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Sunday, August 12, 2018

Why Is A Positive Inflation Rate A Good Thing?

One of the questions that often comes up in economic discussions is: why is a positive inflation rate seen as a good thing? There are a few angles to this question, which makes it somewhat more complex. I am somewhat ambivalent on the subject, but I believe the best answer lies in the area of political economy, not economic theory.


My trigger for this reflection was this tweet by David Collum. I only scanned the associated Twitter thread only briefly; my thinking seemed to run on different lines from the discussion that I saw there.

Although he describes the question as simple, his phrasing buries some subtle points.

The first issue I see is the question: a good thing for whom? Are we discussing the national interest, or what is good for individuals? Readers of a libertarian disposition might make an argument along the lines of "there is no such thing as society," and all that matters is giving the best outcome for individuals. Mainstream economists might take a similar line, but bury the argumentation in the sludge of utility theory. This is really a question of political theory or economics, but most of my arguments are based on the belief that there is a national interest, and that national interest can diverge from what individuals would like to happen.

In particular, there is a fetish among a sizeable group of the population that "money" needs to preserve purchasing power. Whenever I hear those arguments, I think of Séraphin from the film Séraphin: un homme et son péché (word-for-word translation: Séraphin: A man and his sin, but released with the English title Séraphin: Heart of Stone), a miser who dies clutching his hoard of precious coins in his burning house. Modern money is a token, it is used to grease the wheels of commerce, but there is no reason to expect it to be exchangeable for goods at a fixed price. Otherwise, the implication is that prices cannot change, which means that they cannot the precious market information that the same people who worry about purchasing power tend to be concerned about. Obviously, opinions can vary about that issue, but it is clear that there is no national interest in pretending that can fix the market value of inherently worthless tokens, even if some citizens want to believe otherwise.

Once we put the concerns about individual welfare aside, the most important is what context positive inflation is discussed in: are we discussing the current institutional context (in most countries), or a hypothetical discussion of a new institutional arrangement?

In the current institutional arrangement, it is very easy to see why positive inflation is seen as a good thing. We generally make arrangements based on the assumption of some positive rate of inflation (outside Japan, at least). We have formalised this with 2% inflation targets. The only reason that inflation is below that is generally because we had a recession. Recessions represent a waste of human resources, and are thus not in the national interest. So in this case, positive inflation being good can be viewed as it being an absence of a bad.

There is also a useful distributional aspect to this expected inflation. Politically, I believe that we can throw the interests of people hoarding coins under the bus, but we need to look out for the interests of the middle class. (This can be justified on the purely pragmatic grounds of preserving the social order; and coin hoarders are too insignificant a political force to matter.) The standard pattern of life for the middle classes (at least in the Anglo countries) is to contract a large mortgage debt, typically around child-bearing age. These large debt burdens are expected to be reduced by steady income growth, which is the result of gaining job experience, as well as inflation. If wage growth drops below expectations, that debt burden will become onerous. Countries with economically crippled middle classes face weak demand, and we get the post-Keynesian hysteresis story. (See this article by J.W. Mason for a longer discussion.)

The final way of approaching the question is to step away from the current context, and ask whether we ought to change the institutional framework? That is, set the inflation target to zero.

The first question is whether such a target is feasible. Many people have developed beliefs that suggest that fiat currency economies need nominal growth and inflation to function. This is obviously not true; Japan has been functioning for decades as a very fiat currency nation with pretty close to price level stability. The transition from an expectation of positive inflation to price stability might be painful, but once achieved, real economic performance should theoretically be about the same.

However, are there reasons why price stability might be a bad idea? There's a lot of mainstream theory on that topic; determining the societal optimal level of inflation was a giant swamp research dollars were dumped in when inflation targeting was the big theoretical fad. Currently, there might be more worries about the Dreaded Zero Lower Bound (DZLB). As regular readers might know, I take such mainstream theory with a large grain of salt.

I could try to discuss the economic theory questions associated with price stability. My view is ambivalent. (From an MMT perspective, the question shows up in how the Job Guarantee wage is set. From an inflation control perspective -- which is how the policy is being sold -- the coherent policy choice is to a have a fixed wage growth, with 0% growth as an option.) As a result, I would argue that the economic theory is a red herring: what matters is political economy.

The one undoubted advantage of inflation is that it obliterates any notion of "normal prices." Back when I was a kid in the 1970s, having oldsters wail about how much common items cost in previous decades was extremely common. People don't do that any more; almost all price anchors have been obliterated.

