250 Billion Reasons Why the Fed Hates Inflation (and Doesn’t Care About Employment)
Let’s start with the basics:
Increased inflation results in (in a sense, is) a wealth transfer from creditors to debtors.
Debtors get to pay off their loans in less-valuable dollars — dollars that can’t buy as much real-world stuff, stuff that humans can consume, that they value.
If you’re holding a hundred million dollars in bonds — you’ve lent out hundred million dollars — and bananas are going for a dollar apiece, an extra percent of inflation means that a year from now, you can only buy 99 million bananas. The people who borrowed the money from you get the other million bananas. If inflation stays up and the loan remains outstanding, they get another million bananas next year. You don’t.
You can start to see why creditors might be inflation-averse.
How big is this wealth-transfer effect? Here’s a quite conservative back-of-the-envelope calc.
Figure that there are somewhere north of $50 trillion dollars in private “credit market instruments” out there in the U.S. as of Q3 2011 ($120 trillion in total liabilities).
Do the math: 1% of $50 trillion is 500 billion dollars. One extra point of inflation transfers that much wealth — buying power — from creditors to debtors. Every year.
This is probably an overstatement — many people/businesses are both creditors and debtors, so part of the transfer is from them to themselves. But still: let’s cut the number in half. An extra point of inflation transfers a quarter of a trillion dollars per year in buying power — real wealth — from creditors to debtors.
Because this effect impacts the huge existing stock of financial assets, 1. it is a permanent , and 2. its scale utterly dwarfs the relatively measly (and multidirectional) effects on flows — often second- or third-order effects — that (neoclassical) economists tend to go on about when discussing inflation. (“Money illusion,” “neutrality of money,” etc.)
And there are far fewer creditors than there are debtors. The effects of the transfer are concentrated on one side, diffused on the other. (See: Mancur Olson).
I’ll have a lot more to say about this in future posts, but keeping this short, I’ll bring it back to the the title of this post:
The Fed is run by creditors. And I’ve heard it said that financial incentives matter. The Fed governors have a huge incentive to keep inflation low, and ignore the other side of their dual mandate: employment.
We tend to talk in very big numbers these days, but a quarter of a trillion dollars a year seems like it’s still enough to get people’s attention.
Cross-posted at Asymptosis.
It has been said the FED abandoned full employment as a goal during Volcker’s reign in his quest to control inflation. The real question is whether it is a lower cost to have 20% of the Non-Institutional Civilian Population as either the Unemployed or in Not In Labor Force. Is this a far greater drag on the economy as an infrastural cost than a 1 or 2% inflationary increase?
Time to put some debtors on the board of the Fed.
I keep waiting for soemone in the know to disabuse me of the notion, but no one has. Given that the banks’ default hedges ended up being worthless pieces of paper, are the inflation hedges just as bad? Bascially are we looking at a counterparty that has no ability to pay in an inflationary world? So are the banks going to face another huge hit if there is even moderate inflation?
“Do the math: 1% of $50 trillion is 500 billion dollars. One extra point of inflation transfers that much wealth — buying power — from creditors to debtors. Every year.”
OPK, let’s accept that number for a moment.
So, back when we had 5%, or 10%, or 20 %, inflation, why weren’t debtors getting fabulously rich?
And if they didn’t get fabulously rich at ten or twenty times the transfer you’re talking about, what’s wrong with your argument?
Oh, and those with fixed rate mortgages did get rich at that time. But not everyone else. So where is the general flaw?
Perhaps it’s that most debt is not fixed rate? So a rise in inflation just gets built into interest rates?
Wouldn’t be better to declare a debt Jubilee, if the desire is to free debtors?
Tim, good questions. Semi-random responses:
Yes re: fixed rates.
Nick Rowe has repeatedly pointed out to me that *unexpected* inflation is what causes the wealth transfer. If it was expected it would be priced into loans already. I’m not completely sure that’s completely true except in the potentially very long term (there are a lot of 30-year fixed-rate bonds and mortgages floating around out there…), but tossing it in.
Also remember: this effect doesn’t transfer dollars, it transfers buying power (which can/is at some point, to some extent, converted back into dollars via trade? gotta think more about that). Kind of magical — the tally sheets don’t change, but distribution of wealth does.
Nobody has explained, that I’ve found, what the terms of the jubilee would be. Who gets to default? Everyone who owes anything? Both individuals and businesses? Sole proprietorships? S-Corp-elected LLCs? Foreign entities? Who decides?
1. I can’t see it happening, and
2. I can imagine huge problems emerging as mind-boggling quantities of actual dollars (as opposed to buying power) change hands
An extra point or three of inflation for a few years doesn’t seem to have those problems.
then would “expected taxes” be priced into business contracts… including loans?
good idea Richard
and if the desire is to avoid taxes, you can just cut off your head.
“So, back when we had 5%, or 10%, or 20 %, inflation, why weren’t debtors getting fabulously rich?”
Worstall brings up a great question. I would think that a large part of it is due to how slow wages are adjusted for inflation. Is being an employee a type of creditor (people labor for a week/two weeks/a month before they are compensated).
I would also think that trying to become wealthy through inflation requires fantastic timing , like getting a few mortgages in 1965 or 1972.
“then would “expected taxes” be priced into business contracts… including loans?”
According to Robert Barro, yes! (What a hack.)
A fine question. Holding up my thumb and squinting, I’d say yes. Be interesting to hear from folks who have a better-informed thumbs than me…
“Also remember: this effect doesn’t transfer dollars, it transfers buying power (which can/is at some point, to some extent, converted back into dollars via trade? gotta think more about that).” It seems you just need to review standard principles of macro material on the ex-ante real interest rate and its interpretation.
Think of the wonderful benefits of deflation to the creditor: “Ten years ago I could buy only one house in the Hamptons. . .”
That they will meet the Judgement.
The “shining city on the hill” is rooted in the Bible. The Bible holds “usury” a sin.
” If you lend money to any of My people who are poor among you, you shall not be like a moneylender to him; you shall not charge him interest.
26 “If you ever take your neighbor’s garment as a pledge, you shall return it to him before the sun goes down.
27 “For that is his only covering, it is his garment for his skin. What will he sleep in? And it will be that when he cries to Me, I will hear, for I am gracious. (Exodus 22:25-27)
Here is Smith’s invisible hand, a hand which sees the true cost of any action that harms a human being has a cost to the social contract.
The mandate to control unemployment trumps inflation and the impediment of the “interest” of the few called creditor.
The logic is at least 4000 years old.
i suspect that the effects of inflation upon a debtor is dependent upon it being a commercial borrower or personal debt. In the case of an individual borrowing for personal use; mortgage, school loan, car loan etc., i don’t see the benefit of inflaction. Granted that the loan is being paid back in dollars that have less purchasing power, but unless the debtor has an increased amount of income he still has the disadvantage of having so much less after the loan payment. If 10% of a debtor’s income goes to debt satisfaction, and no additional income is available, then that debtor is left with 90% of income in less valuable dollars. I don’t see an advantage given the double edged sword character of debt reduction in an inflationary period. The same number of dollars are left to the debtor and they are worth less than before.
I suspect that the effects of inflation upon a debtor is dependent upon it being a commercial borrower or personal debt. In the case of an individual borrowing for personal use; mortgage, school loan, car loan etc., i don’t see the benefit of inflaction. Granted that the loan is being paid back in dollars that have less purchasing power, but unless the debtor has an increased amount of income he still has the disadvantage of having so much less after the loan payment. If 10% of a debtor’s income goes to debt satisfaction, and no additional income is available, then that debtor is left with 90% of income in less valuable dollars. I don’t see an advantage given the double edged sword character of debt reduction in an inflationary period. The same number of dollars are left to the debtor and they are worth less than before.
On the other hand commercial debtors are more likely to experience an incrfease in income during an inflationary period an thereby gain a real advantage in regards to paying their creditors with less valuable dollars. They will have an increased amount of income remaining as a result of inflation. The issue doesn’t seem so clear cut as Steven explains.
“It seems you just need to review standard principles of macro material on the ex-ante real interest rate and its interpretation.”
Would this allow me to make predictions like this?
Not happy reading when you combine it with the latest CPI numbers, which seem to show that the US is on the brink of deflation http://tiny.cc/0bf8w
It makes perfect sense to me:
Say I want to borrow a million dollars from you for 10 years, and to make this simple, I’m going to repay 100,000/year plus simple interest. You assume a 2% inflation rate and charge me 5% interest, which gives you an 3% rate of return. You get 150,000/year and we’re all happy. But – instead of loaning the money to me, you could have bought 10 houses for 100,000 each. You don’t do that because you know that housing prices will increase only by the rate of inflation for ten years.
