UNDERSTANDING WHY INFLATION IS GOOD

Inflation is an issue that affects elections. So it is important to understand what is really good and bad about it. Inflation in the United States from 1987 to 2021, as well as in Japan and Europe, was too low. Central Bank inflation targets under 3% were too low. The optimal amount of inflation is probably 4% or higher. The high inflation in the US today has led to a higher dollar, low unemployment, and unexpected economic strength.

To understand inflation, we can start with something else Republicans don’t like, the minimum wage. Suppose a teenager walks into a pizzeria looking for work. He says I want $20 an hour. The manager says I will give you $5 an hour. They find a rate they agree on. If that rate is below the minimum wage, the kid goes home without a job. The minimum wage prevents a large number of productive employment transactions from taking place.

In wages, transactions cannot take place below the minimum wage. In lending, transactions cannot take place below 0%. When inflation is too low, and too many loans would return near that 0% minimum, it prevents a large amount of business activity, such as loans and mortgages, from being possible. Because like there is a minimum wage, there is a minimum interest rate, 0%. If somebody can only pay back -1%, I will not lend him anything. Rather I will just earn 0% by holding cash, which always returns 0% no matter how low inflation goes.

Suppose I have $1 million to invest. Somebody says he can use that money to build an amusement park, and sell tickets for 10 years. He buys $300,000 of land and spends the rest on labor and equipment.

Suppose inflation is expected to be between 3% and 7% over the next 10 years. Suppose inflation is only 3% and his business is bad. The ticket sales profit $70,000 a year, and the land is worth $390,000 at the end. At the end he pays me back $1,090,000, and closes his business.

$1,090,000 is worth more than the $1 million I started with. So even though I would have needed $1,300,000 to keep up with inflation, I still did better than holding cash. So because of inflation, investing in a bad business was better for me than holding cash.

And this is reality. It is better for people to work and build things, than to do nothing. This is not theory. The Great Depression, and decades of economic stagnation in Japan, resulted from inflation that was too low. During the Great Depression, they burned fruit in the fields rather than transport it to market, while people went hungry. Farmers were homeless, and bankers owned farmland.

Back to the amusement park. Suppose inflation had instead been 7%, and his business had been good. The land at the end would be worth $510,000. Ticket sales profited $140,000 a year. Then he could get a new loan on the land, and pay me back $1,910,000. That is more than the $1,700,000 I need to break even after inflation.

So if inflation is between 3% and 7%, my $1 million will either lose money (after inflation) by getting back $1,090,000, or I will make money by getting back $1,910,000. Either way, I will invest, and he will build an amusement park, hire workers, and sell rides. When there is inflation, cash is not given an incorrect value that is greater than production.

Now suppose inflation is expected to be between -1% and 3% for the next 10 years. If inflation is -1%, the land may be worth only $270,000 after 10 years. Even if he still does the bad business of $70,000 a year profit on tickets, he can only pay me back $970,000. $970,000 is less than the $1 million I started with, so I may just hold cash or buy government bonds.

To summarize, when inflation is too low, it creates too large a chance that doing nothing – holding cash – will perform better than doing something. It sends a bad incentive to economic actors, to hold cash and buy government bonds. We don’t want people doing nothing. So when inflation is too low, it sends people the wrong economic incentive – a bad “price signal” – to do something we don’t want them to do.

People in Europe for years recently, had been investing money in government bonds at a negative interest rate. It resulted in high unemployment, and low economic growth. This is because the European Central Bank was created with a 2% inflation target, which was too low. This too low inflation target was an overreaction to bad past experiences with devalued currencies.

What are the costs of inflation? It makes it hard to write contracts. If you want to write a three-year contract, you have to say I will pay you $10 this year, and $11 next year, and $12 the year after. If your rent goes up every year, you have to ask your boss for a raise every year. That is not really a cost, you should be doing that anyway. This cost of the numbers changing all the time, is greater the more uncertain inflation is. It is generally expected if inflation is higher, it will also be more unpredictable. So you won’t know if inflation will go up 4% or 8%.

But having inflation at 2% does not really fix this problem. Because if inflation drops to 1% or 0% it creates much bigger problems. When a business owes 5% on a loan, and corn or condominiums are worth less than the previous year, they have negative cash flow and default. Their stock goes to zero, the bank owns the business, they have to find new jobs and new owners, and sell the building.

But nobody will loan anybody money to buy the empty building, for the reasons I described. And so everybody ends up unemployed and defaults on their mortgage. The problems of even a year of negative inflation are a disaster, much bigger than having to ask your boss for a raise every year. You remember the housing crisis in Florida? You don’t just have to change your lease every year, you have to move out and look for work.

Central bank inflation targets under 3% were designed decades ago, based on past experiences with commodity-backed currencies and high inflation. Subsequent experience has shown that inflation under 3% is too low. It causes a gravitation toward deflation. This leads to everyone investing in government bonds instead of the private sector, and “quantitative easing” policies which just make bankers and hedge funds into billionaires.

There had been negative interest rates in Europe for years, and in Japan for decades, and the result was all kinds of distortion and bizarre policies, and weak economic growth. Many economic crises have resulted from the bizarre patterns of investment, and people taking risks on the value of money rather than on the value of business, which result from too low inflation.

There was supposedly at time in Spain’s history, when they had so many gold mines that people did not have to work. They just mined gold instead of producing anything else. They valued military conquest over factories, to acquire more gold deposits. They produced money. Supposedly this still effects South American economies today, where there is still a culture of not working. And there are places in the Middle East you would not want to live, where they pump oil and invade others to get more oil, instead of working. When the value of money is too reliable, relative to the value of investing and working, people invest in money itself, and it creates terrible places.

There is no utopia. There is no money or rate of inflation without multiple problems. There will always be business cycles and mistakes, no matter what the government does or what kind of money you have. There is not some natural state of perfect money in nature, which the government screwed up. Bitcoin might teach you this lesson, that it is not so easy. The world cannot be made perfect, and comparing today’s inflation to a perfect world without problems – a world which has never existed – is silly.

Today’s inflation is like people say about democracy, “the worst system except all the others”. Commodity-backed money makes tinhorn dictators in mining countries rich, instead of making hedge funds rich like the Fed. Is OPEC, or some African mining cartel, better than the Fed? Today’s inflation tilts power to workers and away from bondholders. The people complaining about inflation have jobs. And we have devalued our debt to China.

At least the Fed sends their profits into the US Treasury, and has some voter oversight. Imagine when Saudi Arabia or some cartel of mining countries acts as the Federal Reserve, raising and lowering production in response to changes in the value of the commodity relative to other assets. Money backed by a commodity will not be optimized for US employment or even stock market stability. It is at least better that US banks and hedge funds get rich investing in flimsy California tech companies, than Middle East sultans buy gold-plated yachts.

Today’s inflation is the best Fed policy which we have had in perhaps 20 years. The Fed let this inflation happen because they know what a paralyzing disaster deflation is, and that it can result from economic shocks like the pandemic. If the pandemic had caused a deflationary shock, you would all be unemployed. So yes, our pandemic monetary policy, which includes this inflation, was a success.

So today’s inflation helps Americans by not sending a bad price signal misleading economic actors about the value of money relative to products, durable goods, and developed land. Inflation causes people to build houses, and invest in things you can actually eat. Today’s inflation in the US is not comparable to “record” inflation where many nations from South America to Germany to Asia have added lines of zeroes to their bills. So we have had high inflation recently, and the result has been surprising economic growth, a high dollar, and low unemployment.