On paper, that sounds bad. Won't that create a more inflationary environment? In practice, not really. Other than the gold coin-clutching crowd, nobody really worries about inflation (other than gasoline prices). As a result, we don't see the fights over indexation that were common in the 1970s. (The demise of union power probably contributed as well.) It is perhaps not surprising that inflation models calibrated on pre-1990 data break; there are no second round effects that give the inflation cycle its juice.

The real advantage is that we are much more immune to policy idiocies. Since we no longer have a price level to revert to, there will not be any call for depressions (at least outside the ECB...) to restore price level parities. On paper, we could have a price level target, and not attempt to restore previous price levels. In practice, we have plenty of historical evidence that fixed price level targets is what the hard money crowd would push for. Given that almost the rest of 1920s economic dogma has returned, we need to be thankful that natural price levels are still a relic.

(c) Brian Romanchuk 2018


  1. The Austrian school argues for the existence of good deflation and bad deflation. Here is a quote:

    "Good deflation occurs when prices and interest rates decline, consumers receive more purchasing power from most assets, output expands and productivity expands due to technological innovations. Bad deflation occurs when prices and interest rates fall yet many consumers receive less purchasing power from most assets, output contracts and productivity declines as a result of central bank policies."

    Virtually all economists want to maximize the quantity of investment and consumption goods produced as output in the economy. To my knowledge only the Austrians develop theories of good deflation. In the United States under the metal standard the US dollar was not a national currency region. Instead there were regional banking networks that operated as regional currency regions. An economic depression in one region was possible with expansion of output in other regions of the nation. One would have to also consider the economic winners and losers with policy allowing for episodes of deflation.

  2. A post-keynesian explanation for inflation is that it is a way to reconcile conflicting claims on nominal product by capital and labor. Their "target" shares do not sum to 100 with wage/price inflation being the outcome of this conflict.

    Another argument for positive inflation rates is different productivity growth rates. Manufacturing has historically posted strong productivity growth on an annual basis which essentially means that it can claim a larger part of national income with the same labour input.

    Other sectors do not post strong productivity increases and we actually do not want them to. We want a nurse to only care for a specific number of beds and a teacher for a given number of students and not increase these numbers in order to "increase" productivity. Nor can we decrease the time needed for a haircut to zero. In essence there are many professions for which their product is actually "time" instead of a specific item.

    These professions can only maintain their purchasing power wrt to manufacturing (and other sectors with large productivity growth) through price inflation which will eventually be reflected in overall economy-wide inflation.

  3. Maybe inflation plays differently between income groupings depending upon whether money comes before the earning-of-money or visa-versa? Maybe this chicken-egg question has real world effects.

    Let's think of a shopkeeper who pays his workers in gift certificates (good only in his store). I would argue that the worker first performs and then a gift certificate is issued.

    It would be obviously unfair if the shopkeeper raised his prices after payment (in gift certificates) to the worker.

    Doesn't payment (of the worker) in money work the same way? Workers on the lower income scale would need to work longer (with greater exposure to inflation) to save down payments for minimum things like housing. I would argue that low income workers are hurt more by inflation than upper income workers.

  4. How to get rid of inflation and deflation
    Comment on Brian Romanchuk on ‘Why Is A Positive Inflation Rate A Good Thing?’

    Brian Romanchuk takes the question “Why is inflation above 0% considered a good thing?” as a starting point for a psychological/sociological study of what different people/groups think how inflation/deflation affects them.

    His answer is the usual vacuous It depends: “I could try to discuss the economic theory questions associated with price stability. My view is ambivalent.… As a result, I would argue that the economic theory is a red herring: what matters is political economy.”

    Needless to stress that this is not the answer of a scientist: “In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum)

    Brian Romanchuk, though, is not a scientist but a blathering agenda-pusher. He has NO idea how the monetary economy works. Time to remind him of some economic basics and of some basics of scientific methodology as well.

    As the correct analytical starting point, the elementary production-consumption economy is defined with this set of macroeconomic axioms: (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

    Under the conditions of market clearing X=O and budget balancing C=Yw in each period, the price is given by P=W/R (1). This is the most elementary form of the macroeconomic Law of Supply and Demand.

    In the most elementary case, the price P is determined by the wage rate W, which takes the role of the nominal numéraire, and the productivity R. The quantity of money is NOT among the price determinants. This puts the commonplace Quantity Theory forever to rest.

