Monday, December 30, 2013

Inflation and the Dragon

One of the hardest things for many people to grasp during the Great Recession has been the idea that inflation is too low. We generally talk about inflation as pure economic evil, something that could never possibly be too low. But it is.

If you say inflation is too low, some people will bring up the high inflation of the 1970s or, more hysterically, the hyper-inflation in Weimar Germany during the rise of the Nazis as proof that Inflation Is Bad. But that doesn't really make sense. Inflation is bad when it gets too high, but that doesn't make a modest amount of inflation bad. The sun is bad in Death Valley when it's 130 degrees, but that doesn't make sunshine a universal menace. 15% inflation would be a very bad thing, but that doesn't mean 1.5% inflation is a good thing. 130 degrees Fahrenheit is murderous, but so 13 degrees is also a killer. A lot of our public debate about inflation is like trying to treat a case of frostbite while people keep shouting that heat is a terrible thing and then angrily tell you a long story about forest fires.

Some of the people warning against any inflation under any circumstances either should know better or actually do. They have various political or ideological motives. Some are under the spell of fringe economic theories, like Hayek's. Some are simply seeking short-term advantages for particular business interests, such as the banking sector, that benefit directly from low inflation although the wider economy might suffer. Some, including a healthy slice of libertarians, take their economic thinking from science-fiction or fantasy media and games. The enthusiasm in some quarters for the fictional virtual currency BitCoin is partly driven by genre-fiction economics. Bitcoin imitates gold to the degree that the processing of making it is called "mining"and there is a fixed maximum that can be generated, in imitation of the old gold standard, so that eventually the BitCoin money supply will become inflexible and incapable of expansion. This will make BitCoin immune to inflation (assuming anyone accepts it at face value), and in fact make the currency deflationary. Inflation and deflation are about how much money there is compared to how much stuff there is to buy with the money; when the money supply grows too fast, prices grow too fast. If the amount of goods and services money could buy kept growing, but the money supply didn't because all the money had already been created, as in the BitCoin plan, then the existing money would become more and more valuable as prices kept dropping, as in the Great Depression. BitCoin enthusiasts think this a good idea, partly because they read books like Neal Stephenson's Cryptonomicon and partly because World of Warcraft has been on the gold standard for years.

So I'm going to stoop to the fantasy-example level. Let me use The Hobbit to illustrate the dangers of an inflation-free world.

Tolkien's world, like most fantasy worlds, seems to feature virtually no inflation. A piece of gold is a piece of gold, with value that never ebbs. (This kind of tidiness and solidity is part of the appeal to many digital goldbugs, who like fixed numbers and find the arbitrary and negotiable nature of money 
unsettling.) In fact, Tolkien's world is probably deflationary, in that ancient treasures seem only to appreciate in value. Treasure just gets more precious with time because, as in most heroic fantasy set in an idealized pre-industrial world, there is virtually no economic progress.

The Hobbit of course features a dragon, Smaug, who is sitting on a vast hoard of gold and jewels which represents basically the entire money supply for several hundred square miles. Smaug is quite literally wallowing in his wealth. He has made a big pile of it and is sleeping with his belly on it, while everything else around him for miles and miles is a wasteland. This is all sensible enough draconian behavior because there is no inflation, and therefore Smaug has nothing to lose.

In fact, a deflationary world is excellent for Smaug. The money underneath his scaly belly only gains in value as he naps. If prices in the rest of the economy keep falling, then Smaug's gold will actually buy more this year than it would have last year, and buy more next year than it would this year. He doesn't have to worry about investing his money, or making more, because the money he has keeps gaining in value. The rich get richer by doing nothing.

But this is the problem. Deflation creates an incentive not to invest money, and not to spend it. So that money and the economic value it creates get sucked out of the economy. In deflation, you should never buy anything before you have to, because it will get cheaper the longer you wait. And you don't need to bother investing, because money just gains value by sitting there on the floor. Deflation rewards you for becoming, in the most literal sense, a hoarder. Maybe all that saving sounds virtuous. But if no one ever buys anything, then no one makes any money either. And if no one invests their money, no new businesses can grow. In fact, there is no new money; there's just the old money that gets more and more valuable while everyone else becomes poorer and poorer.

