The preposterous deflation scare Part II – Why are low inflation rates supposedly so dangerous?

The concept that very low rates of inflation are dangerous is closely related to the belief that there is some sort of an “optimum rate of inflation” for the economy, at which economic growth can progress at its smoothest. This concept emerged in the 1950s and 1960s based on the Keynesian approach to macro-economics, the prevailing model of the times.

On the one hand, policy-makers wanted to avoid strong cyclical fluctuations, which had been typical of the 19th Century. They generally favoured anti-cyclical fiscal policies which largely served to stabilise employment, even if they had an inflationary impact. In addition, both the USA and Great Britain discovered the benefits of “soft” inflation (also called “financial repression” today). An inflation rate that was only slightly below or even above government bond interest rates could relatively easily be used to devalue the public debt resulting from World War II. The main prerequisite was the policy had to be implemented very carefully, so that the effects were hardly noticeable, in order to avoid an escalating inflation spiral, as experienced in the German Reich between 1914 and 1923.

The theory emerged that moderate inflation was actually very beneficial for the economy as it facilitated price adjustments and was seen as evidence of sound growth. This concept has continued to shape the thinking of the majority of leading economists to this day and is at the root of why inflation up to 2% p.a. is defined as “stability” today.

Essentially four arguments are given to justify the notion that inflation is beneficial:

  1. If there is no inflation, people start to hoard their money and withdraw it from the economy.
  2. Moderate inflation facilitates price adjustments, in particular with regard to salaries.
  3. Deflation or very low inflation reflects a weak level of overall economic demand.
  4. To ensure full employment, it is necessary that monetary policy and debt-financed public spending regularly provide stimuli which in turn have an inflationary effect.

To argue that people hoard their money seems ill-founded as they only do so when they feel insecure. For example, they hoarded money in many countries during the last financial crisis in spite of inflation. And, in 19th Century Great Britain, people did not hoard their money in spite of deflation. Furthermore, central banks can counteract the effects of money hoarding by expanding the money supply.

The theory that price adjustments are facilitated by inflation is based on the assumption that people are fundamentally afraid of losing something they have already obtained (loss aversion). For this reason, it is often very difficult to cut nominal wages in practice. Instead it is much easier to maintain constant nominal salaries in an inflationary environment and let the decreasing purchasing power of money implicitly reduce real wages.

However, I do not comprehend the logic behind this theory. Because 1) wages are very closely linked to productivity which permanently rises due to innovations; 2) experience has shown that it is not the lack of adaptability of employees that makes labour markets inflexible, but rather the regulatory frameworks that prevent wage adjustments; and 3) trade unions no longer suffer from the “money illusion” and have therefore made “inflationary adjustment” a permanent and central component of their wage negotiations.

The opinion that deflation or low inflation reflects a low level of overall demand is also too superficial because it does not explore the reasons for the low price increases. For example, if deflation is caused by falling raw material prices or decreasing costs due to technological progress, it can even stimulate the economy. Deflation is only negative when it emerges in the context of an economic demand crisis, as was the case in the 1930s, for example. However, at that time, deflation was not the cause but the outcome of the problems. So when people demonise deflation in the context of crises, they confuse cause and effect.

The notion that inflationary policies ensure full employment is very problematic. It dates back to a misinterpretation ofKeynes, who advocated deficit-financed spending programmes. Originally, he recommended them for crises — for situations in which an economy is paralysed in a depressive state of shock. In this case, an economy needs a vigorous push to get it going so that the natural forces of growth can take effect again.

But subsequent economists wanted to take this approach a step further: They believed it was possible to fine-tune the regular economic cycle with deficit-based fiscal policies. In addition, the British economist Phillips established an empirical relationship between employment and the development of inflation (the Phillips curve).

In practice, this attempt to impact the cycle failed miserably. When administered permanently, the Keynesian crisis remedy turned out to be a destructive drug. The expansive measures were never attributed effectively in political practice; on the contrary, the economy got used to them and their inflationary effects. The Philips curve only worked hand in hand with the money illusion, but it no longer worked once employees became aware that inflation was decreasing their real wages.

The rude awakening came in the 70s, when the oil-exporting countries joined together to form the OPEC cartel and substantially raised their prices. This triggered an oil price shock in the Western industrialised nations, which in turn globally increased price levels. Next, the self-reinforcing mechanisms of accelerating inflation, which had already ruined the German Reich in the 1920s with hyperinflation, set in. This time, however, inflation was threatening not only to destroy just one country, but also to spiral out of control across the entire world.

It was only in 1979 that the newly elected Chairman of the US Federal Reserve Paul Volcker took radical measures to cut the inflation rate (by increasing the base interest rate up to 20%) and succeeded in putting a stop to the momentum of inflation.

Since then the rates of inflation have been reduced in all major Western industrialised nations on an ongoing basis and are currently between 1% p.a. and 3% p.a. in these countries. Inflation has remained high in the emerging countries. It is currently at a critical level in Brazil (6.5% p.a.), Russia (7.5% p.a.) and Mexico (4.1% p.a.). And it is threatening to spiral out of control in Turkey (9.3%), India (8.0%), and Nigeria (8.2%). For these highly populated countries, inflation is increasingly becoming a problem, in particular because it worsens the situation of the socially deprived, as can be seen with the recent unrest in Brazil. At any rate, inflation has not turned out to be a barrier to growth to date, which could change if it develops into hyperinflation.

In this generally inflationary environment, there has been only one major country that has undergone a longer phase with minimal or even negative rates of inflation in recent years — Japan. This period was accompanied by a structural adjustment crisis, which is why the Asian economic power is seen as a powerful example of the potentially destructive forces of inflation. But is it really justified to make a generalisation based on this one example?

To be continued tomorrow.

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Posted in Economics

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