is dirt simple.

So what’s the problem? The Federal Reserve has increased the monetary base by about two trillion dollars (they entered 2,000,000,000,000 on their money-making pop-up box), and there’s been no massive increase in inflation. In fact, inflation expectations are currently dropping. How come? Well, that’s easy, too. They also have a big red button on their computer that says DESTROY MONEY. And they’re threatening to push that button at any time, if the people holding money start getting anxious to spend it. And no one wants to rely on money that might not exist tomorrow.

Imagine a genie that shows up at your place and says he’ll give you a one trillion dollar bill. Sweet, you think. I’ve always wanted to buy a small country.

But then the genie hits you with a twist. He’s going to make the trillion dollar bill disappear the moment before you attempt to spend it. At the very moment the wholesale country supply clerk asks for payment, and you reach into your wallet for the piece of green cash with twelve zeros and a picture of Arnold Schwarzenegger, the genie decides to make that piece of cash vanish. Poof! It’s gone. The very moment you most need that money to make your massive real estate investment, the money disappears.

It is impossible for you to spend the money, so why would you try? That’s where we are with the Fed’s last couple trillion. The vast majority of it is still sitting in the computer, gathering electronic dust. It’s not going anywhere. It’s not moving.

There is one more thing the Fed needs to do to increase the effective money supply. After creating the money, they need to let people use it. They need to let the money move.

High prices are the bad effect. You don’t really need to add anything worse on top of that.

The price increases are also not going to be equally distributed. If the oil supply is high inelastic at any higher production levels, we could see notably higher prices. But the thing is, that would be true of any recovery. Oil supply won’t become more elastic until people start learning to substitute away from it, and that won’t happen until the price is a real pinch. Recovery is going to lead to higher cost for energy, pretty much no matter what form the recovery takes. (There’s the fantasy of cold fusion, I guess, which would decrease energy prices, but that’s not exactly a scenario to base our economic analysis on.)

One other note: Another way to say “effective money supply” as I use the term is nominal GDP. That takes into account both the amount of money, and also the velocity of money – how fast the cash is moving through the economy. The velocity of money is determined by our personal desire to hold cash reserves.

6

The only thing to add is that if you have a supply of money in a time of rising prices, it makes sense for you to buy now to avoid price increases, which helps demand. Anyone with money in the early 1980s remembers this. If, on the other hand, you have money during a period of deflation, it makes sense to wait to purchase items, which hurts demand.

People have mentioned how inflation reduces the effective cost of loans. My college loans spanned the 1980s inflation, and became nearly trivial. Anyone owing money in a time of deflation, however, is in trouble, since they are paying the loan back with more expensive money. If you’ve ever seen one of those old late 19th century dramas about the Widow Jones about to lose the farm to the evil banker Smith, that is the reason - deflation at the time made it harder for her to pay the loan back.

7

Someone in this thread said inflation is 1%. Why do prices seem like they are going up at a much faster rate? Isn’t the CPI going up?

And when someone said the last couple trillion is just sitting in the computer. Does that mean nobody is borrowing it or what?

8

No, you are correct. Inflation is good for debters. Your debt stays the same in nominal terms, but the real value of it decreases with inflation.

The problem is that his pay may actually not increase %24. The price of everything else might increase though, which means he will actually be losing money in real terms.

9

Certain indices exclude volatile items such as fuel prices, since you don’t want to give cost of living increases based on something that might decrease in price right after you do so. Also, you probably buy only a subset of the items making up the index, so you might get ones which go up more than the average.

It is more that banks have cut down on lending. We are refinancing, our house is way out of the water, and we have really, really, good credit. The mortgage company is making us document stuff we’ve never had to document before - and we are refinancing with the same bank.
Also, due to lack of demand there are fewer good investments, so money that might be used to increase production is staying under the mattress.

