Sunday, April 27, 2008

How Bad is Inflation Anyway?

Getting away from the Presidential horse race and the horse shit road apples it produces, I was pointed to this article concerning the true rate of inflation by an acquaintance on LiveJournal. Personally I think the numbers are a bit exaggerated, but it should be completely unsurprising that the government jiggers its own statistics on unemployment and inflation for its own purposes.

Before I go into the actual inflation numbers, let me try to sum up what drives inflation in our regulated market economy. (Actual economists are welcome to correct me on outright errors in fact, but bear in mind that I personally believe economists make a living by making wild-ass guesses. Accuracy is by no means necessary- see "supply-side economics" on the one hand and the Von Mises Institute on the other hand.)

To paraphrase a quote from somewhere in J. R. R. Tolkien's many writings, you need gold to breed gold; that is, in a capitalist society you need capital in order to acquire more. Most people do not start life with much capital- little more, in fact, than the productivity of their hands and mind, plus such support as family and friends can contribute. In order to build upon this, a person must gain access in some form to capital in the form of currency. That usually means borrowing money.

Moneylending, of course, never began as a way of financing business; on the contrary, it was used to finance luxury and waste. The modern banking system came about to enable the wealthy to build mansions and castles, to allow kings to prosecute wars with empty treasuries. Only with the dawn of the mercantile era, beginning with the Dutch and English, do you have business turning to the moneylenders on a major scale to finance enterprise.

Moneylenders charge interest on their loans to make their profit. As a general rule, the more risky a loan, the higher an interest is charged. Competition among moneylenders, as a general rule, curbs the greed impulse. In the early days a moneylender could only loan out money he actually had, but this changed about the time of the American Revolution, when some bright people discovered that they could loan out much more money than they actually had... provided that people believed the money would be found if asked for.

This brings us down to our modern system, where less than half the currency in circulation has any actual relationship to real money. The majority of dollars in your bank account exist only because somebody, somewhere, loaned them to somebody else and thus, in effect, created them out of thin air.

If this sounds like a recipe for disaster, you're right, and it's happened before. The trick of loaning out more money than you have only works so long as the vaporware dollars are treated as if they were the real thing. When too many people come back to the bank and demand real money- or, worse, withdraw the investments that provide the core funds to support the loans- this is called a bank run.

If a bank suffers a run, it goes bust, and all the funds that it loaned out without backing suddenly become worthless. In the 19th Century, when banks were allowed to print their own paper currency, this resulted in a lot of people becoming penniless overnight. Bank runs caused three economic collapses- the Panics of 1837, 1853, and 1873- each much worse than the Great Depression. Government eventually solved this problem by regulating it away- but more on that in a moment.

Now, let's put this system into a closed loop, where there is only a finite and unchanging amount of currency. People borrow money; they eventually have to pay it back, plus a bit extra. Some people can pay this money back, in which case the lender profits; some can't, in which case the lender loses all. The system never breaks down completely, but there's a great deal of instability. This means that the economy can never grow very large (which is bad for everyone); it also means that the wealthy risk going bust, which they won't tolerate if they can help it.

Now let's adjust things a bit by allowing a trickle of new currency to enter the system- just a little, but steadily. The first thing this does is make it slightly easier for people to pay their debts- which means that lenders are protected from their own risk-taking. When lenders are protected, so is anyone who has money "created" through the act of lending beyond cash reserves. This results in a more stable and predictable economy. The downside is, of course, inflation.

Inflation is what happens when a currency buys less than it used to. Usually (but not always) this is due to an increase in the amount of currency in circulation. As any collector will tell you, the more there is of something, the less valuable it becomes. If you're a member of the investor class, this is not a problem- you stay ahead of the curve by lending or investing at rates higher than the rate of inflation. If you're poor, or if you are on a fixed income, or if you just sit on your money, then it's a bad thing, because prices go up while your ability to buy goes down.

Deflation, of course, is the exact opposite. Deflation is a good thing for those with little money, because it means they effectively have more. It is very, very bad for investors, though- because when existing money is worth more, there is less incentive to borrow. In deflationary periods loans are paid off and not renewed. Interest rates are forced down by lack of demand. For the truly wealthy this is not too much of a problem. For businesses who only act as middlemen between those with the money and those who borrow it- most banks, for instance- it can kill, leading to the same problems as a bank run.

With this theory firmly in mind, United States banking regulations have skewed towards preserving the system- usually on the premise that it's better for the poor to be ground down by inflation than for the whole economy to collapse. The United States has not had a significant deflationary period since the Great Depression. Government policy has been to keep inflation controlled... but, more practically, to keep inflation, period.

Fast forward to the past ten years or so. During the Republican ascendancy in Congress, and then the Bush White House, regulations and policy have been changed to allow or require more lending, for higher interest. Laws against usury (charging excessive interest on loans) have been relaxed, to the point that some credit cards issued today charge interest of as much as 35% per year- rates which, twenty years ago, would be called loan sharking. The interest rates charged by the government to loan money to keep banks stable have been kept low deliberately to encourage people, both businesses and individuals, to borrow and spend more money. Worst of all, massive deficit spending by the government has led to massive borrowing by that government.

By removing the caps on interest, government has encouraged lending to high-risk borrowers who otherwise couldn't get credit... and who, therefore, don't get the benefit of competition, which means major profit for the lender. Low overall interest rates encourage people to seek loans more often. Government borrowing and spending brings in currency from outside the nation. All of these things mean more loans, which means more "created" money, which means more currency in circulation...

