Why Fight Inflation?

Inflation has existed ever since the invention of money. It is always decried as a bad thing which must be eliminated or at least controlled. Lately the absolutist position of earlier ages has been replaced by inflation "targeting" by central banks. The current head of the US Federal Reserve, Ben Bernanke, even wrote a book on the subject.

My understanding of why inflation is regarded as something to be prevented depends on a model of social and economic interests. In my model there are three broad classes of people. The lowest class, the working class and the rentier class.

The lowest class has no, or almost no, assets. They live a quasi-subsistence lifestyle. Some combination of work, public assistance, the underground economy and other erratic sources of income keep them in place (at least during normal times).

The working class (actually several classes) have modest amounts of assets, with those higher up having more. Typically these assets are automobiles, homes and home furnishing and a small amount of savings and/or investments. Their primary source of income is from their employment. If they stop being employed, and there is little public support during unemployment, they rapidly are forced to draw down their assets or borrow against them.

The top class has a large amount of assets. These include physical assets like homes and furnishings, but also includes extensive investment portfolios. Many of them could live indefinitely without working, if necessary, although some might need to trim back their spending levels. This is the new rentier class. In the traditional use of the term this class described the landed gentry or those who lived by "clipping coupons" on their bonds.

What happens if there is "excessive" inflation to each class?

The lowest class may or may not suffer. Much depends upon how social services adjust to the decline in value of the money. In advanced countries there is now generally some automatic adjustment in benefit levels which is tied to the inflation rate. How earnings adjust for this sector depends upon what happens to the main working class. The earnings of the poor will tend to track higher earnings at a slower rate, but general expectations can make such adjustments happen as well.

During the last period of runaway inflation in the US (the 1970's) there was still enough power from organized labor that salaries tended to track inflation, even for those not in unionized jobs. Even in under developed nations when inflation gets too high there are pressures to increase wages. In many cases this requires public protests, or general strikes, but the aim is met to some degree. Only totally failed states like Zimbabwe fail to cope with this sort of situation.

The sector that traditionally suffered the most in the nominal loss of wealth has been the rentier class. When the bulk of one's holdings are tied up in long-range, fixed interest, bonds, or land and rent contracts, then the value of the holdings declines inversely to the rise in inflation. In addition the income that these holdings generate gets paid in increasingly watered money. It is this knowledge that makes many wealthy shift to tangible, tradable, items as an inflation hedge. During the prior inflation period, jewelry, fine art and antiques were popular choices. The trend is summed up in the aphorism: "cash is trash".

In most societies those with the most wealth also have the most economic and political power and, thus, policies tend to support their interests. The wealthy see a loss of value in their holdings during an inflationary period so government polices have been directed at suppressing inflation. The recent idea of using targets is just an acknowledgment that a total elimination of inflation has never been successful. If the wealthy know that inflation will exist at a relatively constant rate they can factor this into their investments and demand that the interest on their holding be high enough to compensate for the inflation rate.

Over the past 40 years there has been a change in attitude towards investing by the wealthy (and governments as well). The idea that one should invest in long-term, fixed rate, instruments has been replaced by the concept of flexibility. The US Treasury stopped issuing 30 year bonds, several years ago and made the longest term ten years. This has been slightly revised recently for a number of reasons. Firms no longer borrow by issuing long-term bonds either, they prefer to use commercial paper which has a short maturity cycle or issue other instruments which can be called after a time. This trend toward shorter term investing means that the risk of holding assets that will depreciate during inflation has declined.

So who is the Federal Reserve (and other central banks) protecting by battling inflation?

My thesis is that current policies are based upon a model which is no longer important. The traditional clients of the central banks no longer exist, but there are no new models. The result is that the policies being put into place are obsolete. The Fed was prepared in the past to cause high unemployment to protect the rentier class. It is still prepared to do this, but there is no rentier class to protect. The wealthy have adopted defensive techniques to protect themselves.

Even banks which used to be at risk when they issued fixed rate loans are no longer in the same situation. Many home mortgages now have floating rates, are resold, or are expected to be paid off in a short period of time as borrowers refinance or replace their investments. There may be some value in keeping inflation at a fairly low level, it makes society feel more stable and predictable, and avoids the tensions that are present when people have to press for wage increases.

So are central banks fighting the last war by building an economic Maginot Line? Is there any reason to fight inflation during the normal changes in the business cycle?

__________________________

--- Policies not Politics