Inflation is Bad, Actually

Reflections on weak arguments in support of inflation and the costs informed by price theory

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Amidst the recent bout of high inflation, there seemed to be a number of people who were surprised by the extent to which the general public was upset about inflation. Meanwhile, I was surprised at their surprise. Inflation is costly. In fact, I think one reason why economists were surprised is that conventional arguments about inflation tend to downplay and underestimate the costs of inflation. This is largely because inflation is seen as a macroeconomic topic and the costs are framed in terms of macroeconomic costs. In reality, it is much better to think about the costs of inflation from a price theoretic perspective.

In today’s newsletter, I would like begin by discussing why certain economists argue that some level of inflation is good and why these arguments do not hold up to close scrutiny. Subsequently, I will then explain why the conventional costs of inflation are understated.

Why Do People Say Inflation is Good?

I think that pro-inflation arguments can largely be placed into two categories. The first is that a low, stable rate of inflation helps to insulate the economy from deflation. The second is that inflation is just another form of revenue creation. As such, it is just another tool in the policymaker’s toolbox and thus should be used accordingly. I think both of these are bad arguments, but I will assess them one at a time.

Inflation to Avoid Deflation

One common argument that you hear in favor of inflation is that a low rate of inflation helps us to avoid deflation. Implicit in this argument is that deflation is not only bad, but that we need to take active steps to avoid it. In my view, the fear of deflation is predicated on a misreading of monetary history and poor economic reasoning. Allow me to elaborate.

The lesson for many people (both economists and non-economists) from the Great Depression is that deflation is bad. For some, it seems enough to know that (a) the Great Depression was incredibly costly in terms of the decline in output and the rise of unemployment, and (b) this was also a period of dramatic deflation.

Admittedly, it is not hard to make this argument. For example, suppose that farmers take out a loan from the bank to financing the planting of their crops. Since prices are typically stable, the farmer anticipates that the price of his product at harvest time is likely to be somewhere around the level it is at today. The farmer takes out a loan in dollars. Subsequently, come harvest time, there has been considerable deflation. The farmer’s crops are now selling for 10% less than what he expected. Yet, the value of the loan he must repay is in a fixed number of dollars. It has not fallen by 10%. As a result, it is harder to pay back this loan. If prices fall far enough, the farmer might have to default on the loan. The bank, which diversified its loan portfolio, now finds that such diversification was illusory. Since deflation represents a general decline in prices, on average, throughout the economy, even those in other industries are more likely to default on their loans. Thus, although the bank thought it was diversified, the deflation causes a wave of defaults and also puts the bank at risk of failure. To the extent that banks are themselves interconnected through interbank loans, this risk of failure could spread across banks.

That certainly sounds like a compelling story or, if not compelling, plausible. However, there are a lot of implicit assumptions hiding in this argument. I will address two of these assumptions.

The first implicit assumption is that the deflation is unexpected. The chain of events that I describe only makes sense if the farmer incorrectly predicted that the future price of his crops would be about the same as the prior year. Had the farmer anticipated deflation, the terms of the loan would have been different. Clearly, the farmer would not have agreed to a loan that he anticipated that he could not pay back.

The second implicit assumption is that deflation is demand-driven. To understand why, consider that falling prices alone are not sufficient to claim that the farmer cannot pay back the loan. What matters is the farmer’s revenue. A demand-driven deflation would lead to both lower prices and a lower quantity sold. This necessarily implies that the farmer’s revenue declines. By contrast, a supply-driven deflation would be caused by something like a productivity improvement. This would mean lower prices, but a greater quantity sold. There is no obvious reason that this would cause financial distress.

In fact, this distinction between supply-driven and demand-driven deflation is empirically important. Michael Bordo, John Landon-Lane, and Angela Redish examined periods of deflation from the classical gold standard era. They found that deflation during this period tended to be driven by supply-side factors like rising productivity and was therefore “primarily good.” They distinguish this from the deflation associated with the Great Depression as being demand-driven. They are not alone. David Beckworth provided an overview of differences between demand-driven deflation and supply-driven deflation and how this squares with the empirical evidence. In short, among those who have thought about this carefully, there seems to be a clear consensus that deflation is good when it is driven by supply-side factors, but harmful when it is driven by demand-side factors.

In fact, George Selgin has made a compelling argument that the price level should reflect the supply conditions of the economy. Specifically, in a growing economy, the price level should decline with rising productivity.

Supply-driven deflation seems easy to understand. Rising productivity causes an increase in supply and a decline in prices. At the same time, productivity reduces the cost of production per unit. As a result, the lower prices from increased supply do not reduce the profitability to the producer. Workers, even if their nominal wages stay the same, are better off because their real wages rise (i.e., that wage can buy them more stuff).

But what causes demand-driven deflation?

Historically, demand-driven deflation seems to mostly result from bad policy. Since so much of the fear about deflation comes from the experience of the Great Depression, it is important to understand why the Great Depression was deflationary.

