Saturday, February 18, 2012

Everything You Never Wanted to Know About Inflation

First I just want to say it is hilarious how we run through more inflation indicators than Japan goes through Prime Ministers.  Every time the indicators go too far above single digits, our government changes the methodology so they grow more mildly.  They did so in 1980, 1990, and probably will do so again (and would have done so already if it was not for the Great Recession).  Yet we don't have people rioting on the streets complaining about the price of bread.  In fact, the 90s and mid 00s were considered prosperous years.  So what is going on?

Is it that nobody really cares about inflation?  Or more specifically nobody cares about the increase of prices in of itself. What people really care about are their welfare and standard of living.  Most of the time inflation is "bad" since we cannot buy as much goods and services as we can before.  But does that not imply we always need the other side of the equation before we can judge?  Don't we need to know how much people are making?  Who cares if prices increase 20% if wages increase 100% in the same period?  Would that not be a net 80% increase in welfare overall?

I plugged some numbers into the FRED and something that should have been obvious jumped out at me: there is a great correlation between Consumer Price Index (inflation) and wage disbursements (nominal paychecks). 

Then I looked at the 70s.  Yeah wages kept up more or less, but it was still a time of turmoil and uncertainty.  It seems to me that what destroyed the 70s was the ever increasing rate of inflation, which completely demolished confidence and optimism.  Thus I postulate that if the rate of inflation stays the same, society will have no trouble adjusting past the short term.  More precisely, with a flat rate of inflation, wages almost have to increase after the short run.  Think about it: assuming consumers can still afford to pay, the producers now are earning higher nominal revenues and profits (assuming the inflation is happening across the entire supply line).  Producers will pass on some of this profit to their employees, in effect growing wages to keep up with inflation.  

In effect, I'm saying that constant rates of inflation does not hurt the economy.  When money supply grows, that money has to go somewhere.  Assuming most people are not total misers, that money eventually spreads throughout the economy.  What ends up happening is this:  suppose you sell everything you own and you get $100 for your troubles.  Simple equation says $1 x 100 = $100.  You buy everything back and do the same thing with the exact same stuff next year.  But this time you sold it all for $120 ($1 x 120k = $120).  Yes each dollar is worth less, but you have more of them.  What we should care about is if the greater number of dollars make up for the lower value of each one.  Past the short term, it always should, assuming rate of inflation never becomes incredibly volatile.

If you are ever confused about inflation or monetary policy, remember this: fiat currency is just a unit of accounting.  The amount of it in a system is only half the picture.  What people really care about is their individual ratio of goods/services produced : goods/services consumed.  Only when that gets too out of whack do things get ugly.  Public deficits, inflation indicators, value of a dollar: these are good things to know for a Business 1000 test, but does not tell you anything important.