What is Inflation?

    After having a disagreement with a good-liberal friend of mine yesterday, I see this question must be asked. It is no idle question. One of the reasons I like economics better than politics is economics is based in facts and knowledge in a way that politics isn't. In economics having a strongly held, passionately believed opinion by no means makes it true. In politics it's easier to believe this illusion.

    What this friend of mine declared-they are on other things intelligent but certain aspects of economics are clearly a "dark continent" for them-is that inflation is simply a conspiracy by greedy business owners and that basically inflation is evil. They believe if we had no inflation right now-we don't have much at the present anyway-this would be a tremendous relief to the average American who could now afford the necessities of life. This I think is a total misunderstanding of economics.

    The crux of the problem is that they believe that inflation is a conspiracy of greedy business owners and bankers. This misconstrues the difference between real prices and nominal.

    So for example the fact that say, coffee had-for argument sake-a price of $.25 in 1970 and $2.25 today then that means that this represents nothing but a total transfer of wealth between us and those who sell coffee. This can only seem plausible if you ignore that there are costs in selling coffee, and not everyone who sells coffee is a rich corporate chieftain. True this is true at Star Bucks but what of the small business owner who owns a little store that sells papers, coffee, soda, etc. and whose main business clientele are those making their early morning commute? 

    Are these people to be understood as being 9 times as wealthy has they would have been in 1970? Again if you don't understand the difference between real and nominal prices, you can't begin to understand inflation. Of this extra $2 that coffee costs today in 2011 compared with 1970, to make a real apples to apples comparison you have to compare real prices not nominal. If you do that you might even realize that the price of coffee in real terms has gone down. Indeed the $2.00 price increase coffee has rise since 1970 is composed of two parts: the fraction of it that is inflation and the part real. So for example, let's argue-for argument's sake of course-that $1 of it is inflationary and $1 real then coffee in real constant dollars is only $1 rather than $2 more expensive since 1970. What matters is not nominal prices looked at in a vacuum but buying power.

   My friend insisted on seeing inflation as this conspiracy of rich against poor and Wall Street vs. Main Street: in reality it is not nearly so simple. If inflation is bad and deflation is good why do the creditors hate inflation so much? Why has the period of income stagnation for the median American corresponded with the period of The Great Moderation? (roughly the late 70s till the present time).

   My friend wouldn't even admit that homeowners are hurt by deflation, that it would be a relief if housing prices went up tomorrow the homeowner would be richer, indeed the economy would come back.

    Let us return to the question as to why creditors-as they surely do-hate inflation. When you take out a loan on anything, your real interest rate you pay on it is the stated interest rate minus the rate of inflation.

    So for example if you have a credit card with a stated interest rate of 25 percent-all too common during the the Bush years-then your real interest rate is 25 percent minus the rate of inflation. During The Great Moderation-where inflation was whipped-inflation was typically only about 2 percent, which is the Fed target rate. So it is clear why creditors favor low interest rates. They lost very little of their asset, but you got very little relief from your liability as your effective interest rate is still 23 percent. Note that the lower the inflation rate the better it gets for creditors. If the inflation rate is actually negative 2 percent you actually owe effectively more than the stated rate-27 percent.

     On the other hand, during the 70s we had very high inflation rates. If we had such rates today it would provide some real relief for those with credit card debt-or any kind of debt, like mortgages for instance, or just as important today, student loans which are absolutely killing students today. If the inflation rate were 8 percent which is 400 percent higher than the Fed's target that would mean that your effective interest rate would be only 17 percent-in other words you would pay 30 percent less in interest.

    If it were 15 percent then you would effectively pay only 10 percent.  The point is not that inflation is always good but that there's a trade off. In the 70s high inflation hurt due to the increase in materials but it helped debtors. Today the big problem facing our economy is deflation not inflation. If we had a rise in inflation it would go along way to freeing us of our debt burdens, it would be very helpful for the student loan debtors. I don't claim inflation is always an absolute good, just that a common perception that it always an absolute evil is wrong. Right now an increase in inflation is needed. The belief in "hard money" actually benefits creditors which is why historically it was the bankers in the pre-Fed era who supported this ideology whereas a populist like William Jennings Bryan was all about high inflation he hoped to achieve through "free silver!" He may have believed in it too much, clearly history showed his fetish for silver was misplaced. But this shows that the idea that deflation would actually help the little guy and hurt the banks is wrongheaded.