... which means more, much more, inflation.

The result? A period of illusory prosperity. The economy appears to expand, but since the expansion is entirely based on borrowed money created for the purpose, any actual gain in value is concentrated exclusively in the investing classes. Those who don't loan out money for a profit find that any gains they make go into paying interest. Meanwhile, prices go steadily up, and up, and the more money is borrowed, the faster the prices go up.

There are two ways to control or reverse inflation. The more pleasant method is to make the currency in question more desirable- that is, to increase its buying power. This can be done, but it depends on a stable economy and a government budget that's at least close to balanced- which isn't happening any time soon.

The other way is to take money out of circulation. That means, in this case, cutting back on all the borrowing and lending- cutting back a LOT.

The problem is, if you cut back on borrowing and lending, you get a recession- a period where the economy shrinks. That's unpopular on multiple levels. The fact that sometimes it is necessary appears to be lost by everyone in government at the moment. Again, stability of the system (and the benefit of the wealthiest) is more important to those in power than long-term effects from an artificially "productive" economy based on borrowing.

So- what's being done, now that loans are beginning to default on massive levels?

First- lenders who loaned money unwisely are being bailed out of the consequences of their mistakes.

Second- those who borrowed money on blatantly false pretenses are NOT being bailed out. Net result of these two points- an encouragement to loan out more money, and to deliberately deceive borrowers in the process.

Third- government policy is keeping interest rates to banks low. Result- encourage, you guessed it, more lending and borrowing.

Fourth- deficit government spending continues to increase, which requires- guess what?- more lending and borrowing.

Thus, in trying to stave off recession, the government creates more and more inflation. Eventually these efforts will not be sufficient- we may have got to this point already- and we get stagflation, which is where the economy shrinks and inflation grows at the same time. Jobs dry up, wages either stay low or fail to keep up with inflation. This is the worst of all possible worlds...

... for everyone except the moneychangers, who in the short term will make a killing as they loan money to people who try to extend their standard of living a bit longer, hoping the period will pass. Evidence strongly suggests we're already at this stage, and have been for most of the Bush Presidency.

If it doesn't pass, then you get a crash- a deep recession such as the 1970s, or maybe even a new Great Depression.

The softest solution would be a mild deflationary period- allow people to get out of debt, retract the borrowing, balance the federal budget, and consolidate the national economy. This would especially benefit the very same people who are currently facing foreclosure and bankruptcy- bankruptcy under rules recently changed to benefit the lenders and to make it much, much harder to get out from under crippling, unrepayable debt.

But, since deflation is bad for banks, bad for investors, bad for the wealthiest of the wealthy... neither the Democrats nor the Republicans are willing to consider it.

A major crash is coming. It's been coming for thirty years or more, since the very term "stagflation" was coined during the Nixon administration. The longer that crash is averted, the worse it will be when it hits. Unfortunately, rather than aim for a soft landing, our politicians are attempting to avoid the crash entirely, pretending that an economy can grow forever and that borrowing to sustain that growth can be done indefinitely without consequences.

And what has been the result? Well, for my little business it's meant that the prices I charge today for product are, roughly speaking, 150% the prices I charged ten years ago. (And they're about to go up a bit more.) It means that a soft drink that cost $0.89 in 2000 costs $1.39 now- about the same price change as a dozen large eggs, or a cheap loaf of bread. It means that people who have had a 2% annual increase in income every year have actually been losing money, because prices have been going up by more than that- much more. It means that all but a tiny segment of Americans have been getting steadily poorer, not richer...

... and it's been that way for quite some time now.

To end at the beginning, let's look at the chart which makes up the basis of the article I mentioned reading.

Averaging out the monthly estimates of annual inflation into a single number for the year- and, to make it easier on myself, a whole number estimate of that- here's what the chart says:

2001 - 3%
2002 - 2%
2003 - 2%
2004 - 3%
2005 - 4%
2006 - 4%
2007 - 3%

2001 - 5%
2002 - 4%
2003 - 5%
2004 - 6%
2005 - 7%
2006 - 7%
2007 - 6%

2001 - 9%
2002 - 8%
2003 - 8%
2004 - 9%
2005 - 10%
2006 - 10%
2007 - 11%

Using these numbers, by the Clinton-Bush standard what you could buy for $100 in 2000 now costs $123; by the Reagan standard, that $100 in 2000 dollars now costs $147; and by the pre-Reagan standard, that $100 worth of stuff now costs a whopping $186.

I think we can all agree that the first standard is an outright lie. We can discuss which of the other two is more accurate, but fact is that both are very, very bad. If inflation isn't curbed (or, for personal preferenced, reversed for a while), the economy will collapse not from the top down but from the bottom up, as the buying power of the lower and middle classes dries up. That will lead to a prolonged depression and catastrophic reduction of money supply.

It took a world war and the gutting of the economy of the rest of the world for the United States to recover from its last depression. If it happens again, what will it take to recover?

WILL we recover?

And if we can't answer those questions, then why don't we find a solid, long-term solution to the problem instead of temporary patches and quick-fixes that will only make the crash worse when it comes?

Trickle-down economics doesn't work in the long term, rich folks. If you want to preserve your spot on top of the economic ladder, you'll start making sure the rest of the rungs don't fall out.

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