The Truth About Inflation - Paul Donovan :: Andree Huk

My recommendation: 7/10

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Summary of notes and ideas

The nominal price of bread has gone up, but the real price has in fact gone down (bread prices have fallen relative to the prices of other goods and services). Bread is actually less important or less desirable to the British consumer today than it was in the past.

Indeed, from an economic point of view, the headline consumer price index is almost certain to be the wrong index to be using in calculating the real value of anything. And if the wrong price index is used, then investors, or consumers, or writers of investment blogs will end up miscalculating changes to their standards of living. Real will not, in fact, be real; using the wrong inflation index makes real data a fantasy.

Indeed, the misapplication of consumer price inflation to debt and debt interest rates, when wage or income inflation is the appropriate measure, is one of the more damaging problems that a poor understanding of inflation can produce.

…to have struggled on with continuous increases in prices for the past seventy years or so. Indeed, the continuous rise in prices that has occurred since the Second World War has not only been possible

[…] this refusal to accept that inflation need not be any trouble in a modern economy is loss aversion bubbling up to the surface of the reader’s subconscious. The fear of loss of purchasing power is a potent fear.

The moment uncertainty creeps into the popular consciousness, the costs of inflation start to ratchet up. The saver says ‘I want 1,000 per cent interest to compensate me for inflation, but just in case the economists are wrong in their forecasts I want another 100 per cent interest as an insurance policy.’

So, for an economist, or an investor, or a consumer, the damage that is wrought by inflation is not because prices change per se. The damage wrought by inflation is because people are uncertain about the future path of inflation, and demand additional compensation as an insurance against that uncertainty.

Good deflation will take place if an economy has become more efficient in the production or the supply of a range of products or services. Greater efficiency means that more can be supplied at less cost. Such deflation is likely to be temporary, as the improvement in efficiency is likely to be a one-off structural change rather than a persistent improvement. The key characteristic of good deflation is that consumers will respond to the fall in prices by increasing their demand (‘things are cheaper, so we can buy more’). The increase in supply of products or services is then met with an increase in demand, and thus prices stabilise over the medium term

The central point to take away from this chapter is that it is not inflation that is damaging, but the uncertainty about inflation that is damaging.

The central point to take away from this chapter is that it is not inflation that is damaging, but the uncertainty about inflation that is damaging. Inflation stability should be the objective of any policymaker, because (providing that they are convincing) making inflation control a policy objective should minimise inflation uncertainty risk, which will then promote investment and economic growth.

It is true that gold may be the only legal tender (and thus the only form of currency acceptable for paying taxes, or the form that a creditor can insist upon receiving in settlement of a debt) but other forms of currency will circulate.

One could also make a claim that the cow is the one true physical form of currency that has been consistently used by humanity over the millennia.

The English, and then later the British, monetary system used silver as the main medium of exchange for most of its history (hence the pre-decimal symbol for a penny being 1d – a reminder of the Roman denarius). Britain only truly operated a gold standard for its currency in 1821 with the lifting of the Bank Restriction Act, although silver coins had effectively disappeared from circulation around a century earlier.

Most of the world’s gold-based currencies have actually operated on a Rumpelstiltskin principle. The systems work by spinning something like straw into a gold proxy. The systems depend on maintaining the belief that the gold proxy could be converted into gold on demand – but if confidence in convertibility collapsed there would be a rush to trade in these other forms of currency in order to hold physical coin.

Above all else the idea of gold as having intrinsic value needs to be rejected for the fairy tale that it is. Gold has the same intrinsic value as a Bitcoin – that is, none at all. Gold is worth only what it can purchase; which means it is worth only what other people will willingly surrender in exchange.

In short, acquiring an asset is about providing for a future standard of living by acquiring a future income or capital gain; owning an asset says nothing about a consumer’s current standard of living. Consumer price inflation is all about how price changes are affecting a consumer’s real current standard of living. Asset price inflation relates to future income; consumer price inflation relates to current spending.

However, if policymakers are trying to decide whether they should be taking action and changing interest rates or other policy measures on the back of inflation, then there is an argument for using core inflation. Core inflation is more susceptible to the influence of policymakers, as it reflects inflation causes that they can actually control.

Core inflation is not an accurate measure of how the cost of living has changed for a typical family, but it may nevertheless be politic to use this in the setting of policy, as this is the core inflation measure that represents the bit of inflation that policy can actually influence.

If the central bank is credible and has a clear inflation target, then that inflation target is likely to form the basis of pay negotiations. If the central bank’s credibility has been undermined then workers are likely to regard the inflation target as a starting point for negotiations, to which an inflation uncertainty risk must be added.

[…] on average inflation is around 60–65 per cent labour (because payments to labour are the equivalent of around 60–65 per cent of corporate value added in an economy).

Therefore, if labour costs are relatively stable, and the price of wheat rises 10 per cent, then the price of bread should not rise by any more than 2 per cent. Similarly, if the price of raw milk rises by 10 per cent then the price the consumer pays should not rise by more than 7 per cent. The problem with this situation is that the presence of all of this labour is hidden from the consumer. Partly this is by design – consumers like to think of food as something that is natural. One does not want to think that lawyers have been metaphorically handling one’s loaf of bread before it gets to the breakfast table; such a thought is calculated to blunt even the sharpest of appetites. As already identified, advertising plays to this perception, in presenting food as directly linked to the farmer, rather than the reality of a very remote relationship.

This desire that the authority of government should take on the might of the market through direct intervention has a long tradition.

The problem with trying to legislate prices is that governmental will rarely defeats the force of the market.

Consumers tend to focus on the more superficial breakdown of inflation, and pass judgement on relative prices. This is natural, as the consumer is conscious of the price of a finished product rising. As the food example has made clear, consumers are generally unaware of the economic components of that finished product.

Why should one work to produce goods or services if one does not receive what one considers to be an adequate level of compensation? This makes price controls potentially self-defeating; controlling prices reduces supply, creating further upwards pressure on prices. If this cannot manifest itself in the ‘official’ price (as sanctioned by law) then it will encourage the development of a black market where goods or services will be supplied at the price that truly reflects the supply and demand balance

The second problem with legislating to prevent inflation is that it distorts the ability of relative prices to adjust. To have governments set prices (or even to constrain the ability of prices to change) presupposes that relative prices will remain static.

The problems of supply and relative prices apply to wage controls as well as to price controls. This is logical enough: wages are simply another term for the price for labour.

Wage and price controls give rise to two potential distortions, therefore. First, they raise the risk that supply will be constrained and goods or services are not available at the legislated price. Second, they raise the risk that relative prices or wages become distorted as demand patterns change. These reasons create inefficiencies over time which ultimately bring about the demise of controls.

Printing money is not now, and has never been, a source of inflation. It is not printing money that creates inflation, it is printing too much money that creates inflation.

The form of money that matters to inflation today may not be the form of money that matters to inflation tomorrow.

The central bank has to balance control of narrow money with the risk that participants in the economy are scared off by the controls and move to use forms of money over which the central bank has less control.

If the central bank is not going to acquire foreign currency to balance the printing of narrow money on its balance sheet, the general alternative asset class that the central bank acquires will be government bonds. Any asset would do, and other assets are sometimes used, although the purchase of bonds and bills (which are just short-term bonds) is the most common way of increasing liquidity or narrow money supply.

Quantitative policy is buying and selling securities with the objective of controlling the quantity of money supplied to the economy (and the interest rate is the independent outcome of that operation, not the objective of the operation).

Whether or not the central bank is receiving an adequate return on the assets that it is purchasing is not likely to be terribly important to the central bank. In other words, quantitative policy will introduce a significant buyer of assets in specific markets, who does not play by the conventional rules of financial investing. This will distort the price of those assets (generally raising the price above the ‘market clearing price’ of course).

If the central bank buys government bonds, and raises the price above the market clearing price, that will dissuade government bond investors from buying bonds in that market. These former government bond investors will have to find some home for their money, and if government bonds are unattractively priced they will move into other asset markets (generally markets which are considered to have a higher risk). That will increase demand for assets in other markets, influencing their price. The economic description of this is ‘moving out along the risk curve’.

The difference from quantitative policy is that the central bank is purchasing the bonds and bills directly from the government. Conventional quantitative policy does not involve this direct relationship, as the central bank is acting in the market and purchasing assets from investors

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