Friday, August 23, 2013

Explain Like I'm 5: Inflation Edition

Argh inflation was such a simple concept before economists got involved.  Now it's like forcing Koreans to only watch Telemundo, confusing the shit out of everybody.  Here is all you have to know:

Basically we have two big pots: one is consumable goods/services and the other is currency.  For there to be 0% inflation, both pots have to get bigger and smaller at the same rate.  Thus if we become more productive (say we pass a new law saying either get more productive or we will shoot your face), but don't increase the money supply, we will have deflation.

Extremely Simplified Example:
Pot A has 100 apples.  Pot B has 1000$.  Apples will go for 10$/apple.
Now we are more productive:
Pot A has 200 apples.  Pot B still has 1000$.  Apples will go for 5$/apple.
Ta-da, deflation.

Usually here, people start catching on: Pot B doesn't really matter, as in if an economy only has apples or these pieces of paper you call currency, people will just want the apples.  Whichever society owns more apples will probably be happier.  Pot B just decides how many zeroes are on your paper money.  It's completely arbitrary.  Thus, policy makers only ask themselves: how do we encourage people to produce more goddamn apples.  From here, they quickly realized inflation encourages transactions and transactions encouraged increased productivity.  If everyone knows his money is worth less everyday, holding money becomes a game of hot potato where people want to flip it as quickly as possible.  All these transactions mean more trees are planted, more Pedros are hired to pluck the fruits, and more trucks are hired to transport them.

On a macro level, inflation adds an incentive to everyone's productivity as it forces the households/firms circular flow to...flow faster than it would otherwise.

This is because every single arrow (transaction) can only be done with currency.  If that currency is worth less every day, there is an impetus to do the deal today.

So the powers that be target a positive inflation rate, but the rate doesn't matter.  It only matters how good the central bank is at hitting that target.  Suppose the CB is targeting inflation rate of 10%.  You say that's too high man.  But if the CB really does hit that 10% like clockwork and thus has credibility, inflation will not hurt the private sector.  Everyone will just price in the 10% in all contracts and every deal.  But because inflation still exists, everyone is still forced to not sit on the currency.  Win win.  Therefore, the crux of whether the whole scheme works is if the CB can hit their inflation target.  If it is hitting the target like a drunk dude peeing, then the CB would have forced needless volatility onto the private sector, where at least a few businesses and households will invariably go bankrupt due to inaccurate speculations.

Hell just think of the recent precious metals rout.  How many people got fooled thinking we would have crazy high inflation and thus bought a shitload of gold and silver?  The whole time the CB swore up and down it was targeting 2%.  Sure you can call the goldbugs nutjobs or that they deserved it, but this is a side effect of the CB losing credibility.  It's the same thing with a bank run.  It's not just a self-fulfilling prophecy; it's the logical aftermath of an institution that has no credibility.

I think going down the road of targeting a positive inflation has been a stroke of genius, but changing the target too many times will have unintended consequences.  For example, it is now becoming vogue, in a hipster economics way, to suggest increasing inflation targets to 4% or even higher.  Sure this will help a great deal of those who are in debt today, but not only will this mean that all new deals will price in the higher inflation (thus making the whole thing really temporary) but also forces the private sector to weigh these types of overt government actions in all future deals.  In other words, if the private sector now expects the government to increase inflation every time debt becomes too much, then all new debt will have even higher nominal interest--call it the government intervention premium.

Variables are the demons of rational individuals.  Have only a few variables and it's easy to make a good decision.  Have a couple more and it's exponentially harder to do anything.  To price interest rates (or anything), you already have to speculate on a number of variables, but if you have the government changing inflation targets for short term gains too, there will be a lot of volatility for no damn good reason.