An argument against inflationary monetary policy
(I’m using “inflation” in the Austrian sense here: increase in the money supply, rather than increase in CPI price levels)
I just heard this recently, and it made sense to me:
1. The entire Keynesian scheme of monetary/fiscal spending to stimulate the economy only works because it takes time for people to catch on to the reality that newly printed paper is not real wealth. That is, people don’t immediately realize that they are spending fiat-money, and thus act based on thinking they have more money than they really do.
2. This temporarily causes greater investment, which has the potential to create real wealth and real economic growth.
3. However, as time goes on, sellers realize that buyers have more money, and thus prices rise accordingly, bringing the economy back to status quo ante, except with possibly increased debt (if enough real economic growth did not occur before the sellers caught on).
4. In the case of monetary policy specifically, newly printed money inevitably goes to the rich first: to banks, and from there to massive corporate investments.
5. As time goes on, more of the poor get the new cash, but it also simultaneously becomes less valuable, since prices are rising.
Thus, monetary policy seems to be, inevitably, welfare for the rich.
(Note that none of this would be an argument against government welfare, based on tax-hikes (not spending fiat money), for the poor.)
Interesting argument.
Here some thoughts as an investor:
(1) CPI has not been affected by the inflation of fiat money because there has been no velocity (MV=PQ). Instead of lending money, banks have bought safe US treasury notes to pad their reserves. They have used TARP money to do this. Essentially the US government lends TARP to banks which lend it back to the US government. Also the Federal Reserve bank has bought CDOs from the bank, and the banks have used that money to buy US treasury notes as well.
(2) What we’ve seen since the 2008 credit collapse can therefore be better described as reflation–reflating shrunken credit with fiat money. There are still some mortgages that are collapsing so it may be sometime before we see the most serious detrimental effects of current US fiscal policy (1-2 years?).
(3) Investors are probably more aware of the potential dangers than the public. Therefore we have been making moves in anticipation of a US dollar collapse. This is known as the US dollar carry trade.
(4) Gold is an indicator of inflation, but it also experiences the anticipatory effects of panic about the dollar, as well as periods of profit taking. Its price may therefore at times suggest an overcompensation.
(5) The best hedge against inflation is debt. But you have to buy something with the funds you borrow in order to cover the interest: real estate, dividend bearing stocks, or income investments in foreign currencies or countries (a.k.a., carry trade). The risk is that the investment you make with the debt will not maintain its value, but I consider the current risk of loss of holding currency to be an absolute certainty. So better to own anything except money. For this reason, my current non-registered investment portfolio is 150% in stocks.
(6) Inflation caused by government deficits is not really generational theft as suggested so often by conservatives (or those criticizing current deficits). It is theft of current creditors, bank account holders, fixed income earners and workers, whose current paycheques are garnered through the hidden cost of inflation. It is true that CPI lags inflation, but then pay raises lag CPI. I consider inflation to be especially a heist of the retirement accounts of the older generation–financial advisers often recommend subtracting your age from 100 and that remaining number is what you should have in volatile assets like stocks. The remaining is to stay in fixed income. So if you follow this advice and you are over 70 years old, then 70% of your portfolio is subject to government theft by inflation. Many of these retirees just abandoned stocks altogether during the collapse and now they have cash which is being killed by inflation. It is not a pretty picture. But inflation is not a theft of the younger generation because when the enter the workforce they will earn the currency at it current value.
(7) Inflation in the US will be necessary: (i) to be able to pay the interest and principle on the current debt, inflation is the only way–it is a form of bankruptcy; (ii) to create an effective decrease in the recent minimum wage hike which has put millions of teens and other low wage earners out of work. (iii) to use bracket creep in order to increase everyone’s taxes; (iv) to make effective reductions of entitlement obligations which can’t be paid for.
(8) I am not “rich”, but as an investor, I’ve been able to ride this wave, and I’ve done very well thanks to being able to make the right kinds of move in anticipation of current US inflationary policy, but I may have to bite the bullet on an investment I made with my brother in Austin just before the collapse and that hurts.
(9) While not “rich”, we were able to get a huge amount of bank credit just when I needed it in Oct 2008. That has been great boost to my investments. So indeed, the banks were giving credit to some people, contrary to the widely held belief that no one could get loans.
(10) It is much better right now to be in Canada than the US.
A couple more:
(11) Inflation doesn’t rob the poor but the middle class and wealthy who have holdings which are not hedged against inflation.
(12) Ferengis will make money during periods of inflation.
Peter,
There’s a lot for me to chew on here, but just as a brief reply: I think, even if you are right about inflation robbing the middle class, that would still be the “poor” in relative terms. It doesn’t harm the richest of the rich as much as those below them on the economic ladder.
Or so it seems to me…?
