Thursday, August 27, 2009

Debate on the Benefits and Drawbacks of Inflation




Here, again, is a follow-up on my blog post of a few days ago, Denial: The Imaginary Tale of a Recovery. Yesterday, with his permission, I posted on my blog Chad Clawson's comments on that piece. I entitled it, Banks Kicking the Can Down the Road. The discussion, however, gathered steam today on the news section of MIT Massachusetts Institute of Technology Alumni in Linked-in. It is high level and very insightful.

I reproduce it here:

Chad, Nice post. Hard to argue with your logic. I think the BIG question is whether we are headed for hyper-inflation (because of the massive Bernanke Helicoptor drops of money) or deflation. Every credit bubble bust in history has resulting in massive deflationary forces. Credit tightening and banks not lending drastically slows the "velocity of money" and is thus deflationary. Can Helicoptor Ben print enough money to counteract these deflationary forces?? If he overshoots, then you have hyper-inflation. Not sure which is worse. -Rakesh

By Rakesh Shukla Founder at 170 Systems
posted 6 hours ago


Rakesh, Perversely, there is an upside to inflation in the current circumstances. What matters is how debt is indexed. A simple example: I have a fixed rate mortgage. Inflation lets me pay that back with lower-cost dollars. When I sell my house, I get paid in the dollars current at the time of sale (the inflated ones). Fixed rate Treasurys work the same way... on a hyper-inflation-adjusted basis, the $20T in national debt will be reduced in terms of real GDP. And note all the efforts to get people to refinance off of ARMs (securitized by toxic assets) and into fixed rates. A little inflation helps these folks too. Of course, not all mortgages and Treasurys are fixed rate. And, of course, this trick creates all sorts of economic distortions. No doubt this is a bad thing. But consider the politics: paying off your house more easily is very tangible and near-term to a voter, while the deleterious effects of inflation are much less tangible (or only affecting "those big corporations" and not the individual voter) and longer term. I know who would win that election!
By Dan Greenberg Experienced business development executive and product manager
posted 4 hours ago


Dan, I understand your argument, but there really isn't an upside to inflation. While it is true that individual borrowers (and the federal government) generally benefit by being able to pay back fixed amounts of money with devalued dollars, the lender, who is on the other side of the transaction, loses. The lenders are not banks and large financial corporations, which institutions are merely the conduit through which lenders have access to savers' money. The losers are the savers. Hyper-inflation wipes out savings--it's a giant transfer of wealth from savers to borrowers, and savers are critical to economic growth and development. Savers get wise to this quickly and quit lending money, or they charge a very high interest rate if they do. This stifles economic growth and innovation. This is bad for everyone. (Also, consider what would happen if lenders to the U.S. government like China and Japan quit lending us money or lend it at a very high interest rate. Not good.) You might be able to pay off your home with inflated dollars, but you may not have a job and/or your wages may not keep up with inflation, which is generally the case. The results of hyper-inflation are not that much different from what we have just experienced. In both cases lending has been choked off, affecting consumers, businesses, etc.

Rakesh, I haven't looked at the numbers closely enough to make a strong argument for or against future inflation. I may do that at some point. I would, however, like to point out the following: We have already experienced significant inflation over the past few years, at least in certain asset classes such as real-estate and stock price/earnings multiples. (By the way, people cheer when real-estate and stock prices go up dramatically, but not when gasoline and milk go up in price. This seems logical but if you really think about it it is not. Dramatic increases in stock prices and/or real-estate are not a good thing, unless you are near retirement and plan to convert your stock or real-estate into cash soon and downsize your residence. After all, in the long term stock prices tend to increase only modestly, so a dramatic increase in price over a short period may make you feel good, but will likely stifle future gaines and the higher prices make it more expensive to invest new money into stocks for the long-term--your gains will be smaller on the money you invest today than if the stock market was rising only modestly. With real estate, you may be thrilled that you paid $200K for a home and now it's "worth" $300K, but have you really gained anything? If you sell your home you still need a place to live. An equivalent home will still cost you $300K. There is no real gain, it's an illusion.)

This asset price inflation was driven largely by speculation and unbridled credit, which effectively dumped hundreds of billions of dollars into the economy, not that unlike what the Fed is doing now. The only difference was that it was individuals and corporations doing the borrowing and dumping it into the economy rather than the government doing it. Some portion of the government borrowing and spending has just served to fill the hole left when private credit dried up. Some of the government money has merely replaced the financial losses suffered by the banks, getting us back to par. Therefore, it's not clear to me that there will be massive inflation. It depends upon how much money the Fed has dumped into the economy vs. the financial losses they are covering, and how quickly they can pull back as private capital again becomes available.

By Chad Clawson Managing Director, PPMG
posted 4 hours ago


Chad -- Your response to me is absolutely correct: inflation is bad based on any academic argument, economic theory, or long-term perspective. I absolutely agree with you. However, my comment was not an academic or economic one, but a political one. Government does a lot of things in this country because it benefits the majority in the short term (the length of time between the benefit and the next election), even to the severe detriment of the minority or the long term. Anyone who held Chrysler's *secured* bonds (i.e., a mortgage from Chrysler) will tell you that. Making everyone a homeowner by enabling ludicrous lending standards from Fannie and Freddie is another example. Let's combine your response into my original example: suppose there are 200M voters in the 100M households in the US. Suppose 20% are the savers who ultimately loan money to the borrowers (the other 80%). Now hold an election. The 80% will surely vote for a policy of transferring wealth to themselves from the 20%!! Is this the right thing to do for the greater good? No. Is it the right thing to have happen to ensure long-term prosperity? No. Will it happen? Let's not be naive.

By Dan Greenberg Experienced business development executive and product manager
posted 3 hours ago


Dan, Sorry I misunderstood you point. I think I now see it, but don't think that most voters would make a strong connection between inflation and paying off their homes with cheaper dollars. I was around in the 70's when inflation was as high as 14% as I recall, and I don't remember anyone at any income level being happy about it. They saw stagnant growth, unemployment, and other costs, such as food, clothing, energy, and taxes increase and were not happy. Inflation would be bad for the political party in power, even if it helped the borrowers. At the end of the day, we may have no choice but to inflate our way out of the mess we have gotten ourselves into with unbridled spending and unfundable entitlement programs that will go into the red very soon.

By Chad Clawson Managing Director, PPMG
posted 3 hours ago


I am not an expert in this area but my gut tells me that deflation is a bigger risk than hyper-inflation based on the history of bursting credit bubbles. The other deflationary force is that asset-backed security (ABS) market is now a skeleton of its former self. The derivatives built on ABS to "spread the risk" has also been impaired to say the least. This has resulted in an implosion of available credit. The house of cards has tumbled down so to speak. I believe Bernanke got his PHD studying the Great Depression. Hopefully, he realizes the "tight-money" policy mistakes that were made in 1937 - they started tightening the money too soon. I believe the FED needs to stay accommodative for a lot longer because we are far from out of the woods here. So far this has been a smoke-and-mirrors market rally based on earnings that have exceeded expectations due to cost-cutting rather than top-line growth. That is just not sustainable. -Rakesh Shukla

By Rakesh Shukla Founder at 170 Systems
posted 3 hours ago

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