Tuesday, 12 August 2008

WRONG: Inflation is a bad thing

Inflation, or the ongoing rise in prices that reduces the spending power of money, is the bane of every national treasury. For the uninitiated, it’s the mysterious tendency of the pound (or cruzeiro, or baht) in your pocket to buy you less and less each year. It’s measured against the Consumer Price Index, which tracks the cost of a literal (and big, and unlikely) shopping basket of goods. The basket for 2007 included:

•olive oil
•frozen pizza
•an electric fan
•a toothbrush
•chicken kievs
•a digital radio
•tracksuit bottoms
•wallpaper paste
•kiwi fruit
•nursing home fees
•motor oil
•a dvd recorder
•an acoustic guitar
•a hamster
•squash court hire
•fish and chips
•“corn-based snacks”

The following is one very simple model of inflation (the “cost push” model, if you really want to know):

1. Everyone wants higher wages.
2. As wages go up, employers pass on the cost of the raises to consumers by putting up prices.
3. If prices are up, everyone wants higher wages.
4. Go to Stage 2.

Monetarists, who are generally followers of the economist Milton Friedman, would say inflation is the result of changes to the money supply. The more money there is in circulation, the less it is worth, as the German government of the 1920s discovered when they printed so many banknotes that people found it cheaper to burn them than buy firewood. In Hungary in July 1946, prices more than tripled every day, leading to the issue of the quite remarkable 100 million trillion (100,000,000,000,000,000,000) pengo note. It was worth about 10p, and meant the smaller denomination notes had the same value – and possibly the same use – as a sheet of toilet paper. The treasury, presumably clamping their hands over their ears and shouting “La la la la la,” printed an even larger 1 billion trillion pengo note, but it was never issued. Instead, sadly, the pengo was replaced with the forint, which doesn’t sound nearly as much like an animated penguin.

A similar case is occurring in Zimbabwe today – at the time of writing, the weekly national lotto prize stands at 1.2 quadrillion dollars.

It should be noted, however, that “money” does not only mean cash. It covers spending of all kinds.

Followers of John Maynard Keynes (the fact that the names of the two most prominent 20th-century economists combine to form “Milton Keynes” is a coincidence. The Buckinghamshire new town’s name originated as a corruption of “Middleton” and a Norman landowning family called Cahaines) argue that money supply is only a small factor among the causes of inflation. Aggregate demand – a combination of government spending, public consumption, investment, and the export/import balance – is the key. Other schools of economic thought have different opinions, and so far there is no clear consensus on the exact causes of – or remedy for – inflation, though monetary controls have historically proved effective.

The unexpected conclusion that most economists have come to, however, it that inflation isn’t always a bad thing. As long as it is slow and wages are matching it, then it’s a good sign that the economy as a whole is growing, and is controllable because it is predictable. Deflation – a sustained downward trend in prices – sounds great in principle, but actually reflects an unwillingness to spend, as in the Great Depression of the 1930s.

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