inflation as politics

I’m going to write here about what I perceive the political dynamics of inflation in the United States to have been in the past century.  I presume, but don’t know, that the same process can and has occurred elsewhere.

early days

The latter part of the nineteenth century and the first half of the twentieth were times of what amounts to class struggle in the US between business and labor.  Issues ran the gamut from child labor and workplace safety to wage levels and unionization.

The sides coalesced around two political parties, the Democrats representing labor and the Republicans defending business.

(This struggle is basically over today, I think–leaving both major parties trying without a great deal of success so far to redefine themselves.  For good or ill, most Americans no longer draw a sharp distinction between management and labor.  This is partly because the nature of work has changed, partly because most Americans consider themselves part of management.)

During the time when workers were fighting for what we would now regard as basic, and self-evident rights, inflation became a significant weapon in the battle.  How so?

inflation and bonds

A conventional bond is a series of interest payments made to the holder plus return of principal at the end of the bond’s term.  The present value, or value today, of the bond is the sum of all these payments by discounting each back to the present using an appropriate interest rate.  The higher the interest rate employed, the lower the present value.

the holder

A rising inflation rate erodes the present value of a bond.  If, for example, when the holder purchases it, inflation is at 3% the buyer may be content with a 6% coupon.  He receives $60 a year in interest payments and his $1000 back a the end of the bond’s term.   The interest payments offset inflation and provide a real return of 3% annually.

Suppose the inflation rate rises to 7% immediately after the holder purchases the bond.  Suddenly, he is no longer receiving a real return on his money.  Part of the purchasing power of his investment is disappearing, due to the higher rate of inflation.

the seller

Conversely, the seller benefits from an increase in the inflation rate, since that results in a real decline in the value of the payments he has agreed to make to the holder.

back to politics

It seems to me that during the late nineteenth and early twentieth centuries a basic assumption of the Democrats, the party of labor, was that its constituents held no physical or financial assets.  In fact, many might be net borrowers, or, as the financial world would put it today, be “short” financial assets.  Their main source of economic worth was their ability to sell their labor.

In contrast, Republicans thought of their constituents as the “longs,” wealthy bond-coupon clippers, with ownership of vast amounts of physical and financial assets.

two opposing agendas

These differences set the agendas of the two parties.  If the Democrats were in power, they could attempt to transfer wealth from business to labor overtly by increasing taxes on the wealthy and/or by raising benefits provided by the government to workers.  Or they could do so covertly by establishing economic policies that induce inflation.  That would decrease the wealth of the old time robber barons–and at the same time it would lessen the real value of the loans workers had taken out from them.

When the Republicans were in power, they would start to undo the policies initiated by the Democrats, by trying to balance the government’s books and by fighting inflation with restrictive economic policies.

I think this is the way Washington worked even through the 1970s.

the new order

Not any more, though.

The nineteenth century model was one of massive capital investment in plant and equipment (think: blast furnace steel) operated by manual labor.   Accelerating rates of technological change have destroyed that economic model.  Who are today’s economic heroes?–Google, Apple, Amazon, Pixar, biotech…  They are relatively small groups of highly educated people creating service businesses that require little physical capital, many of them using the internet as a substitute for having a large advertising budget and extensive physical distribution facilities.

the old dynamic reborn

At present, most domestic economists are praying for any sign of inflation to emerge, simply to give the US some breathing room against the possibility of deflation.

Beyond this, however, inflation has reemerged as a political issue in the US.  The new dynamic has arisen from the fact that Washington has borrowed heavily from foreign governments–notably Japan and China–as well as from domestic sources.

So the drama of the first half of the twentieth century has been recast, with the Chinese in the role of big business and Washington in the role of labor.  It is certainly tempting to lawmakers to attempt to repay foreign creditors in inflation-diminished dollars rather than to have to have tax revenues large enough to generate the entire real amount owed.  On the other hand, China, sensing this line of thought, has been increasingly vocal over the past year or so in its concern that Washington protect the purchasing power of the dollar through economic orthodoxy.

This new drama is still in rehearsals.  The collapse of the euro has meant it won’t need to open on Broadway any time soon.  But it will still be important to monitor how the play is shaping up.

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