Why the Government Likes Inflation

In my last post we learned that inflation is caused by the government's central bank putting more money into circulation than the economy can handle. This dilutes the value of each dollar, causing prices to rise.¹

In a perfect world the central bank (the Fed) would maintain precisely the amount of money in circulation to cause neither inflation nor deflation.² However, it is difficult for the Fed to be so precise with the money supply because exactly what the money supply is supposed to correspond to in the economy is not universally agreed upon; and even if it were agreed upon it still might not be possible to know the level of that thing or things in real time. Managing the money supply is a lot like piloting a super tanker. You have to make course changes long before you see the results of them, and then you have to continue to make adjustments based on lagging and possibly misleading feedback.

The Fed, however, always seems to err on the side of inflation. We have almost never had a spat of annual net deflation unless there was some unforeseen economic crisis that caused it. Besides a 2009 rate of -0.34 caused by the credit crisis, the last time we had annual net deflation was in 1955, and then the amount was only -0.28%. While in 1979 through 1981 we experienced inflation rates of 11.22%, 13.58% and 10.35%. So the government is clearly more than willing to tolerate some inflation, usually about 2-4% per year but often more, rather than risk any deflation at all. Why is this?

The official answer you will hear is that they regard deflation as the worst thing an economy could experience. Their fear, which goes back to the Great Depression (the last time we experienced significant deflation) is that falling prices will discourage buying because consumers will hold out for even lower prices, which will cause prices to drop more, causing lower profits, layoffs, less spending, and on and on, in an unstoppable "deflationary spiral."

However, falling prices in electronics over the years haven’t discouraged people from buying HDTVs, computers and smartphones. People buy things when they become affordable to them. Also, true spiraling deflation is only caused by an economic upheaval, like that which caused the Great Depression, not by prices falling -2% a year because the Fed did not print enough money.

So the fear of deflation is an overblown and somewhat disingenuous excuse to always err on the inflation side. The real reasons the government prefers inflation are based on less than stellar motives.

The first reason the government likes inflation is that, all else aside, it gives the impression of growth when there is none. This is because wages increase with inflation as well. Most people are familiar with “cost of living” raises which are supposed to help earners keep pace with inflation. Even though inflation-caused cost of living raises and deflation-caused cost of living reductions would effectively produce the same result, the fact is cost of living raises are much more politically palatable. This is true even though, as we shall see, inflation punishes saving and deflation rewards saving. Politicians want people to think that the economy is growing, so they point to the growth in Gross Domestic Product and leave out the fact that some, most, or all of it was simply inflation.

The second reason the government prefers inflation is that it benefits debtors, and the United States is in debt. Inflation over time lowers the value of debt. If you borrowed a dollar last year and this year a dollar is only worth 97 cents (3% inflation), you’ve saved three cents. In ten years it will only be worth 74 cents, so you would save 26% on your debt simply by the effect of inflation!

Deflation on the other hand causes debt to increase over time. With 3% deflation over ten years, one dollar of debt would become $1.35 of debt, and this in not even counting the interest on the loan.

By the same token, inflation punishes savers. At 3% inflation, a dollar saved would be worth only 74 cents in ten years. Today’s passbook savings accounts pay less than 3%. So even while paying interest such a savings account would lose value over time.

Since inflation punishes savers and rewards borrowers, it discourages savings and encourages borrowing. This suits the government just fine because such a situation encourages borrowing and spending instead of saving and investing. Why in the world would the government want to do this?! The answer is because borrowing and spending stimulates the economy in the short-term, while hurting it in the long term, and saving and investing do the opposite. And since politicians are only interested in the short-term, they prefer borrowing and spending, i.e. inflation.

The third reason government likes inflation is because it is effectively a tax. It is a way an in-debt government can reduce its debt by reducing the wealth of citizens. The last time I checked, that's a tax. It is also a flat tax and a regressive tax--which is ironic considering the multitude of liberal Democrats who support the Keynesian economics that produce inflation. It hits the poor and those on fixed incomes the hardest.

You may have heard of "vice taxes." Well, inflation is a virtue tax. It punishes the thrifty and rewards the spend-thrifts. This matters little to an in-debt government, because as it gets more drunk on debt, the more attractive inflation becomes, and the more undesirable deflation becomes.

Notes:
1. Nobel prize-winning economist Milton Freidman famously said, “Inflation is always and everywhere a monetary concern." He meant that true inflation is caused by increasing the money supply, not by price shocks.

2. This is, supposedly, the advantage of keeping a currency on the gold standard, because tacking a currency to gold prevents the willy-nilly printing of money for any reason. However, the gold standard is not a perfect solution.

Inflation and Deflation

Everyone has heard of inflation and deflation, but many people don't know what they really are and what causes them.

Most people think inflation means rising prices. This is true, but there are two main causes of rising prices. One cause is shortages. For example, as oil gets scarcer its price rises. Most people understand this intuitively.