As I have previously written about, early in the Bank of England’s history, Britain realized that the Bank could be used as a tool to pay for war. During wars, Britain would suspend the convertibility of bank notes into gold at the Bank of England. They coupled this with an explicit promise to restore convertibility at the previous parity to gold following the war. This allowed Britain to use inflationary finance during the war, while also anchoring long-run inflation expectations (more on that later).

By World War I, this had become common practice. The belligerents in the war left the gold standard. Following the wars end, some reneged on the commitment to restore the convertibility at the previous parity and devalued their currency. Others, like the U.S. did not. Given the higher nominal price of gold, any return to the previous parity should be expected to be associated with deflation. Furthermore, a return to the gold standard also meant an overall increase in the demand for gold. As I’ve explained before, under the gold standard, the supply and demand for gold determines the price level. This increase in the demand for gold is also deflationary. However, this latter effect could have been mitigated by central bank cooperation. A cooperative reallocation of the world’s gold stock would have prevented a net increase in the worldwide demand for gold. In fact, this seemed to work to prevent deflation until the late 1920s. At that point, both the U.S. and the French prioritized their own domestic circumstances for monetary policy. This collapse in international cooperation meant that there was a significant increase in the global demand for gold and thus a significant and severe deflation was the result.

One way that we know that this was the cause of the period of deflation is that (a) deflation occurred in all gold standard countries, but not those who were not on the gold standard (like China), and (b) the timing of the recovery from the Great Depression coincided with countries’ decisions to devalue their currency in terms of gold or to leave the gold standard entirely.

Again, most people took the wrong lesson from this scenario. Many argued that the gold standard itself caused the Great Depression. However, there was no inherent flaw in the gold standard that caused the severe deflation. In reality, it was central bank mismanagement of the gold standard (policy errors).

To summarize, there isn’t much to fear about deflation, unless that deflation is driven by policy errors. This makes it somewhat odd to say that we need inflation to give us some cushion to avoid deflation. This is tantamount to saying that we need inflation to prevent us from the consequences of the policy errors that we are likely to make. I find that to be an incredibly weak argument in support of inflation.

Inflation as a Tax

A second argument that people make is that inflation is effectively just another form of taxation. When the government spends, it can either pay for that spending with taxes now, borrowing (taxes later), or money creation. Generally speaking, paying for government spending with money creation will cause prices to rise. Persistent monetary financing will cause inflation to rise. For those holding currency, this is akin to a tax since the nominal value of the currency is fixed, but its purchasing power is declining. In other words, taking two dollars away from someone with one hundred dollars is not really any different than reducing the purchasing power of that hundred dollars by two percent.

Like any other tax, this creates a distortion. When people expect inflation to eat away at the purchasing power of their currency, they will tend to economize on their currency holding to try to avoid the tax. This reduction in money balances will ultimately reduce exchange and economic activity in comparison to a world without inflation.

When thought of this way, inflation is just another tool for the government to tax. The issue becomes merely technocratic. Should you use inflation or formal taxation? The problem is merely to determine which of the options will generate the most revenue with the fewest distortions in economic activity.

There are a number of problems with this view. The first problem is that tax policy is often explicit. Raising the tax rate on income requires legislation. The inflation tax is hidden. It does not require any legislation and thus no consent of the governed (however illusory one might think such consent may be). People are often unaware that such a “tax” has been levied until they see it in their daily lives. It is a “hidden” tax.

A second problem is that inflationary finance can be quite unreliable. Recall the example of the Bank of England from earlier. In order for inflationary finance to be effective in raising revenue quickly during times of war, the government had to commit to restoring convertibility at the previous parity to gold. This meant that any inflation during that war had to be followed by deflation after the war. The reason for this is quite simple. The amount of tax revenue generated from an inflation tax is proportional to real money balances. The general public determines the quantity of real money balances to hold. Higher rates of inflation, without a commitment to price stability, will lead to people substituting away from holding money, which will further increase inflation. Over time, this decline in the demand for money will reduce the revenue that one can get from an inflationary tax.

In short, it is very difficult to raise consistent revenue with inflation, especially once people begin to expect that the government or central bank will resort to inflationary finance more frequently.

The third and final problem with this view is the subject of the final section of this newsletter. The inflation tax argument fails to take into account the broader costs and consequences of inflation. The distortions from people economizing on money balances are likely dwarfed by these other costs. But to understand those other costs, we need price theory.

A Price Theoretic Approach to Inflation; or, Why Inflation is Bad, Actually

To think about the costs associated with inflation, think about how we typically frame our price theory discussions. Price theory is fundamentally about relative prices. In theory, that would seem to suggest that money, as a unit of account, isn’t particularly important. For example, suppose that the unit of account is the dollar, the price of a t-shirt is $10 and the price of a hat is $20. The cost of buying a hat is two t-shirts. Now, suppose that the unit of account are seashells. The t-shirt costs 100 seashells and the hat costs 200 seashells. The cost of buying a hat is still two t-shirts. So why does the unit of account matter?

To answer that question, let’s think about the role of a unit of account. Suppose that there was no such thing as a unit of account. Goods are simply all priced in terms of other goods. The act of setting prices and making basic economic calculations would be difficult.

