Why Inflation
A recent hobby of mine has been arguing with Libertarians about the value of the Federal Reserve and fiat currency in general. Having just popped into a Crypto-Currency (e.g. Bitcoin) Convention last Wednesday (more on that later) and heard someone point blank tell me that "deflation" works, I felt compelled to write down my thoughts on the matter.
First, I will summarize the deflationary argument I heard. Deflation works because, if your currency is more valuable today than it is yesterday (i.e. prices have fallen) then that's an incentive to spend. As your currency continues to rise in price (as Bitcoin did) then you want to spend it.
I don't know if this is the standard line but it sets the stage. In the world of limited currency - Bitcoin, Gold coins, whatever - you eventually reach a point where you can't make any more. As a result, the value of each piece of currency rises relative to the goods produced in the economy and their prices fall. What was 100 gold coins last month is now 70 gold coins this month as people are increasingly desperate to get their hands on the limited medium of exchange for trade. One counter-argument of crypto-currencies is that they are endlessly divisible. Like, infinitely, to the .0000000000001 and beyond. But that's the whole point - what was a Bitcoin today is .98BC tomorrow, will be .96BC after that and so on. So, if I have a Bitcoin, I'm gonna wait three days and get two of whatever I want. Or maybe I'll wait a month when it costs .50BC, what a deal!
This hasn't work so great in the past. If the Great Depression taught us anything, it's that inflation's upward spiral is way preferable to deflation's downward spiral. In that real-life example of deflation, as prices dropped people held on to their money, especially firms. When you expect that prices tomorrow will be lower than prices today, why would you spend money today?! Especially if you're going to spend a lot on a large purchase. It's true, there are things that people need to buy regardless - like food and shelter, but optional purchases will be put off and, even those necessary purchases are killing the economy as prices drop.
But here's the rub: Even when you buy the things you can't put off, the decreasing price means that profit margins are thinning. For goods and services that are put of entirely, demand simply plummets. Plummeting demand leads businesses to lower prices - which is precisely the reason you're putting off your purchase - and, as they really hit trouble when people wait out the market, they start cutting jobs because people don't want what they're selling anyway. Cut jobs, though, and now people don't have money to spend and they
a) put off buying, waiting for prices to go down even more
b) don't buy anything because they have no money, permanently removing their demand from the economy
This all creates a downward spiral where even a small moment of deflation - expectation of lower prices (or more valuable currency) - leads to a momentary reduction in demand which results in a round of layoffs which permanently reduces demand which makes those layoffs permanent and causes more price cutting which leads to more layoffs.
A side note, interestingly in a situation like this, policies like no minimum wages, no taxes and no regulation don't really help. The removal of all those things are potentially stimulating to an economy, but if you look at the problem, dropping demand, none of those supply side focused ideas will solve it.
1) No minimum wages: Well, you don't need more workers because no one's buying anyway. Even if you COULD pay workers less, it wouldn't really make a difference unless you paid them enough to at least buy what you were selling. Because the problem isn't that you need to make more, it's that you've got an unemployment problem and no one can afford goods in the first place.
2) Scrapping taxes: Of all the policies, this is the most likely to have a positive impact and is known as Fiscal Stimulus. IF a person is making money, THEN scrapping their taxes will allow them to purchase more potentially raising demand. What we saw with the Bush Tax Cut in the 2000s, though, was that a lot of people just saved it :( (and there's a lot of economic theory about what people will do with tax cuts generally).
Scrapping taxes for businesses can have a positive effect as well if done early enough. As mentioned before, a part of the problem is not just that individuals stop buying, businesses stop buying - and they buy a lot. They invest making huge purchases like factories, buildings, R&D, etc. Convincing them not to put off these, you know, "job creating" activities can prevent the downward spiral from starting. It won't do much good once it's started, though, because without demand there isn't much point in investing in production capacity.
3) Eliminating regulations: Same problem with the minimum wage. Things that affect profit margins, but don't address the fact that no one has any money to buy, means that the stimulating effect on the economy will be relatively low. And by the time you've figured that out you've messed up your environment or removed some overlooked but critical piece of market infrastructure; like Glass-Stegall or something.
And so I just summarized the Keynesian argument for spurring aggregate demand as an aside.
Back to deflation. Or, I should say, now a review of inflation. Inflation has the opposite effect; it is when people expect prices to rise. In this scenario, people and businesses whose money is losing value want to buy now, before prices go up. As you might guess, this leads to a rise in demand for pretty much everything and pushes businesses to hire more people and invest in more factories; which then means more people have money and demand rises even more.
So, why is this a bad thing, or even a tremendously, catastrophic, horrible thing? Runaway inflation or, to use a technical term, Hyper-Inflation, is pretty crappy. When something $50 today costs $500 tomorrow and $1000 the day after that you've got a real problem since:
a) there's a run on stores and everyone buys everything as fast as they can
b) wages paid today? Worthless tomorrow - no one an afford anything
c) With this insane uncertainty in the economy and near guarantee that investment will lose value, business grinds to a halt
d) the worthless currency essentially throws the economy back to the stone age as people try to make do without a legitimate medium of exchange
However, we can sort of see that mild inflation might be nice for an economy. Not only that, as an economy grows, inflation is necessary. As more goods and services which did not exist hit the market, the money supply ideally needs to grow with the offerings of the economy and incorporate these new activities. This is why most governments or Central Banks have a target of around 2% inflation per year.