10

The CPI includes things like consumer electronics and housing costs, both of which have been falling recently. If the price of milk goes up, but the price of cereal goes down inflation may be stationary. Unfortunately, for many of us, what is going up is things that must be purchased on a regular basis (food, fuel) and what is going down are things that we buy infrequently (TV, computer) or have already purchased and are paying down (house).
[

](http://www.bls.gov/cpi/cpifaq.htm)

11

So once you’ve printed off 2 trillion extra dollars, how do you get it circulating into the hands of the consumers?

12

You have to give it to someone. You can either pay off debts, which means that investors and banks have to put their money else where, use to buy goods and service (e.g. infrastructure upgrades), or hand it out via tax breaks or direct payments.

13

Very carefully.

This is the complex part, because they have to create the money in a fashion that allows them to destroy it in the future. They don’t just print up the money and drop it from helicopters (although that would be cool), because there would be no way for them to gather the bills again to make them vanish. Instead, they buy financial assets with the magical new genie cash, most often US government debt but also lately other assets like mortgage-backed securities. With the purchase of assets, they leave themselves an escape route: if inflation seems too high, they have stuff they can sell to suck those dollars back out of circulation (“destroy money”).

What happens in the markets is an exchange of assets: the banks from which the Fed buys its assets receive cash; in return, the banks have sold some of their securities. Now, they thing about cash is that it is in normal situations “high-powered money”. If I want to buy a new car, the bank can’t lend me a mortgage-backed security to help me make my purchase, but they can lend me cash. And once the cash has been lent out a single time, it can bounce around the system all it wants. What helps the cash bounce around so much in such a high-powered way is that it can be spent and spent again, or lent and lent again, because cash in normal situations has no yield: it earns no interest on its own. It is a dead asset on the books. Banks are in the business of earning yield, so when their balance sheet is loaded up with 0% interest cash, they want to exchange that cash for something that will earn them their spread, like a new loan, or purchasing a new kind of security to replace the one they sold to the Fed.

Any of these methods will get the money into the economy. They are called the “transmission mechanisms” of monetary policy, and there’s actually a bit of dispute about which are most important. In your OP, you talk about the balance-sheet effect, which is very real. Voyager talks about the “buy now to avoid inflation later” effect, which can be called the hot-potato effect, which is also very real. msmith talks about declining real wages, which is bad in one sense, but also helps businesses hire more workers for less real burden and thus increase employment, which is also a very real effect. There’s an export effect. There’s also an effect on asset prices like stocks, and thus also business investment. These effects all exist.

No one can know how to separate these effects of new money to find which is most important. The one thing I can say is these effects, if they come to pass, will all show up in the number of dollars that are passed from one person to another for the purchase of new goods and services. That is to say, they will show up in nominal GDP calculations.

Nominal GDP can thus act as something like a traffic signal. The two trillion can hit the economy in all manner of ways, none of which can be precisely distinguished from the other. But if they are having an effect, then that effect will show up in an expansion of NGDP. And the primary insight of modern macroeconomics is that the majority of that expansion of the effective money supply in a situation like ours will show up in real production instead of inflation. But there would be some inflation. There would have to be some inflation. Can’t be avoided. And the Fed’s current traffic signal is… inflation. Not employment, not the effective money supply. Just inflation. So instead of letting the money move, they are prepared to suck the money out of the system, prepared to make the money disappear in a puff of smoke. And that’s why banks are sitting on their excess reserves like dragons guarding a hoard. The cash just piles up on the computer instead of going anywhere.

Money can flow through people’s hands in all manner of ways, likely in many other fashions I haven’t even thought of, but it needs to be loosed in order to do that. The first step under our present system is convincing the banks that they can rely on the future existence of that money, that it will not disappear when they need it.

14

There’s one important point in the previous post I hinted at but didn’t make sufficiently clear.

It’s not just about printing up two tril of money, and somehow getting just that new cash to circulate. It’s also, and often even more importantly, about getting the money that is already in the economy to move more quickly. We could have zero increase in the amount of total base cash on the computers, and yet still have a massive increase in the effective money supply if people started passing around already existing cash more quickly.

