No alternative to inflation

February 9, 2009

John Kemp Great Debate– John Kemp is a Reuters columnist. The views expressed are his own –

Every budding economist is taught the distinction between nominal variables (expressed in terms of contemporary cash values) and real variables (adjusted for inflation and expressed in constant-dollars).

An oil price of $50 per barrel in 1980 is not the same as an oil price of $50 a barrel in 2009 because inflation has steadily eroded the purchasing power of the currency in the intervening years. Moreover, economists are taught that real values are more important than nominal ones — because “money is a veil” (to use the phrase of the Austrian economist Joseph Schumpeter).

Prices are important because they perform a signaling and allocating function, encouraging supply and rationing demand. What matter are relative prices not absolute ones.

If all prices and wages double, there is no impact on the distribution or quantity of production and consumption because the relative prices remain unchanged. Money is a veil and focusing on nominal values risks succumbing to money illusion — believing that purchasing power or wealth has increased simply because it is expressed in more units of a devalued currency.

When the US Department of Commerce releases its updated National Income and Product Accounts at the end of each month, investors focus on the real growth rate in GDP, adjusted for inflation. You would be hard pressed to find the nominal GDP growth rate on dealing screens, or for that matter in the Commerce Department’s press release.

But surely that doesn’t matter, because we are only interested in how much output is produced, how many cars, how many homes, not their selling value.


Because one set of important relationships in the economy is almost always expressed in nominal terms, not real ones: debt.

If household incomes double in nominal terms, and the price of a representative basket of goods also doubles, purchasing power has not changed. But the proportion of household income spent servicing and amortizing old debts is halved.

Nominal values become crucially important in a dynamic economy where time as well as price is important, and where debt contracts such as mortgages and firm loans are fixed in nominal terms rather than indexed.

Prices have two functions: a static function allocating resources among producers and consumers; and a dynamic function generating incomes, saving and a flow of payments on debt contracts. For the static function, what matters is real or relative prices. But for the dynamic one, nominal prices are more important because they determine the sustainability of the fixed debt contracts.


The nominal income or cash flow received by households determines how easily they can repay debt contracts fixed in nominal terms. In the same way, the nominal income or cash flow received by companies determines how easily they can repay debt contracts in fixed currency.

At the most general level, nominal GDP is in some sense the “national cash flow” — and determines how easily the economy as a whole can support an overall debt structure fixed in nominal terms. Nominal GDP growth becomes exceptionally important, especially at times when debts are at a high level.

The attached charts show quarter-on-quarter and year-on-year growth in GDP in both nominal and real terms since 1947.

Chart 10 (below) shows the quarter-on-quarter growth in real GDP (expressed at annualized rates). Real GDP growth is very variable. Declines in real GDP during recessions are common. Real output has fallen in 37 quarters since 1947 (about 15% of the time) and risen in 207 quarters (about 85% of the time).

But look at Chart 11, which shows the quarter-on-quarter growth in nominal GDP. Nominal output has only fallen 13 times since 1947. The last quarter-on-quarter decline in nominal GDP was in Q3 1982.

Before that, you have to go back to Q4 1960 to find a quarter in which GDP declined in nominal terms.
Chart 12 shows nominal GDP growth on a four-quarter or year-on-year basis. Nominal GDP growth has not been negative year-over-year since Q1 1961.

From the late 1960s through until the current decade, relatively high rates of inflation ensured that GDP continued to grow in nominal terms even when it fell in real ones during cyclical recessions. Even during the deep recessions of the 1970s and 1980s, nominal GDP was generally growing because the decline in real output was more than offset by relatively high rates of price and wage inflation.

Payment ability for households which experienced unemployment and firms that experienced a sharp drop in demand for their products was often severely impaired. For these few, homes were often repossessed and individuals and companies could be made bankrupt.

But for the majority of households that remained employed, and for companies that experienced only a moderate decline in demand, wage and price inflation continued largely unabated, continued to raise their nominal cash flows, and make it easier to pay off debts incurred during the previous boom.

The combination of falling output with rising prices (labeled “stagflation” ) is usually seen as the worst possible outcome for the economy. Well, the worst except one: debt-deflation.

Because stagflation in the 1970s and 1980s ensured that, for most people, the real burden of debt remained manageable, or even improved, despite the recessions. The misery was borne by the minority of workers who became unemployed and the minority of firms that became insolvent. For the rest, inflation continued to boost nominal cash flows and increase debt-service capacity.

The strong, consistent growth of nominal GDP between the late 1960s and the late 1990s was mostly the product of persistent inflation. Before the mid 1960s, in the 1940s and 1950s, inflation rates were much lower, and nominal GDP growth was much more variable, turning negative on ten occasions between 1947 and 1960.

