Naked Economics (31 page)

Massive inflation distorts the economy massively. Workers rush to spend their cash before it becomes worthless. A culture emerges in which workers rush out to spend their paychecks at lunch because prices will have gone up by dinner. Fixed-rate loans become impossible because no financial institution will agree to be repaid a fixed quantity of money when that money is at risk of becoming worthless. Think about it: Anyone with a fixed-rate mortgage in Germany in 1921 could have paid off the whole loan in 1923 with fewer marks than it cost to buy a newspaper. Even today, it is not possible to get a thirty-year fixed mortgage in much of Latin America because of fears that inflation will come roaring back.

America has never suffered hyperinflation. We have had bouts of moderate inflation; the costs were smaller and more subtle but still significant. At the most basic level, inflation leads to misleading or inaccurate comparisons. Journalists rarely distinguish between real and nominal figures, as they ought to. Suppose that American incomes rose 5 percent last year. That is a meaningless figure until we know the inflation rate. If prices rose by 7 percent, then we have actually become worse off. Our paycheck may look bigger but it buys 2 percent fewer goods than it did last year. Hollywood is an egregious offender, proclaiming summer after summer that some mediocre film has set a new box office record. Comparing gross receipts in 2010 to gross receipts in 1970 or 1950 is a silly exercise unless they are adjusted for inflation. A ticket to
Gone with the Wind
cost 19 cents. A ticket to
Dude, Where’s My Car?
cost $10. Of course the gross receipts are going to look big by comparison.

Even moderate inflation has the potential to eat away at our wealth if we do not manage our assets properly. Any wealth held in cash will lose value over time. Even savings accounts and certificates of deposit, which are considered “safe” investments because the principal is insured, are vulnerable to the less obvious risk that their low interest rates may not keep up with inflation. It is a sad irony that unsophisticated investors eschew the “risky” stock market only to have their principal whittled away through the back door. Inflation can be particularly pernicious for individuals who are retired or otherwise living on fixed incomes. If that income is not indexed for inflation, then its purchasing power will gradually fade away. A monthly check that made for a comfortable living in 1985 becomes inadequate to buy the basic necessities in 2010.

Inflation also redistributes wealth arbitrarily. Suppose I borrow $1,000 from you and promise to pay back the loan, plus interest of $100, next year. That seems a fair arrangement for both of us. Now suppose that a wildly irresponsible central banker allows inflation to explode to 100 percent a year. The $1,100 that I pay back to you next year will be worth much less than either of us had expected; its purchasing power will be cut in half. In real terms, I will borrow $1,100 from you and pay back $550. Unexpected bouts of inflation are good for debtors and bad for lenders—a crucial point that we will come back to.

As a side note, you should recognize the difference between real and nominal interest rates. The nominal rate is used to calculate what you have to pay back; it’s the number you see posted on the bank window or on the front page of a loan document. If Wells Fargo is paying a rate of 2.3 percent on checking deposits, that’s the nominal rate. This rate is different from the real interest rate, which takes inflation into account and therefore reflects the true cost of “renting” capital. The real interest rate is the nominal rate minus the rate of inflation. As a simple example, suppose you take out a bank loan for one year at a nominal rate of 5 percent, and that inflation is also 5 percent that year. In such a case, your real rate of interest is zero. You pay back 5 percent more than you borrowed, but the value of that money has depreciated 5 percent over the course of the year, so what you pay back has exactly the same purchasing power as what you borrowed. The true cost to you of using someone else’s capital for a year is zero.

Inflation also distorts taxes. Take the capital gains tax, for example. Suppose you buy a stock and sell it a year later, earning a 10 percent return. If the inflation rate was also 10 percent over that period, then you have not actually made any money. Your return exactly offsets the fact that every dollar in your portfolio has lost 10 percent of its purchasing power—a point lost on Uncle Sam. You owe taxes on your 10 percent “gain.” Taxes are unpleasant when you’ve made money; they really stink when you haven’t.