The other cause of inflation is an increase in the money supply. This is the kind of inflation I'll be focusing on, because it is the most insidious and the one with the most potential to cause economic disaster.

The amount of money in an economy goes a long way in determining how much things cost. Imagine a simple economy where there are only ten $1 bills and ten oranges. In this case, each orange would cost one dollar. What would happen if we added ten more $1 bills to the economy? In that case, the cost of each orange would rise to two dollars. The money supply would double and the buying power of each dollar would be cut in half. That is monetary inflation. So inflation is largely determined by the amount of money in the economy; and the amount of money in the economy is determined by how much the government, the Fed, creates.

Deflation is caused by a decrease of money in the economy. When the money supply decreases, the buying power of each dollar increases, because there are less of them. This drives prices down.

Now, I oversimplified things because inflation and deflation are not just caused by the amount of money in the economy, but also by the speed the money moves around in the economy. If there is a lot of money out there, but no one is spending it and it is not moving around, that can cause deflation, too. This is what happens when an economy is sick. And this is why when the economy gets sick and threatens deflation, the Fed, as it is doing now, feverishly tries to pump up the economy by creating money. It also explains why, even with all this money being printed, inflation is not a big threat; because when an economy is sick it just wants to lay down and get better. It doesn't want to be given a stimulant so it can get up and run around the bed. This is the state of our economy at this time.

True economy-wide deflation rarely happens in the U.S., while inflation seems ever with us. Is this because inflation is hard to tame, or is it because the government chooses to create some inflation?

Remember that modern governments, via central banks, in our case the Fed, can create or remove money any time they want to. The Fed says that its dual mandate is to maintain high employment and low inflation. But if you watch what they do you'll see they are actually trying to produce some inflation. In fact, since the creation of the Fed in 1913, the U.S. dollar has lost 95% of its buying power to inflation.

Each year for the last 22 years the Fed has kept inflation below 5%. But the fact is they could drive it to -5%, that is, 5% deflation, or more, if they wanted to. But they don't. They act like inflation is this beast they are fighting to tame, when actually they are the ones producing it by printing money.

So why do they choose to reduce the buying power of the dollar on a regular basis?

We'll see in the next post.

How Markets Interact, Part 5: Tying It All Together

Okay, so we’ve looked at the four major global financial markets--stocks, bonds, commodities and currencies--and learned a little about them and how they interact. Now let’s get them all on the table and try to get an overall grasp of how these markets react to and influence each other.

First let's look a little in general at how markets interact, then we'll examine in more detail.

Market Relationships (during typical inflation) 

• Stocks and bonds usually trend together. 
• Bonds usually change direction before stocks. 
• Stocks and commodities usually trend together. 
• Commodities usually change direction after stocks. 
• The U.S. dollar trends in the opposite direction of commodities and inflation. 
• Inflation moves up as stocks get higher. 
• Interest rates rise to fight inflation, causing bonds to turn down, then stocks, then commodities. 

During periods of economic health, stocks and bonds should both trend up, because this shows full confidence in the business environment. Commodities should trend slightly up, showing increased demand, but not overly inflationary demand. Inflation should by the same token be slight. However, vigorous growth in the economy will also cause dollar to rise, pushing inflation and the cost of commodities down. This reflects a time of great expansion and prosperity.

Prosperity that is driven too much by monetary expansion and not enough by real growth causes inflation. Inflation causes interest rates to rise, which eventually signals an end to the expansion. 

In deflationary economies, which are rare but not unheard of, stocks and bonds decouple and begin to move in opposite directions. Stocks down and bonds up. This is because a deflationary environment is much more uncertain. Money becomes more scarce and begins to seek out the safest haven, that being bonds. This is known as the "flight to safety" or "risk-off."

We have seen this come and go in the last fifteen years because of deflationary pressures on the world's economies. Stocks and bonds moving markedly differently are a clue the economy has an underlying deflationary problem--as they have been lately with bonds being very strong and stocks being so-so. Central banks have been pumping massive amounts of money into economies to stave off deflation. So far they've been fairly successful. But because of the huge amounts of world-wide debt, deflationary pressures are still there and aren't going away soon.

A Full Business Cycle

Below is a diagram showing a full business cycle from late contraction (recession), through early and late expansion (recovery), to early contraction. Let's go through this from left to right. (Note that in this example rising inflation implies a falling dollar, and vice versa.)

