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.

Wrong.

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.

NOMINAL GDP GROWTH STALLS

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.

NEED TO REKINDLE INFLATION

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.

Chart10: https://customers.reuters.com/d/graphics/Chart10.pdf
Chart11: https://customers.reuters.com/d/graphics/Chart11.pdf
Chart12: https://customers.reuters.com/d/graphics/Chart12.pdf

70 comments

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Amazing, This is the first time I have actually heard someone in the media utter these economic fundamentals on debt burdens vis-a-vis inflation. The only way to save the banking system and the American way of life is for the Federal government to inflate the banks out of their debt burdens (skajillion dollar stimuli anyone?). Anybody who thinks the government won’t ‘make money’ on their TARP investments is naive (they just made 700 billion of it right before your eyes) – the Federal government easily controls the nominal value of money when the direction they want inflation is up. Down the road, getting it to come back down is the unpleasant part.

Spot on. I was a little surprised you didnt refer to the concept of “Quantative Easing” (a euphemism for printing money as you’re aware) or the giddy rate of change of M2. The Treasury will issue a tsunami of debt and the Fed will buy it. The creditor nations such a China will dump Treasuries and spend their cum-devaluation dollars as soon as they can or they’ll buy hard assets such as gold (or large stakes in the likes of Australian commodities heavy wieght Rio Tinto). The yield curve will never have been steeper. Why would anyone own 30 year treasuries?

Posted by Simon | Report as abusive

With all due respect, your concept of inflstion is twisted. The governement has used inflation for over 50 years as a way to pare down their debt to outside interests. Paying debt of with cheaper dollars than you boorrow sounds like a wonderful idea except for one small, and obviously insignificant factor, the American worker and taxpayer. Inflation is also refactored every year. A 5% inflation rate this year means we have have a reduced buying power of 5% of what we have left of our wages – which were only 95% of the year before – thanks to inflation. Inflation reduces the wage earner’s capacity to support his family. It’s only friend is our illustrious overspending government. The same government that feels fine passing along the bad debt of fat greedy financial institutions to the very people they steal from. Banks that got TARP money charging 24+% on credit cards when they got the money at 2%??? Government sponsored extortion! Capone is apparently the new standard of excellence todays bankers try to emulate. So of the debt we are been given and deflating my buying power to pay for it, I say this. Burn the TARP plan. Let badly run businesses die and the the conservative solid survivors pick over their bones. Do it before you make a bigger mistake. Once the governemnts of the world start trying to pay for this mess with “inflation backed” currencies we’ll be lucky to be able to afford to live in this Carteresque government sponsored inflationary nightmare.

Posted by Bill Anderson | Report as abusive

Like many others, I question the logic of encouraging consumers to spend borrowed money , even at low rates, as a solution to the crisis. How does more debt solve the problem? Worse, such spending results in overvalued homes, cars, etc…

Posted by ross perilman | Report as abusive

I had this same conversation yesterday with co-workers.

On the one hand, inflation solves our nation’s issues, and bails out the financial institutions globally.

But of course, as noted above, all of this comes at the detriment of the global workers’ quality of life. And just as we saw this financial mess snowball, there is no telling that inflation rates would come down with any rapidity.

The ivory tower economists see this is a macro solution, but this mess has affected too many at all levels.

Lest we forget Germany in the post WWI years, the Carter era disasters, etc. we need to seriously evaluate the pros and cons of hyper-inflation as it affects the working families of the US and the world.

The US government can’t loose! They are “The House” and the reserve currency of the planet. They are spinning pure gold! Chips aren’t worth anything until you cash them in. However, if your circumstances force you to redeem those chips at a predictable rate over time for such predictable expenses as food, shelter, health care, etc…, then you are but a puppet on a string.

Posted by anonymous | Report as abusive

People need to remember that the Carter era was brought on by the sudden doubling+ of gas prices by the newly formed OPEC.
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A lot more lasting economic damage was brought on by Reagan who more than doubled the national debt. The only reason his admin did not go up in flames is that the Iran-Iraq war brought a tremendous reduction in gas prices.
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It really irks me that the Republicans when they have the presidency run up the debt, but as soon as a Democrat is elected they become born-again balancers. See:
http://www.lafn.org/politics/gvdc/Natl_D ebt_Chart.jpg
http://www.cedarcomm.com/~stevelm1/usdeb t.htm

Posted by jmmx | Report as abusive

The second to last statement of this article is a very dangerous one “Fiscal and monetary policy needs to create enough real demand and inflation; sustain employment and wage levels; raise output and prices.” I am not convinced of this simply because I believe this will eventually lead to hyperinflation and a total loss of confidence in our currency.

Posted by libertarian | Report as abusive

A very well thought out analysis but I must disagree for the following reasons:

(a) If inflation increases, we’d all better hope that our incomes also increase accordingly. For some, this will be so somewhat right away. For others, there will be a lag time in which their real purchasing power will drop off sharply. For the rest, there will be no income increase at all!

(b) Even if inflation and incomes generally increase to relatively the same levels, such that real purchasing power is unaffected, it’s a myth to conclude that debt servicing capacity will improve. The X factor in debt servicing is interest, and if inflation increases, even if incomes stay stagnant, you can bet interest rates will also increase. Otherwise, the simply truth is that no one would lend money, since lending is for gain, not a public service. No one is interested in recouping, in real terms, less than they lent out. So, in fact, there is ALWAYS an externalized compensation with debt, which corresponds to the interest rate plus a portion for real profit. Since the indebted will have to pay the higher interest rates, based on the specifics of their contracts, they will either see their debt servicing cost forceably increased, or they will end up with more debt generating yet more interest to pay in the future.

So, all in all, it’s a zero sum game. Sorry.

You want a recovery and a lessened debt burden? Find a successful way to stimulate real economic activity while keeping inflation as LOW as possible. People will generate greater incomes and pay off their debt faster in real terms as a result. Look into Canada’s statistics. We’ve combined frenetic economic activity with low inflation for years, and were doing quite well until this global recession hit.

The only hope I can see in your arguments, and if it is the substance of your arguments you didn’t make that clear, is that some lag time exist during the current crisis between the uptick of inflation (and wages) and the uptick of interest rates. In that brief nirvana, debt repayment would be … like butter. The resulting restored capacity, on the part of lenders and borrowers alike, would aid in the recovery.

Good article. As one who has been through many years of cycles, let me add that inflation also “steals” what has been earned over the years. Fixed incomes go down in real value, long term gains that are only the result of inflation are taxed, yielding a net loss. It is true that only real wealth creation will bring back prosperity and solve debt problems. We used to import low cost materials and add value through manufacturing and development. It has changed in that increases in costs have been skimmed at so many levels that the apparent value is artificial.

Posted by John Harnec | Report as abusive

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.

Yours

Stephen

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