Having said all that, moderate inflation, were it a constant or predictable rate, would have very little effect. Suppose, for example, that we knew the inflation rate would be 10 percent a year forever—no higher, no lower. We could deal with that easily. Any savings account would pay some real rate of interest plus 10 percent to compensate for inflation. Our salaries would go up 10 percent a year (plus, we would hope, some additional sum based on merit). All loan agreements would charge some real rental rate for capital plus a 10 percent annual premium to account for the fact that the dollars you are borrowing are not the same as the dollars you will be paying back. Government benefits would be indexed for inflation and so would taxes.

But inflation is not constant or predictable.
Indeed, the aura of uncertainty is one of its most insidious costs. Individuals and firms are forced to guess about future prices when they make economic decisions. When the autoworkers and Ford negotiate a four-year contract, both sides must make some estimates about future inflation. A contract with annual raises of 4 percent is very generous when the inflation rate is 1 percent but a lousy deal for workers if the inflation rate climbs to 10 percent. Lenders must make a similar calculation. Lending someone money for thirty years at a fixed rate of interest carries a huge risk in an inflationary environment. So when lenders fear future inflation, they build in a buffer. The greater the fear of inflation, the bigger the buffer. On the other hand, if a central bank proves that it is serious about preventing inflation, then the buffer gets smaller. One of the most significant benefits of the persistent low inflation of the 1990s was that lenders became less fearful of future inflation. As a result, long-term interest rates dropped sharply, making homes and other big purchases more affordable. Robert Barro, a Harvard economist who has studied economic growth in nearly one hundred countries over several decades, has confirmed that significant inflation is associated with slower real GDP growth.

It seems obvious enough that governments and central banks would make fighting inflation a priority. Even if they made honest mistakes trying to drive their economies at the “speed limit,” we would expect small bursts of inflation, not prolonged periods of rising prices, let alone hyperinflation. Yet that is not what we observe. Governments, rich and poor alike, have driven their economies not just faster than the speed limit, but at engine-smoking, wheels-screeching kinds of speeds. Why? Because shortsighted, corrupt, or desperate governments can buy themselves some time by stoking inflation. We spoke about the power of incentives all the way back in Chapter 2. Still, see if you can piece this puzzle together: (1) Governments often owe large debts, and troubled governments owe even more; (2) inflation is good for debtors because it erodes the value of the money they must pay back; (3) governments control the inflation rate. Add it up: Governments can cut their own debts by pulling the inflation rip cord.

Of course, this creates all kinds of victims. Those who lent the government money are paid back the face value of the debt but in a currency that has lost value. Meanwhile, those holding currency are punished because their money now buys much less. And last, even future citizens are punished, because this government will find it difficult or impossible to borrow at reasonable interest rates again (though bankers do show an odd proclivity to make the same mistakes over and over again).

Governments can also benefit in the short run from what economists refer to as the “inflation tax.” Suppose you are running a government that is unable to raise taxes through conventional means, either because the infrastructure necessary to collect taxes does not exist or because your citizens cannot or will not pay more. Yet you have government workers, perhaps even a large army, who demand to be paid. Here is a very simple solution. Buy some beer, order a pizza (or whatever an appropriate national dish might be), and begin running the printing presses at the national mint. As soon as the ink is dry on your new pesos, or rubles, or dollars, use them to pay your government workers and soldiers.
Alas, you have taxed the people of your country—indirectly.
You have not physically taken money from their wallets; instead, you’ve done it by devaluing the money that stays in their wallets. The Continental Congress did it during the Revolutionary War; both sides did it during the Civil War; the German government did it between the wars; countries like Zimbabwe are doing it now.