And while governments are almost always behind bouts of hyper-inflation (though external shocks are also possible culprits) all stable economies have settled on allowing low inflation and guarding strongly against deflation. The risk of deflation encouraging under-production and under-employment loses out to inflation's risk of over-productions and over-employment any day.
First, I will summarize the deflationary argument I heard. Deflation works because, if your currency is more valuable today than it is yesterday (i.e. prices have fallen) then that's an incentive to spend. As your currency continues to rise in price (as Bitcoin did) then you want to spend it.
I don't know if this is the standard line but it sets the stage. In the world of limited currency - Bitcoin, Gold coins, whatever - you eventually reach a point where you can't make any more. As a result, the value of each piece of currency rises relative to the goods produced in the economy and their prices fall. What was 100 gold coins last month is now 70 gold coins this month as people are increasingly desperate to get their hands on the limited medium of exchange for trade. One counter-argument of crypto-currencies is that they are endlessly divisible. Like, infinitely, to the .0000000000001 and beyond. But that's the whole point - what was a Bitcoin today is .98BC tomorrow, will be .96BC after that and so on. So, if I have a Bitcoin, I'm gonna wait three days and get two of whatever I want. Or maybe I'll wait a month when it costs .50BC, what a deal!
This hasn't work so great in the past. If the Great Depression taught us anything, it's that inflation's upward spiral is way preferable to deflation's downward spiral. In that real-life example of deflation, as prices dropped people held on to their money, especially firms. When you expect that prices tomorrow will be lower than prices today, why would you spend money today?! Especially if you're going to spend a lot on a large purchase. It's true, there are things that people need to buy regardless - like food and shelter, but optional purchases will be put off and, even those necessary purchases are killing the economy as prices drop.
But here's the rub: Even when you buy the things you can't put off, the decreasing price means that profit margins are thinning. For goods and services that are put of entirely, demand simply plummets. Plummeting demand leads businesses to lower prices - which is precisely the reason you're putting off your purchase - and, as they really hit trouble when people wait out the market, they start cutting jobs because people don't want what they're selling anyway. Cut jobs, though, and now people don't have money to spend and they
a) put off buying, waiting for prices to go down even more
b) don't buy anything because they have no money, permanently removing their demand from the economy
This all creates a downward spiral where even a small moment of deflation - expectation of lower prices (or more valuable currency) - leads to a momentary reduction in demand which results in a round of layoffs which permanently reduces demand which makes those layoffs permanent and causes more price cutting which leads to more layoffs.
A side note, interestingly in a situation like this, policies like no minimum wages, no taxes and no regulation don't really help. The removal of all those things are potentially stimulating to an economy, but if you look at the problem, dropping demand, none of those supply side focused ideas will solve it.
1) No minimum wages: Well, you don't need more workers because no one's buying anyway. Even if you COULD pay workers less, it wouldn't really make a difference unless you paid them enough to at least buy what you were selling. Because the problem isn't that you need to make more, it's that you've got an unemployment problem and no one can afford goods in the first place.
2) Scrapping taxes: Of all the policies, this is the most likely to have a positive impact and is known as Fiscal Stimulus. IF a person is making money, THEN scrapping their taxes will allow them to purchase more potentially raising demand. What we saw with the Bush Tax Cut in the 2000s, though, was that a lot of people just saved it :( (and there's a lot of economic theory about what people will do with tax cuts generally).
Scrapping taxes for businesses can have a positive effect as well if done early enough. As mentioned before, a part of the problem is not just that individuals stop buying, businesses stop buying - and they buy a lot. They invest making huge purchases like factories, buildings, R&D, etc. Convincing them not to put off these, you know, "job creating" activities can prevent the downward spiral from starting. It won't do much good once it's started, though, because without demand there isn't much point in investing in production capacity.
3) Eliminating regulations: Same problem with the minimum wage. Things that affect profit margins, but don't address the fact that no one has any money to buy, means that the stimulating effect on the economy will be relatively low. And by the time you've figured that out you've messed up your environment or removed some overlooked but critical piece of market infrastructure; like Glass-Stegall or something.
And so I just summarized the Keynesian argument for spurring aggregate demand as an aside.
Back to deflation. Or, I should say, now a review of inflation. Inflation has the opposite effect; it is when people expect prices to rise. In this scenario, people and businesses whose money is losing value want to buy now, before prices go up. As you might guess, this leads to a rise in demand for pretty much everything and pushes businesses to hire more people and invest in more factories; which then means more people have money and demand rises even more.
So, why is this a bad thing, or even a tremendously, catastrophic, horrible thing? Runaway inflation or, to use a technical term, Hyper-Inflation, is pretty crappy. When something $50 today costs $500 tomorrow and $1000 the day after that you've got a real problem since:
a) there's a run on stores and everyone buys everything as fast as they can
b) wages paid today? Worthless tomorrow - no one an afford anything
c) With this insane uncertainty in the economy and near guarantee that investment will lose value, business grinds to a halt
d) the worthless currency essentially throws the economy back to the stone age as people try to make do without a legitimate medium of exchange
However, we can sort of see that mild inflation might be nice for an economy. Not only that, as an economy grows, inflation is necessary. As more goods and services which did not exist hit the market, the money supply ideally needs to grow with the offerings of the economy and incorporate these new activities. This is why most governments or Central Banks have a target of around 2% inflation per year.
And while governments are almost always behind bouts of hyper-inflation (though external shocks are also possible culprits) all stable economies have settled on allowing low inflation and guarding strongly against deflation. The risk of deflation encouraging under-production and under-employment loses out to inflation's risk of over-productions and over-employment any day.
posted by Ben at 8:52 AM
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