    In the elementary production-consumption economy, the price P performs a random walk which in turn depends on the random changes of productivity R and wage rate W. Note that the price movements do not depend on the random changes of employment or on whether the economy is at full employment or not. Equation (1) implies W/P=R, i.e. the real wage W/P is always equal to the productivity R.

    Monetary profit for the economy as a whole is defined as Qm≡C−Yw and monetary saving as Sm≡Yw−C. It always holds Qm+Sm=0, or Qm=−Sm, in other words, the business sector’s surplus = profit equals the household sector’s deficit = dissaving. Vice versa, the business sector’s deficit = loss equals the household sector’s surplus = saving. This is the most elementary form of the macroeconomic Profit Law.#1 As long as C=Yw, macroeconomic profit is zero.

    As a matter of principle, the elementary production-consumption economy is reproducible for an indefinite time. It is important to note that there is no such thing as an equilibrium or price stability or full employment.

    Now it is easy to see that price stability, that is a rate of inflation/deflation of zero, can be established with a simple institutional rule: change of wage rate = change of productivity. In equation (1) this stabilizes the price P forever at the given level. No inflation, no deflation, no random price movements.

    See part 2

    1. Although I am certainly a "blathering agenda-pusher," I also accidentally got a proper academic training. There is an extremely long line of academic arguments that suggest the determination of what is "good" is a question of philosophy/ethics/religious belief. Other than a few reductionists, I am unaware of much support for the notion that "science" can determine the answer to such questions.

      Have a nice day.

  5. Part 2

    So, if the Legitimate Sovereign decides to implement absolute price stability and asks the economist how to achieve this goal, the economist has a clear-cut answer. It reads W'=R' with ' indicating the rate of change. No wish-wash here, no ambiguity, no senseless blather.

    Of course, things become more complex in the investment economy and when the price becomes the independent variable and employment becomes the dependent variable. These issues have been dealt with elsewhere.#2 The bottom line is that to set the inflation target at 2 percent is plain economic idiocy.

    Egmont Kakarot-Handtke

    #1 Truth by definition? The Profit Theory is axiomatically false for 200+ years

    #2 See cross-references Employment

  6. Brian Romanchuk

    You say: “There is an extremely long line of academic arguments that suggest the determination of what is ‘good’ is a question of philosophy/ethics/religious belief.”

    True, and this is why economists should stop blathering about philosophical, ethical, and religious issues. Science is about true/false and NOT about good/bad.#1 Economics has to define itself as a system science.

    The elementary version of the correct (objective, systemic, behavior-free, macrofounded#2) Employment Law is shown on Wikimedia.#3

    From this equation follows inter alia:

    (i) An increase of the expenditure ratio rhoE leads to higher employment L (the Greek letter rho stands for ratio). An expenditure ratio rhoE greater than 1 indicates a budget deficit = credit expansion, a ratio rhoE less than 1 indicates credit contraction.

    (ii) Increasing investment expenditures I exert a positive influence on employment.

    (iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment.

    The complete employment equation contains in addition profit distribution, the public sector, and foreign trade.

    Items (i) and (ii) cover Keynes’ familiar arguments about aggregate demand. The factor cost ratio rhoF as defined in (iii) embodies the macroeconomic price mechanism. The fact of the matter is that overall employment INCREASES if the AVERAGE wage rate W INCREASES relative to average price P and productivity R.

    Roughly speaking, the Legitimate Sovereign has two policy parameters: rhoE and rhoF. Now, rhoF, in turn, is composed of W/PR. It is pure dilettantism to set the rate of price increase at 2% without taking the other variables into consideration. What has to be set is NOT one isolated variable but the policy parameter rhoF as a whole. A smart policy to reduce unemployment and to eventually arrive at full employment would be to set P'=0 and W' >R' with ' indicating the rate of change. If, for example, P' is set at 2% and W'=R' unemployment INCREASES.

    This brings us back to the initial question: “Why is inflation above 0% considered a good thing?”

    The answer is because economics is a failed science and economists do not know how the monetary economy works. False theory leads to false policy guidance. With their defective employment theory, economists bear the intellectual responsibility for the social devastation of mass unemployment.#4 Therefore, it is NOT good for society to take these incompetent blatherers seriously.#5

    Egmont Kakarot-Handtke

    #1 Beware of the moralizing economist

    #2 The macrofoundations approach starts with three systemic axioms: (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X. For a start it holds X=O.

    #3 Wikimedia, Employment Law

    #4 For details of the big picture see cross-references Employment

    #5 As Napoleon said: don’t listen to economists


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