• Stage 1: In the late stages of an economic contraction or recession, stocks, bonds and commodities have been falling. The economy has slowed markedly. Finally, interest rates fall to attract borrowing, causing bonds to rise.
• Stage 2: Commodities continue to fall, but interest rates begin to drive down inflation. Stocks begin to rise with bonds in anticipation of a recovery.
• Stage 3: Inflation is down. Due to expansion, however, commodities begin to rise with stocks and bonds. Who cares? The recovery is on! Happy days are here again! Buy! Buy!
• Stage 4: Rising commodities and other prices mean rising inflation. Interest rates rise to control inflation, causing bonds to fall.
• Stage 5: Rising interest rates signal to investors that the party is nearing an end. They begin to dump stocks, pushing the stock market down. Commodities continue to rise however, because inflation is not under control yet.
• Stage 6: High interests rates have slowed inflation. But the evacuation is full tilt. Commodities, stocks and bonds all fall together. Investors run for cover! The world is coming to an end! Sell! Sell!
  
  Until.... back to Stage 1.

Understanding how markets interact is a great help in understanding what in the world is going on in the world's economies. I'll refer to these principles again and again in later posts.

How Markets Interact, Part 4: Stocks

The stock market is the glamour girl of financial markets. It's the one that gets the most attention and press. But actually the stock market is less important to the economy than both the bond and currency markets. Even so, many people are interested in the stock market as they see it as an indicator of the state of the economy, not to mention they may have some money invested in it.

The stock market exists, interestingly, as a side result of companies needing to raise capital. When a new, growing company decides it needs to raise funds for growth, it can make arrangements to "go public," that is essentially sell some or most of the company to the public in the form of "shares" which each represent a tiny bit of ownership of the company. This "initial public offering" of shares, or IPO, raises a lot of money for the company, which it reinvests in itself. But the company's status has fundamentally changed. It has lost its innocence, so to speak, and now the shares it sold can be traded on the open market. The price of those shares show the public's perception of the value of the company at any given time.

The stock market's overall valuation is a generalization of all the values of all the stocks which comprise it. These values are indicated by published indices--like the Dow Jones Industrial Average, the S&P 500 and the Nasdaq indices. These index levels are determined, when all is said and done, simply by the buying and selling pressure on the shares which make up the stocks in them. News, profit expectations, economic outlooks, world events and other things affect stock buying and selling, but it is the pure and simple buying and selling which determines price.

Stock prices respond favorably to low inflation and low interest rates, as these things reflect the availability of money to be spent in the economy on many things, including, not coincidentally, buying stocks!

Since bonds also respond well to low inflation and interest rates, bonds tend to lead stocks and stocks tend to follow bonds in the same direction. This is the normal healthy relationship between them. There is a big exception to this, however. In a deflationary environment, stocks and bonds tend to move in opposite directions.

I'll leave it here for now and try to summarize in the next post.

Next up: Tying it all together

How Markets Interact, Part 3: Bonds

Sooner or later, just about everyone needs to borrow money. Modern economies probably could not survive without the means to loan and borrow. When a government or company wishes to borrow money, they sell bonds to the public. Bonds are IOUs which represent a promise to repay a loan plus interest after a specific period of time.

After being issued, bonds can be traded on the open market. The bond market is second only to the currency market in size. Loaning and borrowing money is big business.

What makes bonds interesting is that the cost of bonds is affected by interest rates, and vice versa--and interest rates directly affect the economy. If investors are buying bonds and driving up bond prices, they are also driving down interest rates. If bond prices are dropping, interest rates rise. Since interest rates are essentially the cost of borrowing money, the bond market directly affects the availability of money in the economy.

Bonds are considered the safest of the four main markets. Some bonds, namely U.S. Treasuries, are considered the safest investment in the world. However, with the United States' debt woes this might be changing. Regardless, safe doesn't mean risk-free. Although repayment plus interest is guaranteed at the end of the bond's term, there is always the chance that the issuer could default.

Also, if the bond holder does not wish to hold the bond fully to maturity, he must sell the bond on the open market, where an increase in interest rates may have driven the bond's price below the amount he paid for it. Of course, the bond price may have risen during this time, too. But there is no guarantee of this.

Several things can cause bond prices to rise. Prices will rise when investors feel the bond issuer, whether a government or company, is strengthening. If the Fed lowers interest rates to stimulate growth, existing bond prices will rise, because they will then offer a higher yield relative to new interest rates.

Also, bonds are considered a safe haven in uncertain times. So sometimes when the stock market goes down, the bond market will go up. This due the "flight to safety" effect. Investors are selling stocks and putting the money into bonds because they feel bonds are a safer investment, at least at that moment.

Another factor to consider with bonds is inflation. When inflation begins to become a problem, interest rates rise to compensate for money being too available. This drives the price of bonds down. But falling bond prices could be looked at in another way--that demand for bonds is waning because of lack of faith in the issuer. If these are government bonds, then if foreigners are selling them they are likely selling our currency, too, to convert the money back into their own currency. This would drive the value of our dollar down, which would exacerbate inflation, causing interest rates to rise more and bonds to fall more. In other words, a chain reaction.

That is how a crash happens, and there may be one of those in the United State's future if we cannot pay our debts and a run on our bonds breaks out.

I'll talk more about bonds in the coming segments.

Next up: Stocks