A government does not have to be on the brink of catastrophe to play the inflation card. Even in present-day America, clever politicians can use moderate inflation to their benefit. One feature of irresponsible monetary policy—like a party headed out of control—is that it can be fun for a while. In the short run, easy money makes everyone feel richer. When consumers flock to the Chrysler dealership in Des Moines, the owner’s first reaction is that he is doing a really good job of selling cars. Or perhaps he thinks that Chrysler’s new models are more attractive than the Fords and Toyotas. In either case, he raises prices, earns more income, and generally believes that his life is getting better. Only gradually does he realize that most other businesses are experiencing the same phenomenon. Since they are raising prices, too, his higher income will be lost to inflation.

By then, the politicians may have gotten what they wanted: reelection. A central bank that is not sufficiently insulated from politics can throw a wild party before the votes are cast. There will be lots of dancing on the tables; by the time voters become sick with an inflation-induced hangover, the election is over. Macroeconomic lore has it that Fed chairman Arthur Burns did such a favor for Richard Nixon in 1972 and that the Bush family is still angry with Alan Greenspan for not adding a little more alcohol to the punch before the 1992 election, when George H. W. Bush was turned out of office following a mild recession.

Political independence is crucial if monetary authorities are to do their jobs responsibly. Evidence shows that countries with independent central banks—those that can operate relatively free of political meddling—have lower average inflation rates over time. America’s Federal Reserve is among those considered to be relatively independent. Members of its board of governors are appointed to fourteen-year terms by the president. That does not give them the same lifetime tenure as Supreme Court justices, but it does make it unlikely that any new president could pack the Federal Reserve with cronies. It is notable—and even a source of criticism—that the most important economic post in a democratic government is appointed, not elected. We designed it that way; we have made a democratic decision to create a relatively undemocratic institution. A central bank’s effectiveness depends on its independence and credibility, almost to the point that a reputation can become self-fulfilling. If firms believe that a central bank will not tolerate inflation, then they will not feel compelled to raise prices. And if firms do not raise prices, then there will not be an inflation problem.

Fed officials are prickly about political meddling. In the spring of 1993, I had dinner with Paul Volcker, former chairman of the Federal Reserve. Mr. Volcker was teaching at Princeton, and he was kind enough to take his students to dinner. President Clinton had just given a major address to a joint session of Congress and Fed chairman Alan Greenspan, Volcker’s successor, had been seated next to Hillary Clinton. What I remember most about the dinner was Mr. Volcker grumbling that it was inappropriate for Alan Greenspan to have been seated next to the president’s wife. He felt that it sent the wrong message about the Federal Reserve’s independence from the executive branch. That is how seriously central bankers take their political independence.

Inflation is bad; deflation, or steadily falling prices, is much worse. Even modest deflation can be economically devastating, as Japan has learned over the past two decades. It may seem counterintuitive that falling prices could make consumers worse off (especially if rising prices make them worse off, too), but deflation begets a dangerous economic cycle. To begin with, falling prices cause consumers to postpone purchases. Why buy a refrigerator today when it will cost less next week? Meanwhile, asset prices also are falling, so consumers feel poorer and less inclined to spend. This is why the bursting of a real estate bubble causes so much economic damage. Consumers watch the value of their homes drop sharply while their mortgage payments stay the same. They feel poorer (because they are). As we know from the last chapter, when consumers spend less, the economy grows less. Firms respond to this slowdown by cutting prices further still. The result is an economic death spiral, as Paul Krugman has noted:

This spiral can poison the financial system, even when bankers are not doing irresponsible things. Banks and other financial institutions get weaker as loans go bad and the value of the real estate and other assets used as collateral for those loans falls. Some banks begin to have solvency problems; others just have less capital for making new loans, which deprives otherwise healthy firms of credit and spreads the economic distress. The purpose of the Troubled Asset Relief Program (TARP) intervention at the end of the George W. Bush administration—the so-called Wall Street bailout—was to “recapitalize” America’s banks and put them back in a position to provide capital to the economy. The design of the program had its flaws. Communication about what the administration was doing and why they were doing it was abysmal. But the underlying concept made a lot of sense in the face of the financial crisis.