The producer cares about the price of what he or she is selling relative to the costs of the things used as inputs. If I’m a baker, I need to know that the price of the cake is sufficient to cover the costs of the cake’s ingredients. At the same time, the producer would have to price the cake in terms of hats and t-shirts and cows and salmon and steak, etc. Furthermore, the price of the cake in terms of t-shirts would need to be greater than the cost of the ingredients in terms of t-shirts. But this also must be true of the price and cost of the cake and its ingredients in terms of steak. But then also if the price of the ingredients in terms of t-shirts and the price of the ingredients in terms of steak are not consistent with the price of t-shirts in terms of steak, then there is an arbitrage opportunity. If the baker isn’t aware of that arbitrage opportunity, the cake might not be profitable in terms of some particular goods.

Finally, to further complicate matters, it is virtually impossible to offer prices in terms of all other possible goods. Without a complete set of relative prices, some potential buyers would be unclear about the price of the cake in terms of other goods that they might be more familiar with.

It follows that one important thing that a unit of account does is that it provides a standard unit of measurement. From the producer’s perspective, this makes things a lot easier. I just need to know that the price of the cake in terms of dollars is greater than the cost of the ingredients in terms of dollars. It also makes it easier for consumers since they don’t have to rely on a complete list of relative prices. Instead, because they are aware of dollar prices of other goods, it is easy to figure out the relative prices of whatever product they see.

The unit of account is a common reference point. This is one reason why inflation is so costly. Inflation erodes the informational value of that reference point.

In the economy, many things are changing simultaneously. Nonetheless, when prices, on average, are constant, it is easy to identify relative price changes. If the price of bananas goes up in terms of dollars, I can be fairly certain that is caused by what is going on in the market for bananas.

The same is not true during period of inflation. Although inflation means that prices are rising, on average, all of these other things that are happening are going to affect relative prices. But money prices are also changing. It becomes much more difficult to determine whether the price change you are observing is a relative price change or simply reflects inflation.

But it is not just relative prices that are affected. Another common reference point when considering prices is what the price was last week or last month or last year. During periods of inflation, it is easy to recognize that the price of something you purchase all the time has gone up. However, what really matters for your consumption decision is how much that price has gone up relative to other goods that you want to consume. The more different that prices are now relative to the recent past, the harder it is to perform these economic calculations.

Higher rates of inflation push us closer to that world without a unit of account in the sense that it erodes the informational content of the unit itself. When prices, on average, are relatively constant the dollar price conveys changes in relative scarcity or abundance. During periods of inflation, the dollar price becomes insufficient. One must constantly find new reference points in terms of frequently purchased items.

It also makes economic coordination more difficult across time. Firms often engage in contracting with other firms. A car manufacturer might buy its transmissions from a different firm. The contract stipulates how many transmissions the manufacturer wants to buy and the price that is paid. By removing a reliable reference point, inflation makes it harder for such contracting to take place. This is especially true the longer the term of the contract.

This is one under-appreciated aspect of something like the gold standard. Under the gold standard, things were priced in terms of dollars, but the dollar was defined as a particular quantity (and quality) of gold. Price changes thus always reflected the relative scarcity or abundance of a particular good relative to gold, even during periods of inflation. The mean-reverting nature of the price level under the gold standard often meant that most price changes were relative price changes. In addition, this mean-reverting nature of the gold standard also meant that dollar prices retained their informational content. At the very least, the long-term stability of prices over time made economic coordination across time easier.

Under the fiat system, there has been no such mean-reversion. Over a long enough period of time, the dollar in and of itself loses its value as a reference point. The higher the rate of inflation, the shorter the period for which the reference point has valuable informational content. A break in inflation or a slowdown in inflation allows time for a reset of the reference point. However, each bout of inflation starts the cycle over again.

So what does all of this mean?

It means that if we ignore the costs of economic calculation induced by inflation, we are severely underestimating the costs associated with inflation. Trips to the grocery store take a little bit longer. Family budget decisions are a little bit harder and take a little bit longer. Both individual people and firms might make strategic purchases based on the expectations. Discrepancies between relative prices can arise that can create arbitrary opportunities for arbitrage. Contract lengths might get shorter and/or contracts might have more contingencies. Either way, contracting costs rise. All of these actions are wasteful in the sense that they could be completely avoided if not for inflation.

Concluding Thoughts

My general view is that it is hard to make the case that inflation is good. The traditional arguments made on behalf of a persistent, positive rate of inflation do not hold up well to close scrutiny. Furthermore, the costs of inflation are often underestimated. This seems to be because inflation is a macroeconomic phenomenon and thus the costs are framed in terms of the macroeconomic costs. However, the price theorist recognizes money’s important role as a unit of account and the significance of this role for economic calculation. Inflation erodes the informational content of the unit of account and as such imposes costs across all types of exchange. These costs are almost certainly much greater than the value of foregone transactions caused by the inflation tax. In fact, these costs can be considerable, but more importantly they are wasteful. They are costs that only exist because of inflation. It seems that inflation is bad, actually.