Inflation helps those with debt but hurts anyone with fixed income investments or wages. The working poor will be hurt bad. the street poor much less because they have no income and no savings. The wealthy with fixed income will be robbed blind. So the answer is that investors who make the right moves (the Frengis) can benefit from inflation–like I have from the reflation. It matters little if those investors are “rich” or just small-time like me. But you are correct to say that the richest of rich can do well, particularly the big banks that are essentially getting federal money for nothing: that is welfare for the rich, if you like.
The claim “Thus, monetary policy seems to be, inevitably, welfare for the rich.” depends very much on implementation. In particular, is the newly printed money give to corporations for expensive defense contracts or doled out at the well-fare counter. Further, we have to bear in mind that rising prices reduce the value of savings and assets, and because the rich (by definition) have more of these than the poor, they may see an overall decrease of wealth even when a large portion of the money is directed at them. (Not to mention the possibility that wealth is effectively tranferred from the cronies of the previous administration to the cronies of the current administration…)
Michael:
Thanks for your reply. I’m not an expert about these things, but I think it’s generally recognized (correct me if I’m wrong), that decreases in wealth are felt more strongly by the poor, even if they are, absolutely speaking, less than decreases felt by the rich. Also, I think monetary policy almost by definition must be implemented toward the rich first, since it goes to banks first. But again, correct me if I’m wrong.
I do not know about wealth (the poor tend to have too little of it: 50 % of nothing is the same as 100 % of nothing); however, a drop in income is far more crucial for the poor. Obviously, inflation has an effect on income too, and even an increase in living costs of a few percent can push someone balancing on the edge into disaster.
(An interesting side-issue is that inflation decreases the burden of debt, which leads to the question who has more of it relative to income: One of the many poor families who has had accumulated debt in the course of living, or one of the middle-class families who have borrowed to buy a house.)
As for where monetary policy goes first: New money need not be freely given to the banks, and need not even use the banks as a distribution channel. Assume e.g. that the new money is used to pay civil servants, paid out as welfare, or used to reduce national debt.
Inflation is a tax, but it’s important to note what is getting taxed and in reality that is savings held in cash and fixed incomes. Since the poor tend not to have much in the way of savings, this has less of an impact on them. What a tax on cash holdings does do is encourage people to convert their cash into something else, like, as Peter observed, stocks. So while inflation might raise prices, it can also act to spur investment and therefore economic activity.
Dan: Too true. Then people pile into stocks and/or real estate when they see that their savings are going backwards, and that leads to a stock and real estate market bubbles, and when the bubbles burst the whole cycle starts over again. Alas!
It would be much better to have stable currency with a higher interest rate.
Dan (and Peter, since you made a similar point):
I don’t quite understand how this works; that is, I don’t understand how inflation (in the sense of increase in the money supply) only devalues one section of the economy’s goods. Do you mean just that it disproportionately affects those sectors more?
This is my current, probably faulty, understanding:
-printing new money, de facto, devalues all currency proportionate to the amount of new money created
-insofar as any assets are liquid, they would also be affected in the same manner
But, maybe that’s your point. Because liquidated assets during a period of inflation (again, Austrian sense) would be worth less than they were originally were, it would make sense to keep them illiquid until they regain value; conversely, it would make sense to get rid of as much cash as possible.
Is that what you are saying?
I think I may be using liquid/illiquid in not quite the correct manner. But I think/hope you get what I mean.
I look at stocks as companies which have a value based upon their assets, liabilities and their ability to generate revenue through sales of goods and services. If the currency goes down in value, one hopes that whatever goods and services that they sell will also go up in price. The same thing is true of real estate. Hopefully, real estate will go up in price while the currency inflates and devalues.
Then people see that the stock are going up, real estate is going up, and that their savings are going down in value, because the interest on the account doesn’t cover their inflation losses. So they begin to put their savings into stocks and real estate. Then those markets go up still more vis-a-vis the dollar, partly because of the devaluation caused by inflation, partly because the demand for these assets has gone up. When people see that, they start saying, “Hey, we should borrow money to buy stocks and real estate because these things can never go down.”–pushing prices up still further which creates even more enthusiasm for these assets. Then an investment adviser starts telling your grandmother that she needs to take out a line of credit on her house so that she can buy stocks. Eventually, the market price of these assets are much much higher, by 2 to 1000x, than their market price–a bubble ready to burst. This is when the value investor must consider selling some of his assets.
When the last bubble burst (Fall of 2008), suddenly the credit market shrunk and there was deflation–cash was suddenly a coveted asset. Then people are so afraid of stocks and they are having their real estate foreclosed upon, then the prices start plummeting below their underlying value. It is at this time that the value investor can find bargains.
I wonder if this explanation helps at all? In any case, I’ve learned most of this since becoming an investor a few years ago through reading internet sources and two books, Benjamin Graham, The Intelligent Investor; and Neall Ferguson , The Ascent of Money.
I think that we are still on the early stages of the present cycle. The increased deficit spending of governments world wide is going to accelerate the cycle this time. Boom and bust cycles can happen without inflation, but inflation exasperates the problem.