On inflation...

Future historians will look back at the last few years of economic upheaval with great interest. Whether it's historically known as the Great Recession (as some pundits are trying to coin it), or some other moderately clever name, it will serve as a great example of how very large social systems are not immune to catastrophic meltdowns.

In this post, I'd like to focus on the idea of inflation and specifically how governments are using inflation as a tool to address the stumbling economy.

What is inflation?

To most Americans over a certain age, "inflation" is a scary word. It is associated with price spikes, as in the recent fluctuations in gas prices, and is universally used as an explanation for any increase in prices (regardless of whether or not such price increase has anything to do with systematic inflation).

In actuality, inflation is an economic term used to refer to a broad increase in prices of goods. This is usually calculated by assessing the prices of a certain basket of commodities (fuel, wheat, coffee, produce, metals, etc.) over the passage of time.

How does this play out?

Another way to look at inflation is to think of it in terms of cash. If you have $1,000 under your mattress, you can take the money out from under your mattress, go to ShopRite and buy $1,000 worth of goods. If you wait a year (keeping the $1,000 under the mattress) and go to ShopRite then, a positive inflation rate will mean that you can buy less than you could had you gone the year before. In other words, you're $1,000 is worth less than it was a year earlier.

With this in mind, the kneejerk reaction is to decide that inflation is a bad thing and that the best result for individuals would be if the price of those goods had gone down (in effect, making that $1,000 worth more money after sitting under the mattress for a year).

However, while there may be satisfaction in walking out of the store with the same amount or more goods than the year before (as a reward for you saving that money for an extra year), the negative effect of the decrease will likely outweigh any benefits.

For example: let's say you have a student loan to repay. You have the loan at a fixed rate of interest and pay $200 every month. If, after a year, inflation has made your dollar worth less money, the fixed loan payment is essentially discounted. Whereas a year ago, that $200 could have bought you 25 pounds of coffee at WholeFoods, you can only buy only 22 pounds today. So, instead of paying back your lender a value of 25 pounds of Whole Foods coffee, you're now only paying them the equivalent of 22 pounds of coffee.

Yes, there's a piece that's missing. In order for this to benefit individuals, income must rise at the rate of inflation. If that WholeFoods coffee gets more expensive and your income has not risen, you're just going to have to go without that extra three pounds of Arabic Blend. However, if your salary keeps pace with the price of coffee, you've benefited by getting the discounted loan payment.

So, what exactly is the government doing?

The federal government is between a rock and a hard place (as are a lot of Americans and their businesses).

The government needs money to fund both its on-going operations as well as the massive stimulus packages they have funded over the past two years- not to mention the other gazillion dollars of debt it had before. The simple solution (and one that they have been utilizing) is that the federal government can literally print money and introduce more money into the country's money supply. Logically, this should result in inflation. The money supply is guaranteed by the full faith and credit of the US government, so each additional dollar does not increase the overall value of the money supply, it simply dilutes it. The existence of additional currency should lower the value of each dollar in the economy.

Printing money has several benefits. For one thing, the US is in debt (have you heard about this?) and its debt is in American dollars. Ergo, by printing more money, the government is decreasing the value of its debt payments while simultaneously creating dollars to pay back that debt.

For comparison, consider the plight of Greece, who is at risk of defaulting (not being able to pay back) their federal debt. Because Greece uses the Euro and the Euro is used by almost every country in mainland Europe, they lack the power to print Euros or devalue their currency. Other countries that are not in debt and are net creditors (meaning they lend money to other countries), do not want to devalue the currency because it would devalue their savings and devalue the money that it is owed. As a result, the entire Euro area is under strain because of the competing interests of the member countries. The US, by sitting ever-so-firmly in the debtor category, has no such conflict of interest.

Secondly, by devaluing the currency against other currencies, Americans selling their goods abroad benefit. If McDonald's is selling a cheeseburger in Paris for 3 Euros and those 3 Euros are now worth 6 dollars instead of 5, McDonald's is earning an extra dollar on each cheeseburger sale. This allows McDonald's to be more competitive abroad, earn more money and (in theory) allow them to hire more employees and expand their operations.

What are the risks?

The main risk of printing so much additional currency is hyper-inflation. Hyper-inflation is a sudden, significant increase in prices. The easiest way to explain this possibility is to imagine that the world loses faith in the value of the American dollar. Other countries and businesses become nervous that the additional printed US currency will significantly devalue the American dollars that they are receiving for their goods. Suddenly, they begin requesting higher prices for their goods, to cover their risk in holding American dollars. Prices spiral upwards, the American government is forced to pay a large premium to borrow money and this combination of factors causes the whole system to collapse.

Thus far, inflation has remained under control. Investors have seen the US as a "safe-haven" to park their savings, as the history and the size of the United States suggests that the dollar will retain most of its value. To be more accurate, the US dollar is simply the least-bad option. The dollar has fallen in value against certain currencies, notably the Canadian Dollar and the Australian Dollar, but has held its value against the Euro and the British Pound (mostly because those currencies are facing their own challenges).

The problem that has popped up has to do with the lack of increases in wages. A high unemployment rate combined with stagnant wages has decreased the purchasing power of Americans. The savings on your loan payments (because of inflation) are of no benefit when you are making the same or less money than the year before. As a result, people have been cutting back on purchasing and going without, which has hurt the sales of businesses. Businesses, in turn, are not able to expand or hire, since their sales are stagnant or decreasing. Further, the high unemployment rate has put downward pressure on wages, since unemployed workers are willing to take less money to find employment.

As inflation persists (even at moderate levels) the decrease in wages and high unemployment is magnifying the effect of inflation.

What is the opposite of inflation?

Deflation is the opposite of inflation. Again, this may seem like a boon in the short term, but it's extremely problematic.

To use the previous example, imagine if the money you left under your mattress is worth more in a year than it is now simply by virtue of time passing. This creates an incentive is to keep the money under your mattress, as holding cash has become a form of investment. Now, both individuals and companies are inclined to hoard their money, as opposed to either investing or spending it. For a non-profitable company, it would be a realistic option to suspend operations and simply retain their free cash, knowing it will increase in value.

Likewise, those who are in debt will further burdened by their loan payments. Since it's likely that wages will fall in a deflationary environment, these payments will become that much more onerous.

The result could be a "deflationary spiral" where prices decrease, investments decrease, wages decrease and employment decreases. The wage and employment decreases will result in a decrease in purchasing power, which which lowers demand, which lowers prices, which will exacerbate the decrease in wages and employment even further. Thus, a spiral is created.