Inflation is the young’s revenge …

November 4, 2008 | Essential posts, Holmes on housing, Markets, Policy, Theory, US News

“If revenge is a dish best served cold,” said Holmes, “then inflation is a dish long marinated.”


Fearing the worst, Watson folded the Times and composed himself in the attentively placid pose appropriate for the straight man.  “Yes?”



Watson knew a disquisition was about to begin


Holmes unlimbered his long legs.  “Inflation is the young’s revenge on their elders for over-spending.  In fact” – he twirled his fingers and the image appeared – “we may express it as a law.”




No longer surprised by Holmes’ image-conjuring abilities, Watson studied the chart.  “Yes, I see how inflation devalues debt.  And since the price of future goods and services rises, those who produce the goods—future workers – can earn more, at least in nominal money, than they did before.  But where can inflation come from, when money is backed by gold, as it is here in England and shall always and ever be?”



Brother Mycroft watches over the Bank of England and the capital markets


“Fortunately or otherwise,” Holmes said with a thin smile, “once money was invented, inflation came along with it.  As opposed to pure barter, where commodities and services are exchanged directly – money is always an abstract representation of a unit of value.  As such, even if it is theoretically exchangeable for these commodities at fixed rates, in all practical matters people can create their own money.  Consider, for example, the humble promissory note.”




“Aside from this note being denominated in American dollars,” observed Watson, “it is dated in the future, 1916.”


“A technicality,” Holmes said, “since the two of us exist outside of space and time, and even though we were created in the 1880’s, I predict we shall long outlive our creator.  This note, as I was saying, comes into being when you and I make an agreement.   Does it have value?”



What might this promissory note be worth?


“Certainly, if it be good.”


“And someone will provide me goods or services in exchange for this piece of paper?”




“Then this note has the effect of increasing the money supply.  When one stops to reflect, that is remarkable, because it means that the effective money supply can expand beyond all government attempts to control it.  And once that is admitted, as the supply of money – paper or electronic symbols that everyone accepts as having value – expands, we have more money chasing the same goods, and inflation can easily result.”


“Hence our laudable emphasis on connecting money to the supply of something tangible and intrinsically valuable, like gold.”


“That is what men have thought since the beginning of time, gold being durable, portable, malleable, and rare.  If that is the case, however, gold creates its own distorting effects.  For instance, when the sixteenth-century Spain of Philip II discovered vast Central and South American gold deposits, the net effect of all that infusion of gilt was simply to create runaway inflation in the empire.”



All that glisters … but what can you buy with it?


Watson considered.  “Money, therefore, creates the potential for inflation.  Fortunately, we in the British Empire have long been spared its effects.” 



Watson knew that the Times never published CPI figures


He gestured, and a chart appeared of historical inflation in the UK (page 16, .pdf).




“When does the supply of money expand most rapidly?”


“Why, when government needs to stimulate economic activity or to prevent a credit seizure.  For example, consider this.”   Holmes was slightly nettled that Watson was able to manifest charts, so he obtained a very large one.




“Taking advantage of our ability to foretell the future, at least through the date of these blog posts,” I can show you the remarkable fluctuations in US inflation between 1787 and 2000.  As you can see on this intriguing interactive History of UK inflation, 1790 to 2005, wars are the most common reason, being the most visible example of a national crisis.  Mr. Pitt the Younger largely invented this form of deficit financing when the Bank of England suspended using gold to back its paper money in the early stages of the Napoleonic Wars.”

“Political ravishment, or the Old Lady of Threadneedle Street in danger”
William Pitt as the rake, the Bank of England as the old lady of Threadneedle Street (its headquarters)

 “Once inflation is introduced, however, a government finds it has many quiet uses.  Consider:


1. Inflation allows gentle reductions and realignments of costs and benefits.  Employers who have contractual or legal obligations to maintain certain payments can lower them in real terms by raising wages more slowly than they raise prices.  This type of ongoing jostle is societally useful, and difficult to accomplish without inflation to blur the relative positions.”


2. It devalues previous debts.  Annuities, loans, and any other form of fixed-rate obligation declines in value.  This is why the yield curve is normally positive, because lenders distrust the value of their future money.”



A typical example,  betting that inflation will rise over time


3. It enables government steadily to reduce payments it owes.  Social security or benefit pledges, and any other form of income that is denominated in fixed money amounts, become worth less as inflation rises.  This is the only way governments get out of having grossly over-promised to their retirees.”



“Dear Mr. Musgrave, we regret to inform you of the diminution of your buying power …”


“The US‘s Social Security, for instance, was introduced in 1935, when the nation expected six earners for every collecting retiree.  Seventy years later, with greater longevity and earlier retirement, the ratio is about one to one.  That is utterly unsustainable, and has been so for two decades, so the only recourse is to dilute the obligations, via inflation.”


4. It allows politicians always to be cutting taxes.  Because inflation increases people’s pay packet in nominal terms, in any country with a progressive income tax structure (higher earners paying higher marginal rates) inflation has the effect of pushing the same worker into ever higher brackets, from which the elected officials can generously rescue her by cutting taxes.”



I slash your marginal brackets!


“My goodness,” said Watson, appalled.  “You make inflation sound a good thing.”


“With one cynical caveat and one enormous exception, inflation is indeed a useful price-cost lubricant.  Indeed, if one examines this curious inflation map, one can see that inflation is omnipresent in greater or lesser degree.  The cynical caveat is this:

5. Inflation is controlled by the current generation.  In practice, inflation is the outcome of macroeconomic, political, and financial practices – all of which are controlled by the current generation.  If the older generation has over-spent or over-obligated government to pay for their empires, their wars, or their old-age pensions, then the younger generation exacts its revenge via inflation.” 

I’ve waited a long time to slice your retirement pensions

 “And the enormous exception,” Holmes finished, “is this:”

 6. Hyperinflation is catastrophic.  Always.  It destroys wealth, ruins economies, explodes finance for years and decades.  It punishes an entire nation, all citizens without exception.  It’s no surprise that tyrannies end in hyperinflation.”

Germany, 1923: The only thing marks were good for: burning for warmth

Despite the zeroes, this can’t be worth much, can it?

Zimbabwe, 2007: When money is hyper-plentiful … 

… goods are hyper-absent: Zimbabwe, 20007

 “This matters critically for housing finance.  Housing being an expensive asset, it is always financed over long periods of time, and for this we need stable capital markets and a reasonably stable inflation rate.  Hyperinflation kills housing.”

 Watson found himself soberly silent. 

 “Technology,” said Holmes, “is the driver of increasing wealth and raising families’ incomes.  Money is the fuel, and inflation a lubricant.  Government creates the laboratory, the enabling or disabling environment.”

For a thorough introduction, see David Hackett Fischer, The Great Wave 

A great entry text on a complex and enduring subject