Inflation (I)-general

I’m going to write about this topic in three posts:  inflation-general; inflation as politics; and, what makes inflation a threat to the US today.  Here goes:

What inflation is

Inflation is a rise in the overall level of prices.  It isn’t enough to have a few prices, even highly visible prices, rising.  Prices in general have to be rising to have inflation.  The inflation rate, which is what commentators usually write about, is the speed at which prices are rising, usually at an annual rate.

Having inflation is better than having its opposite, deflation, or a fall in the general level of prices.  Deflation is harder to fix and has far worse consequences, especially in paying off debt, than inflation. The last serious bout of deflation in the US was during the Great Depression of the 1930s.  (The two other terms typically used in talking about this topic are:  disinflation, or inflation that is advancing at a declining rate–the situation in the US since the early Eighties; and stagflation, the situation where real economic growth is very slow but the inflation rate is high, as was the case for much of the Seventies.)

Fed policy

The Fed has targeted inflation below 2% yearly as the ideal situation for the US economy.  The European Economic Union has a similar target, although historically, in contrast to the US, continental Europeans have been much more concerned with absolute price stability than with economic growth.

When inflation becomes a problem

Inflation only becomes a serious problem for a country like the US when it makes its way into the overall national wage structure and begins to accelerate.  If so it becomes possible for inflation expectations to become imbedded in workers’ psyches.  In theory, at least, workers try to keep themselves ahead of inflation by asking for wage increases in excess of the inflation rate, creating an inflationary spiral of accelerating inflation.

What’s so bad about inflation that isn’t close to zero, say, 4%?

1.  To lead off with the obvious, it’s an extra thing to worry about.  It takes time and effort away from more productive tasks.

2.  It rarely stays tame.  People typically underestimate inflation at first (called money illusion) and subsequently try to make up lost ground.  This is one reason inflation, left unwatched, tends to accelerate.

3.  Long-term planning becomes more difficult.  Figuring out whether a ten-year project makes economic sense requires having a reasonable idea of what revenues and costs will be a decade from now.  In an environment of rising inflation, this calculation is subject to vast uncertainty.  So capital projects stop being done.

4.  Sometimes people try to protect themselves by writing contracts that index future costs and prices for inflation, in an attempt to get around this problem.  Not only does this institutionalize inflation, however, but indices that are based on today’s prices (called Laspeyres indices) invariably overstate inflation.  So indexing compounds the problem.

5.  Rising inflation can disrupt the relationship between labor and capital (more on this topic in my post on inflation as politics).  Lending money at fixed rates, or holding government bonds, becomes a losing proposition.  Holding physical assets and borrowing heavily against them becomes a ticket to success.  In extreme cases of rising inflation, flight of capital out of an inflationary economy begins to occur.  This not only robs the affected country of future growth, but to the extent it depresses the currency it increases inflationary pressures.  (At a low point for the US during the Carter administration, the Treasury was forced to issue government bonds denominated in D-marks and Swiss francs, rather than dollars, so that it could get foreign exchange to help stabilize the dollar during a period of capital flight.)

The US during the Seventies

The US last experienced a period of accelerating inflation in the late Seventies. When the Fed finally acted by raising interest rates violently to put an end to an inflationary spiral, actual inflation was running at 7%, with an expectation that it would rise to 11% in the following year.  It took years of extremely high interest rates–and a consequent  long, sharp economic contraction–to begin to break the back of the inflationary psychology that had developed.

How inflation happens

Theoreticians argue about this a lot, but In simple terms, I think there are three ways for inflation to occur:

1.  government money or fiscal policy that’s too loose.  One way, among several, of explaining what happens is this:  If interest rates are set too low, companies will find that a huge number of new capital projects are now attractive and will start to implement them.  This means hiring more workers.  After a while, this monetary stimulus gets enough new investment underway that the country runs out of available labor.  When this happens, the only way to start a new project is to “steal” workers from other firms by bidding up wages.  That creates inflation.

2.  commodity price rises.  For the US, the only commodities that make a difference are oil and iron/steel.  We don’t use enough of other metals for them to count.  Agricultural commodities can rise for short periods of time, but producers can respond quickly to price signals by planting different crops and expanding or contracting their herds of meat animals.

One could argue that this kind of inflation is also a result of misguided government policy.  Agricultural product prices are kept artificially high throughout the industrialized world by legislative action.  Also, a major reason that oil is an inflation issue for the US is decades-long massive government subsidy of incompetently-run domestic auto companies, which have been unable to produce fuel-efficient cars and trucks.

3. ” imported” inflation.   This is price change caused by exchange rate movements.   Here reality is very complicated, especially for a country as big as the US.  But the general idea is that  if the home country’s currency drops by, say, 10% vs. its trading partners, this is the same as an 11% increase in the price of the imported goods.  If imports account for 10% of what is consumed in the country, this would imply a 1% rise in the price level that year.  Why does a currency drop like this?  Weak government economic policies.

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