Sunday, February 15, 2015

Is inflation really theft?

A few weeks ago I read an article posted on Forbes website that claimed inflation was theft based on the idea that a little girl who saved her money would be able to buy less with it in the future, meaning that inflation had stolen some of the value of her money. That viewpoint overly simplifies economics to the point that it is just wrong.

To show that it is wrong, let's start with an economy in which I am an apple farmer and you are a copper miner. In our simple world there is no money. I store my savings in apple sauce and you store yours in copper. I charge you 1 kilo of copper for a kilo of apples. Now, a new copper mine opens and there is a lot more copper so, based on the law of supply and demand the price of apples goes up to 2 kilos of copper per pound. Did the new copper miner rob you of half of your savings? I don't think so, you just chose to denominate your savings in copper which was a bad choice. Conversely, if one year there is a bumper crop of apples and apple sauce becomes plentiful is it theft if you decide you will trade 1 kilo of copper only for 2 kilos of apple sauce?

Now in our fictional economy suppose that you want a car but the car maker doesn't need copper, he wants steel. The steel maker doesn't want copper, he wants iron ore. The iron miner doesn't want copper he wants railroad ties. And so it goes. You finally work out a series of trades that gets you a car but the chain of trades takes weeks to arrange. There has to be a better way, so you invent money.

Now that we have money, we need to decide how to control the money supply. We could back it with copper but we've seen that the value of copper varies against that of other goods. Do we really want our money supply linked to one particular metal, the value of which fluctuates? We know from history that fixing the money supply to a gold standard makes it very hard to get out of a depression (but more about that later).

So, we decide to have a currency whose supply we control. We can try to have one with a constant buying power. One that can buy the same amount of copper or apple sauce today or a year from now. However, since the value of apple sauce and copper move independently it's just not possible to do that. If copper becomes more expensive relative to apple sauce we either get copper inflation, apple sauce deflation, or some combination of both. We can decide to hold the value of the currency stable to a basket of items, but which basket? Ones bought by manufacturers, young people, old people? A money supply that yields constant prices for a basket of goods bought by 25 year olds would create inflation for old folks who consume a lot of health care, which gets more expensive relative to other goods and services. Even if we settle on a basket of goods that we hold at a constant average price, how do we deal with advances in technology? My car, computer, TV, and TV dinners are certainly not the same as those available 25 years ago. 

So, we quickly conclude that there is no perfect zero inflation. However, we invented money to make our lives better and there is more to the economy than purchasing power. We want to avoid excessive inflation and we want people to be able to find jobs. We decide that the money supply should grow roughly at the rate that the economy does.

Deflation is an even bigger risk than inflation. In a deflationary spiral you have little incentive to spend $1,000,000 hire miners to build a new mine today when a year from now you'll be able to do so for $900,000. This leads to out of work miners, reduced demand for mining equipment and even faster deflation. The great depression was a deflationary spiral. Japan has stagnated for decades in a deflationary spiral. Since we can't measure inflation perfectly and deflation is a huge risk, we decide that we'll target just a bit of inflation to be on the safe side. Currently that target rate is 2%. If you are worried that you won't be able to buy as much copper a year from now you can always buy it now and keep it. Be careful though, the same thing can happen to the price of copper that happened to the price of gasoline. Speaking of which, if when the price of gasoline goes up (inflation) it is theft by the Federal Reserve, when it goes down are we stealing from them?