How’s that for a provocative title? American policymakers have lived in fear of inflation since the 70s. But that’s nothing! The Germans have feared it for approaching 100 years! But is inflation really that bad?
Certainly, uncontrolled inflation is disastrous. Nobody wants the Weimar Republic or Zimbabwe. But what if we thought about it like radiation? We fear a nuclear catastrophe for good reason but limited doses of radiation kill cancer cells.
I’m not advocating instances where politicians print money to save their own skin by propping up the economy and let some future leader deal with the consequences.
That’s immoral and if the unhealthy fear of inflation helps us avoid politicians using inflation as a weapon, then the fear may be useful.
Responsible Inflation: The Least Bad Option
However, we all learn growing up to fear fire because of the worst case outcomes. Yet, as we become adults, we learn to use it responsibly to enhance our life. Responsible, mature use of inflation can be beneficial to society.
Where am I leading with all this? Well, let’s return to the radiation analogy. Nobody would sign up to be bombarded with radiation. You would only do it if you were sick and it was the least harmful of a number of bad options.
Similarly, there is no reason to seek out inflation. It should only be used as a tool when it is the least bad option. When might that be the appropriate treatment? When you have an economy that is overburdened with debt to the point where it is constraining growth.
We have a pending debt crisis in this country. It may not be imminent but the timer has been set and the countdown clock is ticking. The amount of spending this year alone is unsustainable.
And it’s not like we started from a period of health. Government debt as a percent of GDP has continued to climb and, while mortgage debt may have improved, the problem has been transferred to student loans and subprime auto debt.
Higher Inflation vs. Higher Taxes
The traditional political response to this situation would be to raise taxes. That seems practically a given. It is mainly a matter of how much and how soon.
However, that has its own consequences. The best way to bring down debt is to increase growth. Higher taxes obviously hurt growth, especially the magnitude of tax increases that would be required to restore fiscal health.
To put it in personal terms, if you are struggling to pay your student loans down, a raise would make a big difference. If you don’t get a raise because your company isn’t growing due to higher taxes, you can’t pay down your loan. The same thing happens at the government level. We need growth to reduce the debt.
However, if we don’t have growth, there’s one other trick. We can lower the real return of the debtholders. In other words, rather than tax workers, we tax investors.
Inflation: The Subtle Tax
This is where inflation comes in. If I issue $100 of debt and, at maturity, I only have to pay it back with $100 future dollars…that are worth $90 of today’s dollars, I’ve improved my balance sheet by the $10 of “value” created by inflation. (This isn’t really value. It’s a wealth transfer from lenders to borrowers…more on this below.)
Before getting into the merits, let me address a few objections. Doesn’t inflation tax workers too because they lose purchasing power? It might. That depends on how much inflation we’re talking about.
If we avoid double digit inflation, then wages should be able to keep up fairly close to real time (e.g. if there’s 5% inflation, maybe you get 3% salary increases twice a year).
Also, recall our individual with student loan debt. If their wages go up 5% and the goods they consume cost 5% more, but the student loan payment is unchanged, they have more capacity to make the debt payment. They are a net winner.
Or let’s take another demographic. Someone who thought they planned well for retirement but can’t earn anything on their nest egg because of low rates. Even in a low rate world, their expenses are still inflating today (e.g. medical care).
How have many seniors reacted? Making risky investments that promise a higher yield. How’s that going to end???
Higher nominal rates (even if real rates are flat) would let seniors de-risk into safer investments and whatever consumer inflation they see should be offset by the inflation adjustment in their social security checks.
The End of the Bull Market in Lending
Who are the losers? As mentioned, it’s the lenders. Perhaps you bought a two year bond at $100 with a 2% coupon and expected a 2% real return because inflation is 0%. Actual inflation ends up at 5%.
You have realized a negative real return (you got two 2% coupons but the $100 you received at maturity is only worth 90 of your original dollars). Is this fair to ask savers to subsidize the economy?
First, fair or unfair isn’t the point. Unfair things happen every day. However, if we want to play that game, is it fair that bondholders have been the number one winners in this country over the last twelve years?
The Fed has gone out of its way at every turn to avoid credit losses. Part of the way they did that was to also lower nominal rates. So bondholders a) won by the price of their bonds going up from the decline in interest rates and b) won by lower than expected defaults. They have been the ultimate winners!
So yeah, if we do want to talk fairness, it’s fair that at some point bondholders come in last. That’s the risk you take as an investor.
And to be clear, a bond investor would much rather lose on lower bond prices due to moderate inflation that lose due to credit losses. I am not advocating inflation high enough to cause a spike in defaults. That serves nobody well.
There Is No Easy Button
But don’t overlook the main point. The alternative to higher inflation is higher taxes. Higher taxes are more anti-growth than reasonable inflation and poor growth certainly leads to credit losses.
Also, don’t lose sight of the entanglement of the two choices. If the Fed tries to restrain inflation, that obviously hurts growth. That will put even more pressure on the fiscal side because it won’t be able to service the debt and it won’t have the capacity to spend more to offset tighter monetary policy.
That only leaves the option for the government to raises taxes further which is even more anti-growth and causes more strain on the debt service and leads to more private sector defaults.
When confronted with the alternative, letting inflation rise is by far the best option. It is not painless. Nothing will be. But it is the least painful option, even if unconventional.
The Fed’s Role
Now, I’m sure some of you will notice the irony in that I have been critical of the Fed many times for easy money and am now advocating they get even more aggressive. That’s not quite what I’m saying.
There is a difference between growing the money supply to bail out creditors, which has become de rigeur for the Fed, and not restraining the money supply (once the crisis has passed) to create inflation.
On this note, it appears Powell is of similar mind. He has noted he will be patient in removing stimulus once the economy begins to recover and that he finds higher inflation acceptable. In that regard, we are in agreement, though it is unclear if it based on the same reasoning.
Finally, the one big risk in this is obviously that it is human folly to think we can control inflation once it is has been let out of the bag. This is clearly a risk and one that should not be underestimated. On the other hand, man has learned to control fire. We have learned how to use radiation. We need to learn how to responsibly use inflation.