But – what happens if inflation is 5% a year?
At the end of 10 years, houses cost 163,000 each. You have 1,500,000 from me, so you can only buy 9 houses (roughly). From your point of view, you are significantly poorer – even though I’m not any richer.
Since the Fed is composed of creditors, unexpected inflation = evil. It’s never going to change, and there isn’t anything anyone can do about it – the best we can do is just smile nicely and bend over for our corporate and financial overlords.
Fed is of and for the 20 TBTF banks, hang the rest.
“then that debtor is left with 90% of income in less valuable dollars”
But: everybody else — notably the creditors — has less valuable dollars too.
It’s the *proportional* buying power that changes. Debtors end up with proportionally more claims on real output/production — the real stuff that the real economy creates and that can be consumed and is valued by humans — and creditors end up with less.
somewhere the effect of inflation-risk is priced into the cost of the loan.
it makes perfect sense to me too and i don’t know anything.
i have a vague idea there is such a thing as inflation. i enter the market to buy a house on time with that vague idea…probably no worse than the precise idea of the Fed or the Bond Traders… and i pay a price and get a loan that is informed by the vague idea of everyone else in the market.
this is just normal business risk.
the point i think steve is making is that the Fed will always favor policies which they hope will limit inflation over policies which might limit unemployment. that IS a problem.
not sure why Barro… who appears to agree with me that the same logic applies to expected taxes… is a hack… but as far as i can tell from the conversation so far people seem to lose track of the fact that “the market discounts…” all these things.
“not sure why Barro… who appears to agree with me that the same logic applies to expected taxes… is a hack…”
I think he (notably as exemplified in his notion that the market prices in imagined future tax increases) is a shill for the rich. I first came to that conclusion when I realized this:
“but as far as i can tell from the conversation so far people seem to lose track of the fact that “the market discounts…” all these things.”
I don’t think they lose track. They just don’t believe it.
hard for me to tell if you are one of those who “just don’t believe it.”
that, and whatever it is that Barro and i appear to agree about… but probably don’t when you look at the conclusions drawn from the rather simple idea that people do business in an environment where both inflation and taxes are taken into account..
would take more time to develop… or refute… than we can give it here. i think the ideas are worth exploring, but would bet they won’t get any serious attention until someone sees a political advantage in building a bogus case one way or the other.
i would guess, based on what i think is your tone
that B uses “market prices in expected tax increase” to argue that “don’t tax the poor corporations because in the end its the people who will pay… and we know you iibs don’t want to tax the people”
whereas i am saying that because markets price in expected taxes we can stop worrying about all those poor rich people who are just going to have to quit working because their taxes went up a couple of percent.
ultimately taxes just determine what share of our wealth is in the form of consumer goods and what share is in the form of government services. it may readjust the pie a little, but it isn’t going to have a destructive impact on the “free market.”
up to a point, of course.
and since this is a thread about inflation, i have to add what i think is obvious..
the effects of inflation are worst on the very poor whose wages, or pensions, don’t keep up.
the rich bond traders think they are losing money… but they priced in the risk when they bought the bonds, and they will easily make the money back.
high inflation seems to affect people in ways that hurt the economy… leading to high unemployment (not the other way around as in NAIRU)… so it need to be controlled.
and the damaging effects on the very poor need to be addressed (minimum wage adjustments and pensions that are inflation indexed?)
but when they, we, start running around with sky is falling attention fixed on “one thing” we start making huge mistakes and run off the road.
“hard for me to tell if you are one of those who “just don’t believe it.”
Yes that’s me. Government has been deficit spending, while the tax take has been steady to declining, for decades. Have people/businesses, over all that time, been managing their finances as if tax increases are just around the corner — or even inevitable and calculable, some decades out? It doesn’t make any sense to me.
On that tax take thing:
“the effects of inflation are worst on the very poor whose wages, or pensions, don’t keep up. “‘
True. If that’s true. Which it has been for the last thirty years. But it was not true in the thirty years before that. I’d like to see things change so they’re more like they used to be, in that regard: everyone shares in — and crucially, contributes to — greater prosperity increases.