A Failure of Capitalism (IX): More on Inflation

by Richard A. Posner

My last entry described a simple pattern in which the expansion of the money supply by the Federal Reserve and borrowing by the Treasury Department to finance soaring government debt--measures resulting from the depression--create a risk of inflation, which impels corrective action that can trigger a recession that would thus be an aftershock of the current depression. I need to be more precise about inflation, and in particular to avoid an implication that zero inflation is the summum bonum that the government should be striving to achieve.

In fact we may need inflation as one of the weapons to fight the depression, and this for two reasons. The first is to prevent deflation. Deflation, the opposite of inflation, refers to the situation in which the purchasing power of money increases because the ratio of money in circulation to the quantity of goods and services being sold decreases. Between 1930 and 1933, the dollar deflated at a rate of about 10 percent a year. This meant that on average if a product cost $1 in 1929, it would cost only 90 cents in 1930.

Deflation decreases economic activity by rewarding hoarding; in a deflation, money you put under your mattress will be worth more in a year just as if it were earning interest, but it will not contribute to consumption or investment because it is not being spent. To attract buyers in a deflation, sellers must reduce prices (otherwise the real as distinct from nominal price of their goods will rise), which increases deflation by reducing the ratio of money in circulation to goods. And deflation increases indebtedness in real terms, because people who contracted debts before the deflation began or was anticipated pay interest, and repay the principal of their debts, in dollars that are worth more.

We are in a deflation, though so far a mild one.

The Consumer Price Index is .7 percent below what it was a year ago. The signs are in the incredible discounts that sellers are offering for many consumer products, such as automobiles, airline tickets, and luxury goods. And it is important to note that one can be in a deflation, in real as distinct from nominal terms, even when the CPI is in positive territory. For in May of last year the inflation rate (based on the CPI) was 4 percent; so if today it were 1 percent (positive but lower than last year), someone who a year ago had borrowed money for a year at 8 percent, expecting that half the interest he would be paying would merely be offsetting expected inflation--that the real rate of interest was only 4 percent--would be repaying the loan with dollars worth 3 percent more than the dollars he borrowed, because inflation had turned out to be only 1 percent. He thus would be in for a rude awakening when it came time to repay. To prevent burdening debtors in this way, we want the rate of inflation to be well above zero.

Second, as Casey Mulligan (an economist at the University of Chicago) has pointed out, a positive inflation rate will not only prevent deflation, but by lightening the debt load will increase the real income, and hence spending, of persons with debt. Specifically, as he points out, inflation will increase the price of houses but not the size of mortgages, so it will reduce the number of abandonments and foreclosures. The point is not limited to mortgage debt. A feeling of overindebtedness due to a decline in the market value of one's savings increases the propensity to save rather than to spend, and inflation reduces the amount of debt in real terms. When Roosevelt took the United States off the gold standard, shortly after his inauguration, deflation gave way to inflation (the gold standard ties a nation's money supply to the amount of its gold reserves, and though U.S. gold reserves had been growing, the Federal Reserve had "sterilized" gold imports--that is, had refused to allow them to increase the money supply). That inflation is believed to have contributed to the rapid economic recovery that began then.

But it may not be easy to create just the right amount of inflation and at the right time. For remember that the ratio of money to goods depends on the amount of money in circulation, and if people are afraid to spend, just pumping money into the economy may merely increase the amount of money that is hoarded. And the more that is hoarded--that piles up waiting to be spent--the greater the risk of serious inflation when confidence returns and the hoarded cash begins to be spent. This danger makes inflation a very tricky, though conceivably an indispensable, weapon of public policy in a depression.