But in the current lower inflation world, the risk of nominal GDP turning negative has increased. During Q4 2008, nominal GDP growth turned negative for the first time in 25 years. Inflation (essentially zero) was not enough to offset the decline in output in real terms (-0.9% compared with the previous quarter).

Output looks set to decline further in Q1 and probably Q2 2009, and price inflation will probably turn negative. So at some point during H1 2009, nominal GDP growth will turn negative year-on-year for the first time since 1961.


It is the sudden shrinkage of GDP in nominal terms which presents the greatest threat to the solvency of the banking system and the rest of the economy in the coming year. Because if GDP starts shrinking persistently in nominal terms, the already high burden of servicing debt contracts fixed in nominal terms will rise further.

Every job that is lost and every factory that is closed or put on short-time reduces real output. But every wage cut and price reduction is also reducing the cash flows which households and firms need to pay their debts, deepening the crisis.

Governments and central banks are now under intense pressure to sustain nominal GDP, and restart nominal growth, by boosting employment and fueling at least a modest pick up in inflation.

The target is shifting from restarting real growth to restarting nominal growth. Economist Samuel Brittan has written previously in the “Financial Times” about the need for the government and the Bank of England to have a target for nominal GDP growth (rather than a narrow focus on consumer price inflation). But the same is true for the other G20 economies.

Fiscal and monetary policy needs to create enough real demand and inflation; sustain employment and wage levels; raise output and prices.

In some sense, rekindling inflation has become a necessary and inevitable part of the solution to the current crisis.



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The author of the article is correct about keeping prices constant. Falling prices don’t encourage stability in the marketplace.

However, I think all of you miss the point. We have had 30 years of declining real wages for the vast majority of the population. What are the other types of incomes? Royalties, Rents, Capital Gains, Dividends

The problem is that Joe Average, including Joe the plumber, purchases goods and services out of wages, not out of capital gains, rents, royalties or dividends. So as the wage pool decreases, so does Joe Average’s ability to purchase products, pay off his debts, pay off his mortgage.. purchase a home etc.

Although Henry Ford had some unusual ideas about politics, including birthday cards to Adolf Hitler, his economic thinking was really sound. He wanted his workers paid enough to purchase the products they were making on the assembly line. We have lost our way by ignoring the sound advice of this economic genius. Our companies going abroad seeking cheap labor, and violating the spirit of the XIIIth amendment, has really served no one. Too bad it takes a virtual depression for sense and some ethics to be restored to corporations, the american people, and government.



Posted by stephen | Report as abusive

Mr. Kemp’s article presents an oft repeated remedy to our nation’s overwhelming public and private debt. However, it ignores an important factor. Our monetary system is entirely composed of bank credit. There is no “real” money in the economy. In other words, from our monetary base to whatever measures of money supply one wishes to use our entire “money” supply is bank credit generated either by commercial banks or the Federal Reserve. We literally borrow every single dollar spent to run our economy. Thus “inflation” is merely the increase in the overall level of our nation’s debt.

The reason that “deflation” is such a problem is that saving and paying down our debts literally reduces our “money” supply since the only source of “money” creation is bank loans. If we don’t increase our borrowing GDP can’t grow since GDP growth and credit growth are directly correlated.

So the argument that the only remedy for the current deflation is inflation is just another way of saying that we need to devalue old debt by taking on ever increasing loads of new debt. That game may have worked in the past but credit is confidence and confidence is in short supply. When it runs out hyperinflation ensues and we are growing dangerously close to such an outcome.

Posted by Robert | Report as abusive

mr. Robert is correct in his commnent. it is short, but explained the real situation of ecomic problem we are in right now. John Kemp is wrong on everything. does he know about fiat money, or it is just that his readers are ignorants of the economic system, and he is enterteining them with nonsense. there are several alternatives to inflation indiviudally speaking, and for the entire economic system if you will. indiviudally, there is the alternative of gold, silver and commodities.(silver and gold are not just commodities but also real money). if one want to keep the value of our own money, better start traiding in commodities, silver and gold.
do not save in any fiat money!! by SAUL.

Posted by saul | Report as abusive

mr. Robert is correct in his commnent. it is short, but explain the real situation of ecomic problem we are in right now. John Kemp is wrong on everything. does he know about fiat money, or it is just that his readers are ignorants of the economic system, and he is enterteining them with nonsense. there are several alternatives to inflation indiviudally speaking, and for the entire economic system if you will. indiviudally, there is the alternative of gold, silver and commodities.(silver and gold are not just commodities but also real money). if one want to keep the value of our own money, better start trading in commodities, silver and gold.
do not save in any fiat money!! by SAUL.

