Misunderstanding Inflation: There's No Free Lunch

Monetary inflation leads to inflation in goods, services, and/or assets. We just went through a decade (and then some) where there was low product price inflation, but there was significant inflation in asset values.

What was the response from policymakers? Aside from a rare comment regarding “irrational exuberence,” most of the time they were fat, dumb, and happy. Because of their flawed model for understanding monetary policy, they ignored asset inflation, and patted themselves on the back for the lack of goods price inflation. What little attention they paid was through the weak construct called the “wealth effect.”

Make no mistake — printing money leads to inflation; the question is where the inflation goes. The loose monetary policy of the last 20 years has definitely fueled an inflation of real estate asset values above that which is sustainable in the long run.

As such, I have little agreement with the following articles:

• Notes on This Week’s Column: Inflation Fears
• The Inflation Permahawks

We have been through a unique era where monetary has had significant effect on the asset markets, but little effect on the goods markets. Perhaps those effects were affected by demographics, and might change in the future. Just because good price inflation has been weak in the past, does not mean it will be weak in the future.

Monetary inflation — an increase in the money stock or credit, will have an impact on asset and/or goods prices. Which gets affected depends on the proclivity to spend versus save.

There is real reason to be concerned about inflation, then. We face either:

• an unsustainable increase in asset values, or
• goods and product price inflation.

The former looks for likely for now, but who can tell? As Baby Boomers tip the balance between saving and spending, goods and services inflation may predominate over asset inflation.

On the “positive” side, some of the troubles of asset inflation get passed on to credulous foreigners because the dollar is the world’s reserve currency. That weakens the feedback effects in the short run.

My main point is this: there is no free lunch. Either money buys less, or assets buy less because of monetary inflation.

Comments

[Graham and ...:]

"MV=PT" There's another way you could have a rising V without a rising, P (monetary expansion without price inflation); a falling V, velocity of money.

Sep 09 10:38 AM

[chap08:]

Like many people, you make the mistake of looking at only the inflationary or deflationary forces. Don't you know that both exist simultaneously? Yeah, there's a lot of extra base money; but there's also a lot of unused capacity and deleveraging. So don't expect that extra money to show up in consumer prices soon unless the dollar falls sharply against other currencies.

Sep 09 10:42 AM

[Donald Ingram:]

At the moment the economy is experiencing deflation that is gathering momentum. A look at wages, groceries, rents, even dry goods for sale at your local Wal - Mart, have all dropped in price.
This is what the Fed (Helicopter Ben) is most afraid off, getting caught in a wage/price deflationary spiral. More money will be thrown at this 'willy nilly' until something breaks. We may all guess what that would be!
After this deflationary phase (watch interest rate for hikes) the country will then go through a period of inflation. Will it transform into a complete lack of confidence in the dollar? If this happens we will have hyperinflation. Stay tuned. Time will tell.

Sep 09 11:02 AM

[Thomas J. G...:]

I agree with David in general but I disagree with him here. The standard macro textbook says "inflation is a rise in the overall price level". I have read this many times. "the fed had lose monetary policy and the money went into the oil bubble" (steven forbes?), "the fed had lose monetary policy and it went into the housing bubble" (too low interest rate might be a valid argument). I don't see how fed created money "goes" into only particular markets. The fed increases the money supply, the banks and velocity apply the multiplier effect. What is the mechanism that new money only to oil or real estate speculators. I don't buy it.

Sep 09 12:17 PM

[carey_jim:]

Monetary inflation has a political/psychological component as well.

When Germany experienced hyperinflation after World War I, until 1923, it was the result of a decision by the German people to flout the absurd reparations payment requirements imposed by the victorious powers and to print as much money as necessary to pay the impossible amounts demanded.

An excellent article on Wikipedia sums up the causes of severe (hyper) inflation as: en.wikipedia.org/wiki/...

1. The general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. Amounts of local currency held are immediately invested to maintain purchasing power.

2. The general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency. Prices may be quoted in that foreign currency.

3. Sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short.

4. Interest rates, wages and prices are linked to a price index and the cumulative inflation rate over three years approaches, or exceeds, 100%.

These conditions are usually produced by external shocks such as wars and revolutions or severe economic instability as the article points out. But they pose little danger to wealthy individuals who simply convert their wealth into tangible assets and foreign currencies.

In fact, hyperinflation provides another opportunity for the few who are relatively nimble and intelligent to make money by exploiting the fears and ignorance of the many.

Sep 09 12:31 PM

[bcncv:]

I agree in principal, but it adds a few practical problems.

1. How do you measure asset price inflation? Different measurement methods will give vastly different results, all of which could be equally correct.

2. What tools (monetary or fiscal) are available to deal with a situation where there is high asset price inflation, but low product price inflation? Would those tools be politically feasible?

Sep 09 01:50 PM

[Dave Wrixon:]

My take is that we or rather you will have a reversal of the previous trend with high interest deflating asset prices further whilst a depreciating dollar will tend inflate the price of consumer items including food. Enjoy!

Sep 09 06:04 PM

[retired avi...:]

Thomas J. G. (above) has a great point.

The term 'inflation' is commonly understood to mean rising prices in general -- not in specific asset classes such as the dotcom stock binge or the real estate bubble. If only dotcom stocks are inflated, my dollar's purchasing power is not hampered unless I choose to buy dotcom stocks.

We understand these asset price bubbles to be speculative manias -- not a general inflation or a loss of purchasing power in terms of general goods, which is what inflation measures. Though I can see how loose monetary policy can provide the fuel for bubbles to grow, to say that loose monetary policy creates inflation channeled only to specific asset classes is a twisted logic. If inflation really debases the value of the money, it must be debased across a variety of goods and services, or it is not truly devalued.

Another reason why 'bubbles' are not inflation (general currency debasement) is that bubbles eventually pop. When the bubble prices come back to earth, where is the so-called inflation? It is gone.

If you blew $500k on an overpriced Florida townhouse that is only worth $250k today, then today's buyer at $250k has not suffered the loss of purchasing power from the inflated $500k price tag of a few years ago. This "asset specific" inflation has disappeared by the correction.

Sep 10 10:43 AM

[jimmy46:]

Just because good price inflation has been weak in the past, """"

I think this was because of the massive shift of manufacturing from high wage to low wage (china) countries.
Is was a one time event.

It allowed middlemen to boost their margins at the expense of labor.

For the future, irresponsible Federal fiscal/monetary policy will cause inflation in the consumer goods arena.

Sep 11 03:42 PM