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The Misunderstood Inflation Monster

Inflation is sometimes referred to as the cruelest tax, but that's more myth than fact. A little inflation is not a bad thing, actually, and even periods that have seen elevated inflation levels produced, on balance, more winners than losers.

On the other hand, a world without inflation would be as brutal and unforgiving as the atmosphere of Venus -- economically speaking, anyway. Most assets would decline in value, and business profits would evaporate, along with any chance of gainful employment. The only people who would benefit would be creditors, and then only if they were lucky enough to find people who wanted to borrow their money. That would be doubtful, since business and investment opportunity would be nil, providing little reason to be a borrower.

The belief that inflation is harmful stems from the perception that a halt to rising prices would help one's individual income go further. However, this scenario disregards the accompanying consequences for income. If inflation were zero, or if prices were actually falling (a condition known as disinflation or deflation, depending on the severity), business profits would fall, too. After all, in a competitive economic environment, price gains normally tend to be limited. This forces businesses to earn money by cutting costs and being more productive. Labor costs would certainly be among the costs businesses would want to reduce, which would cause hiring to stagnate or fall along with individuals' income.

We often hear inflation referred to as a "monetary phenomenon," one occurring when "too much money chases too few goods." However, monetary growth does not necessarily result in higher prices of goods and services; it can also flow to asset markets or lead to an increase in wages (as mentioned before). This can result in higher levels of household net worth. During the 1970s, when inflation was rising rapidly, household net worth (total assets minus total liabilities) rose 11% annually. This compares to annual increases in net worth of about 8% during the 1980s, when inflation was in rapid retreat.

In the 1970s, real wages kept pace with inflation. However, the decade of the 1980s saw real wages actually decline by 0.8%. Furthermore, home equity (the money that people had in their homes minus the balance left on their mortgages) rose in the '70s. This was the only time in the post-WWII period that home equity witnessed an increase. In general, home equity has been steadily declining: In 1945, it stood at 80% of the value of the home, but it's now at 49%. In other words, the inflation of the 1970s replenished home equity, keeping wage earners' incomes from eroding in real terms.

True inflation can only occur when sellers raise prices, and ordinarily, they can only do so profitably amid an absence of competition, whether through monopolies, trade barriers, exclusive patents, major product differentiation, or even corruption. Furthermore, inflation can and does occur in the midst of underutilized resources, even if we consume more than we produce.

The true losers during periods of inflation are those who hold non-interest-bearing currency (cash) and creditors whose interest on the loans they charge proves to be less than the current inflation rate. (They lose the difference between the rate of inflation and the rate charged for the loan.)

In contrast, debtors gain, because the debt becomes smaller relative to earnings growth. (The debt is a fixed amount, whereas nominal earnings grow.) One very important debtor is the federal government, and inflation makes it easier for the government to pay off or roll over existing debt at a "real" cost less than the historical cost. This can facilitate higher rates of economic growth (by virtue of higher levels of nominal spending, and thus stimulus), with reduced real burdens on the Treasury.

On the other hand, falling inflation results in a windfall to holders of government debt, but places a higher burden on fiscal authorities, potentially prompting tax increases and other remedies aimed at raising government revenues. These would be real tax increases, as opposed to "perceived" ones, and they could offset some or all of the gains accrued to debt holders.

William Vickrey, the late Nobel-laureate economist, once said, "The main difficulty with inflation, indeed, is not with the effects of inflation itself, but the unemployment produced by inappropriate attempts to control the inflation."

He was right. An example of this came in the early 1980s when the Fed, under Paul Volker, bludgeoned the economy with massive rate hikes, sending it into a deep recession, which drove the unemployment rate to near double digits. (In some demographic groups, it was in the mid- to high double digits.) Inflation was killed, but so were personal income, savings, and wealth.

With current unemployment rates of around 4.5%, we are far from approaching the peacetime 1.5% unemployment rates of the 1920s. The extremely low unemployment rates of that era coexisted with falling prices. In contrast, the Fed is currently operating on a hair trigger, ready to raise joblessness and potentially put millions of people out of work so that it can achieve its "target" of a 2% inflation rate -- when real inflation is only running around 2.4%. Is it worth the pain of all those lost jobs for the extra 0.4%? If you work for a living, the answer's probably no. That's doubly true if growth is the goal -- and it should be.

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Fool contributor Mike Norman is an international economist, a business contributor to Fox News, and the founder of the Economic Contrarian Update. In addition, he hosts a radio show on the BizRadio Network.


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