This is why many of the transmission mechanisms listed above aren’t about the banks. I said the first step is “convincing the banks” that they can rely on the future existence of that money, but that’s far too narrow. It’s not just the banks. The first step is convincing everyone that that there will be more money bouncing around.

They’re not doing that. Everyone knows they are more concerned right now about future inflation than the millions out of work. Be nice if they changed their minds on that one.

15

Why wouldn’t wage driven inflation get us out of the mess created by the bursting asset bubble?

I don’t know which of these would be horrible ideas but we could give everyone a million dollar refundable tax credit or the government multiplies the government pay scale by 10.

16

Hellestal, thanks for your insightful comments.

So a large source of the hesitation to spend cash is that the Fed is indicating it will sell (dump?) bonds, etc. at any sign of inflation, and there’s a fear of resulting deflation? Are these indications policy statements? Bernanke interviews? Is the Fed’s real goal is to hit a moderate inflation target and there’s lack of faith that they can do so without overshooting?

I hope it’s not too off-topic, but I keep hearing about corporations sitting on large cash reserves, contributing to the slow economy. Are these mostly financial institutions, or are 3M, GE, et. al. also holding onto cash?

17

Some medicines are poisons when the dose is too large. A massive bout of inflation would solve the debt problem, but by introducing a host of new maladies.

There is a middle ground here which is worthy of our attention. We can return to our previous NGDP trend line. We got off course, and now we should try to get back on course. There’s no reason to overshoot into massive inflation.

I wouldn’t say the fear is “deflation” exactly. The point is that with a given level of very low inflation expectations, combined with a stagnant economy, certain investments make perfect sense while other investments are obvious rubbish. Specifically, the safety of cash makes sense while more real capital goods are unalluringly risky. But if people expect more inflation, then everyone with a big cash hoard is in trouble – they need to realign their investments to avoid the little mice of inflation nibbling away at their treasure. This realignment of portfolios causes money to move more swiftly.

So where are we? The Fed expands the base by two trillion, but simultaneously promises that they are not intending to increase inflation expectations… well, then there is no reason to realign cash-heavy investment portfolios. Money demand stays too strong. The new money doesn’t mean anything, because if it meant anything then inflation expectations would rise. So the money is created but goes nowhere, because if it started going anywhere, then inflation would be too high, and it would be destroyed again, because the Fed has been clear that it’s not out to tolerate a higher inflation rate. Drives me bonkers. The money doesn’t move because portfolios are already quite well aligned with low inflation expectations, and those expectations haven’t changed in the slightest.

The Fed has regular releases of its intentions, most notably the reports from their main committee, the FOMC. They’re in a technical language, which I guess could be seen as a kind of financial code. But what they say is often (though not always) extremely straight-forward. And their message has been: we want to get back up to 2% core inflation, but we don’t want to go higher. And where are we now? 2% core inflation after the last 12 months, right where they said they wanted. And? Nothing higher will be tolerated, so the money doesn’t move any more.

Headline inflation is a good chunk higher than core, but there’s nothing we can do about a series of revolutions in oil-rich countries. (Not to mention that the CPI has counted the cost of housing as going up on average the last several years, which is more than a mite contrary to what the actual prices of the US housing stock would indicate.) So, inflation isn’t pleasant, but expectations are extremely well anchored. Future expectations of inflation are low, continue to be low, and show no signs of being anything other than low.

So no portfolio re-balancing. Everyone holds on to their cash, and the effective money supply stays well below trend.

Corporations that aren’t banks are sitting on mountains of cash and close equivalents. They have built “record piles”. That is extremely relevant to this discussion.

Hot potato. Turn up the heat a bit, make it a smidge more painful to hold cash, and they won’t be holding so much anymore. Ease money a little more, but do it with a clear traffic signal, so everyone knows exactly when you’re going to stop.