And so the area around Smaug is a wasteland, not simply because he's set it on fire at one point but because no one else can make any money or do any business. Nobody mines any more gold, or works gold into objects. Nobody grows any food. Respectable hobbits turn to lives of crime. No business can take place, because there is no capital. Capital is an accumulation of resources set aside for further investment; money that just gets piled up in a cave for years is not capital. And in fact, Smaug could only burn the area down because he had no further economic need for it. He'd grabbed all of the existing wealth and had no interest in anyone creating more, because his wealth would grow in value by itself. The Desolation of Smaug is actually the Depression of Smaug. And it's the platonic ideal of a deflationary economy: an enormous hoard of money with virtually no goods or services worth buying.

But let's imagine the basic economic conditions changing just a little. Let's say that Mirkwood, Long Lake, and the areas to their east actually have an annual rate of, say, 5% inflation. Now Smaug is still enormously wealthy with his ill-gotten gold, but he's not actually getting richer. In fact. he's getting a little poorer every year he holds onto that gold without doing anything with it. Its value is slowly leaking away. This sounds terrible and unfair to some people, who respond by inventing dumb things like BitCoin, but in fact this leakage moves people to more economically virtuous behavior.

What is a dragon to do? He could just be satisfied with his diminishing net worth, but let's face it: he got where he is because of his overpowering greed. So he has to do something. The only thing to do is to make more money. And the quickest way to do that is to leverage the money he has. If inflation is slowly eroding the value of Smaug's gold, Smaug needs to invest his gold for a rate of return higher than inflation. 

So Smaug, with 5% inflation nibbling at his tail, wants to make a 7% to 10% annual return on his gold. So let's say he hires some dwarves, Thorin and Company, to reopen the mining shafts in the Lonely Mountain and to work new gold into new, value-added cups, rings, and whatnot. He tries to sell off some of existing inventory of goldsmithery to the local Elvenking, or to the men of Long Lake, in exchange for other investments. Naturally, the dwarves don't work for free, and neither men nor elves willingly make deals that lose them money. Smaug has to work out arrangements that are profitable for everybody, so that Thorin et al. make enough to keep them motivated while Smaug nets the 7%-10% he's looking for. And suddenly, we have capitalism. The gold is no longer piled up doing nothing, but actively fueling more enterprise; it has become capital. (The "saving" Smaug indulged in in the other scenario may sound virtuous to those who equate saving and virtue, but it is literally the least capitalist behavior possible.)

Now, Smaug's various partners, employees, and trading partners are also facing 5% inflation, so they are also going to want to build their money into more money by investing in new things. And they also have to eat, so some of their wages and profits are going to be consumed. But money someone spends is money someone else earns. The area around the Lonely Mountain will have to become less lonely, because all of those people are going to need places to eat, sleep, buy new shoes, and so on. Bilbo Baggins moves to town and starts selling everyone second breakfast. And Smaug needs all that to happen, because his business can't survive without those things around. He's not going to burn it down again. Instead, his gold is going to circulate out into the community, through many hands, and fuel growth. Pretty soon, you have a bustling Lonely Mountain Economic Zone.
And in fact, this is pretty much the happy ending in Tolkien; once the hoard gets broken up and distributed into many different hands, rather than re-hoarded by Thorin, peace, love, and commercial industry abound.
Of course, if inflation gets too high, the economy suffers. If inflation is devaluing your money faster than you can make it, the economic incentives break down pretty seriously. But deflation also wrecks the incentives and ruins the economic system. A little inflation, in moderate doses, provides a compelling reason to make more money from your money, and money making more money is what makes the economic world go round. Moderate inflation is good for nearly everyone. Deflation is strictly for dragons.

cross-posted from Dagblog

No comments: