This blog is born of frustration.
After many episodes of inflation, some of which triggered financial crisis, it remains clear that never in the field of finance has so little been well understood about such an important concept, by so many.
In the words of more than one Federal Reserve Chair, “it’s a mystery”.
That concept is inflation. This blog is an attempt to address that.
So what is inflation, and why does it matter?
The latter is probably best summarized by none other than Margaret Thatcher, who declared in 1975 “rampant inflation, if unchecked, could destroy the whole fabric of our society”.
So what precisely is inflation? Well there are many definitions. I prefer to use the tenets described by Henry Hazlitt in “What You Should Know About Inflation”;
‘Let us try to see what inflation is, what it does, and what its continuance may mean to us. “Inflation” is not a scientific term. It is very loosely used, not only by most of us in ordinary conversation, but even by many professional economists. It is used with at least four different meanings:
- Any increase at all in the supply of money (and credit).
- An increase in the supply of money that outruns the increase in the supply of goods.
- An increase in the average level of prices.
- Any prosperity or boom.
Let us here use the word in a sense that can be widely understood and at the same time cause a minimum of intellectual confusion. This seems to me to be meaning 2. Inflation is an increase in the supply of money that outruns the increase in the supply of goods.’
Written in 1964, it sets the basis for understanding inflation just as the great inflation of the 1960s and 1970s erupted.
What inflation definitely isn’t, is the increase in prices of individual goods and services, no matter how important – e.g. energy, food or alcohol.
Inflation has to be broader, and result in the rise of more than half the prices of goods and services, in the proportions they are purchased. We attempt to capture that using indices based upon baskets of purchases. It’s not very accurate, but it’s the best we can do.
So what causes inflation? Well most will know this staple from Milton Friedman in “An Economist’s Protest: Columns in Political Economy” (1966);
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
In terms of Hazlitt above, that’s probably 2.
But why does it matter? Well, the best explanation I can offer for that is encapsulated in this quote;
“I do not think it is an exaggeration to say that history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.” Hayek – “The Denationalization of Money” (1976).
But how does Government gain from inflation?
Well, in several ways. For example tax revenues, which are based upon “inflated” nominal revenues, while offsets like allowances fail to take inflation fully into account. But these pale into insignificance compared with the stark reality:
inflation is a form of default.
There are essentially four methods of defaulting on a debt:
- Failure to pay.
- Devalue the currency (if debt is in foreign currency).
- Inflate away (if debt is held by a domestic investor).
- Restructure (where the debt is put off until tomorrow).
Each of these methods of default have their own pros and cons for a government – indeed some are easier for democracies to achieve. While we’ve seen plenty of case 4 recently (think Greece), case 1 is too obvious, while case 2 can trigger alarm amongst foreign investors who can flee en masse. No, case 3 has throughout history been the favored choice. Indeed, sometimes the inflation has been so slight that the “frog hasn’t noticed he was in boiling water, and has actually enjoyed the warmth”. For example, achievement of the targeted 2% inflation in most societies would mean that in 10yrs time, $100 would buy the equivalent of $82 worth of todays goods.
This led market analyst Arnaud Mares to ask the question the ultimate question; “Ask Not Whether Governments Will Default, But How?” – Morgan Stanley, August 2010.
So put plainly, inflation is (the most likely) proxy for the most significant risk investors take – that of default. With debt loads growing to proportions of income and wealth rarely seen before, generally denominated in nominal currency and therefore bereft of explicit inflation protection, and supported by the most extreme suite of global monetary accommodation ever seen in history, it’s little surprise that inflation is seen as the number one worry.
I on the other hand, see it quite differently, and over time, through short blog posts, longer thought pieces, and slide presentations, I hope to present a very different perspective on these issues; one which attempts to explain the bulk of the mystery of recent inflation, one which offers hope that default in any form will be unnecessary, and one which offers clues for global policy makers in their attempt to “keep the party rolling’.
In essence, an inflated opinion.