Posted by saul | Report as abusive

All that bloviating and I don’t think I saw one mention of the impact of inflation and deflation on savings. No concern or mention about those that don’t recklessly spend every cent they can borrow on things they don’t need. The focus on the careless spendthrifts in this country never ceases, and surely just reinforces their egotistical views. So the only solution is to devalue the money supply, thereby canceling the debt of the spendthrifts, and canceling the savings of the savers? How about letting the spendthrifts drown, so we all have a good example of why it’s bad to spend every cent you can borrow as fast as possible? The two biggest players that have caused the current economic debacle have been spendthrifts and stupid bankers. The stupid bankers have been getting burned without sympathy; let’s see the same for the spendthrifts. Why did the median house in my neighborhood get bid up to 600k? Because dumb people were given easy credit, that they often didn’t work a day for (zero down!). Ever ask the question of what that has done to the outlook for savers? Savers are in the same markets, competing for the same houses, and unless they were willing to spend as foolishly as the spendthrifts, they could not buy a house. Is the American dream owning a house, or is it owning a house by leveraging yourself into massive debt? Is the American dream owning a house by leveraging yourself into massive debt and then having a socialistic government bailing you out with your neighbors’ and your grandchildrens’ tax dollars? Recessions/depressions are horrible things, especially for spendthrifts, but also for savers. But a society that continually coddles foolish spendthrifts at the expense of savers is more horrible. We need to let the spendthrifts burn and let deflation run its course, and when we come out on the other side, our kids will be able to afford houses – once they’ve earned them.

Posted by Nick | Report as abusive

There appear to be two basic forms of economies/governments: (1)Free Enterprise, Non-inteference in economic activity by government,(2) Planned economies, government economists decide what should be manufactured, government economists and politicians decide what the workers should be doing. The greater government interference the less freedom the citizens have, but, as in modern China, development and standard of living may be higher IF THE GOVERNMENT DECISIONS ARE RIGHT! The USA, starting with our Revolutionary War and Constitution opted for more personal freedom and less government interference in our commercial and personal lives. As Karl Marx stated in Das Capital, the ‘Bible’ for Communists/Socialists, “Capitalism, without government controls, leads to overproduction and great depressions and mainly the workers suffer for the errors of their employers”. Nevertheless, I for one, would like to have personal freedom and LET THE MARKETPLACE CREATE ITS OWN CORRECTIONS WHEN REQUIRED, WITHOUT GOVERNMENT INTERFERENCE. We Americans now live in the worst of the two worlds I describe. We have developed too much government interference in our business activities as well as our personal lives. This part is plain Socialism. “Government knows best”. The government does not permit the normal contractions of a Free Market to cure and restore the marketplace. More Socialism. But none of the possible advantages of Socialism, such as good universal medical services, or good public school education, etc. So we are just going down the drain on all scores. This type of incompetence in government, and the rising class of the superrich and then the rest, ‘modestly poor’, will lead to riots in the streets and violent revolution. I predict the path we are taking will lead to revolution and violence and forceful change of government within 50 years. The working people will, sooner or later, demand blood to punish whoever they think brought about their pain and distress. Even now the Country is filled with nasty and crooked law enforcement, army reserves, etc. to keep the public in fear and in line. Only the politicians have any freedom. How long can this last?

Nick – your comment is spot on. However since the system is not about to change anytime soon it would be better to use it instead of fighting it. Take out a big mortgage. Buy a second home as rental property. The more long term fixed rate debt you have the better. Especially at today’s low rates with inflation just around the corner.

Posted by Joe | Report as abusive

Whatever happened to the concept that money simply represents value of an object or service to either another individual or to society at large? When you de-link money from a durable benchmark you begin to see all kinds of smoke and mirror inverted pyramids which are either illusionary, unstable or both. If I bought my house for 50k and it’s values seemed to inflate to 150k over the next 10 years should I expect it to be worth more than 50k when our country hits economic hard times? Unless you allow the virtual economy to return to some semblance of reality there will always be the potential for unacceptable instability.

Posted by David | Report as abusive

Nick, as regards your recommendation to take out a mortgage, would that apply as well to people on fixed incomes–especially a rental unit if one lived in one unit and rented the other. Thanks, Robert

Posted by robert zito | Report as abusive

John Kemp, would your advice to take out a mortgage now–ahead of coming inflation—-hold true for individuals on fixed incomes—if it were a rental income unit and I lived in half? Thanks, Robert PS I erred and sent this to Nick

Posted by robert zito | Report as abusive