Monday, January 10, 2011

Why is Inflation Bad?

Yesterday I talked about what inflation is and what can cause it.  Today, I'm laying out the all the reasons that I can see as to why inflation is a bad thing.  In preparing this article, I was shocked to find how few people actually talk about the negative sides of inflation.  For something that economists study, and the department of labor measures, and market watchers fret over, and the entire federal reserve board is obsessed over, you would think there would be plenty of articles explaining all the negatives behind inflation.  Therefore I've decided to lay out all the negative effects of inflation that I could find.

I found an article where the Federal Reserve lays out all the problems it has with inflation.
What's so bad about higher inflation?High inflation is bad because it can hinder economic growth, and for a lot of reasons. For one thing, it makes it harder to tell what a change in the price of a particular product means. For example, a firm that is offered higher prices for its products can have trouble telling how much of the price change is due to stronger demand for its products and how much reflects the economy-wide rise in prices.

This is a legitimate concern.  Inflation can cause inefficiencies in the market.  However, this isn't a problem with inflation per se, it's a problem with inflation that was constantly accelerating and decelerating.  If inflation was at a steady rate, this wouldn't be a problem.
Moreover, when inflation is high, it also tends to vary a lot, and that makes people uncertain about what inflation will be in the future. That uncertainty can hinder economic growth in a couple of ways—it adds an inflation risk premium to long-term interest rates, and it complicates further the planning and contracting by businesses and households that are so essential to capital formation.

Again, this isn't a problem with inflation per se, it's a problem with unsteady inflation.  High inflation is only described as a problem because that tends to lead to a unstable changes in inflation.
That's not all. Because many aspects of the tax system are not indexed to inflation, high inflation distorts economic decisions by arbitrarily increasing or decreasing after-tax rates of return to different kinds of economic activities. In addition, it leads people to spend time and resources hedging against inflation instead of pursuing more productive activities.

There are two good points about the problem of inflation.  The first is that it can shift the tax burden in ways the legislatures may never have intended.  For instance if your wages rises precisely at the same rate as inflation, you will not actually be making more money.  However, its possible that your income tax could slip into a higher bracket and you would end up paying more taxes.  Another example would be a sin tax.  At first an extra 5 cent bottle deposit might sound like a lot, but over time, that 5 cent deposit isn't the incentive it used to be to recycle cans.  Fortunately, this can be solved by indexing some taxes to rise and fall with inflation, as well as a legislature that's ready and willing to adjust tax rates as needed.

The second point is a good one.  If you are worried about inflation, then instead of being a productive person and making more money, you may find yourself wasting time managing your current savings so that it isn't eaten up by inflation.  Unfortunately, as long as inflation is anything besides zero, this problem will always exist.  The only way to mitigate it is to keep inflation low.
Another problem is that a surprise inflation tends to redistribute wealth. For example, when loans have fixed rates, a surprise inflation redistributes wealth from lenders to borrowers, because inflation lowers the real burden of making a stream of payments whose nominal value is fixed.

Once again, this isn't an argument against inflation itself, just unsteady, rapidly changing inflation.  If the inflation rate was always constant, the person making the loan could adjust the interest rate to accommodate long term inflation.

So of the 5 reasons the federal reserve gives of why inflation is bad, 3 of the reasons aren't against inflation, just "surprise" inflation.  Of the other 2, one could be solved by small tweaks to tax laws.  So that leaves only 1 reason for the fed to hate inflation.  People spending time hedging against it, instead of being productive.  It kind of makes me laugh to think that we have an entire institute dedicated to fighting inflation for that one reason.

Fortunately, that's not what the fed does.  The fed likes to set a target rate of inflation and try to keep it as close to that target as possible.  That way 3 of the 5 problems go away.  They also try to set that target for inflation to be low.  That's to mitigate the last 2 problems as well.

There are other very good reasons to keep inflation low that the federal reserve doesn't mention.  For instance, inflation can make some one destitute if they are living off of a fixed income.  Examples would be people living on a pensions or a "reverse mortgages".
Inflation can also hurt people living off of their savings because the value of their savings goes down.  Of course people can mitigate this problem by try and invest and hedge against inflation, but then you have the problem the fed mentioned which is people wasting time managing their existing savings instead of trying to add to it.

The last problem with standard inflation is the "menu" problem.  Imagine inflation was 10% a year - that's a high rate.  That would mean restaurants would have to order a new menu every 6 to 12 months that adds 5 to 10% to all the prices on the menu.  This, of course, wouldn't be a problem just for restaurants, but any retail or service company.  Instead of spending money on hiring new staff or expanding, they have to waste time and energy constantly updating their prices.  Obviously, not a productive use of time.

Finally, we come to "hyperinflation".  Some people describe Hyperinflation as very very high inflation.  I think that undersells the problem with hyperinflation.  Hyperinflation is usually a self-feeding loop.  More money is needed, so more is created, which leads to more inflation, which leads to more money being needed.  This results in ridiculously high inflation of 100% per month and even higher in some cases.  Hyperinflation can be both a symptom and cause of a bad economy - usually both.  So it's important to make sure that inflation never starts to get that high.  How high does inflation have to be to qualify as hyper-inflation?  Unfortunately, there's no set definition, but it must be ridiculously high and keeps accelerating.  I personally define it as more than 100% a year, but that's purely subjective on my part.   I'll talk more about hyperinflation in the future.

So that's all the reasons that inflation is bad.  As you can see, most of the problems with inflation deals with surprise accelerating and decelerating inflation.  There are also problems with a high inflation rate.  Therefore the goal of our economy should be to keep inflation at a very steady, low rate to avoid these problems.
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