Preference for inflation over deflation reflects a Keynesian argument that has frayed
The Australian
Adam Creighton
October 30, 2015

“Deflation means impoverishment to labour and to enterprise by leading entrepreneurs to restrict production … it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier (those who hold rental properties / income-earning investments) ,”...
Thus inflation is unjust and deflation is inexpedient. Of the two perhaps deflation is, if we rule out exaggerated inflations such as that of Germany, the worse; because it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier (those who hold rental properties / income-earning investments). But it is necessary that we should weigh one evil against the other. It is easier to agree that both are evils to be shunned.”
[Essays in Persuasion, p. 75 - Social consequences of the changes in the value of money, 1923]

wrote John Maynard Keynes in his seminal 1923 tract on money.

News Australia’s consumer price index — which measures the prices of the goods and services that people want to buy, except homes, a niche product apparently — rose only 0.3 per cent over the three months to September elicited disappointment this week.

It was a sign of economic weakness, apparently, that the Reserve Bank should offset with stimulatory rate cuts.

Keynes’ brilliance has entrenched a preference for inflation over deflation. Falling prices are thought to choke business investment and fuel lay-offs, while inflation does the opposite but saps the value of rich people’s wealth.

But even if Keynes was right in the 1920s, the premises of his arguments have frayed.

Indeed, this century’s rentiers, far from being euthanised, have been doing handsomely out of central bank efforts to fight deflation by pumping new money into the financial system. In the two years to 2015, the world’s richest 1 per cent have seen their share of global wealth increase from 46 per cent to 50 per cent. That can’t all be due to extra effort.

If the bulk of rentiers’ assets were fixed in nominal terms in the 1920s, they aren’t now. Property, stocks and art are among the ­favoured repositories — real assets whose values are ultimately immune to erosion by inflation. Inflation would be more likely to disappoint the workers, whose real wages have stagnated. According to Labor MP Andrew Leigh, in the US at least household income has stood still since 1989. In any case, the much lauded inverse relationship between inflation and unemployment has broken down.

If anything, in the past 40 years it’s been broadly positive. Contrast the 1970s and 1980s with the 1990s and the current situation of ultra-low inflation and modest or falling unemployment.

Entrepreneurs aren’t as fussed about the direction of the aggregate price level, either.

In Keynes’ time, new businesses might worry about having to pay back loans if deflation were about to set in. Today, risky ventures increasingly do not require the vast financial ­inputs that fuelled the emerging manufacturing empires of the early 20th century. The innovative frontier this century has been dominated by businesses such as Uber and Airbnb, and emerging fintech companies, which typically require little in the way of debt finance. The biggest profits are increasingly flowing to the best ideas rather than heavy-duty machinery.

Finally, the world is no longer “impoverished”, at least in rich countries. Life may still have been nasty, brutish and short in Keynes’ 1920s Europe. Now, it’s quite nice, at least in a material sense. The unemployed are looked after. Society is teaming with paid “carers”, antibiotics, and household appliances that have eviscerated early 20th-century drudgery.

The unconvinced will point to the supposed unfolding economic disaster in Japan, which has been flirting with deflation for 15 years. Despite perceptions, Japan’s growth between 2000 and 2014 has been reasonable; once it is adjusted for a shrinking population, it has outgrown Europe for much of that period.

Moreover, Japan’s unemployment rate has averaged 4.5 per cent, compared with about 6.5 per cent in the US and 9.5 per cent in Europe, which have “benefited” from consumer price inflation.

Central banks frustration with low inflation is also odd. Owing mainly to excessive issuance of paper money, the German mark went from 4.2 to the US dollar in 1914, to 65 in 1920, and 7600 in 1922. In August 1923, the hapless Von Havenstein, governor of the Reichsbank, having already provided unlimited sums to the German government and even private German businesses, boasted to parliament he had the infrastructure to increase all Germany’s money supply by 60 per cent in a day. Over the next four months, the mark was blown to smithereens: from 620,000 to 630 billion — yes billion — against the US dollar. In the same year, Keynes was writing his monetary tract, Germany provided a timeless lesson in how, in a fiat money system, inflation is always a policy option and one that can spiral out of control, even in the most technologically advanced nation.

The sense of targeting an aggregate national price level is becoming less meaningful as online commerce enables consumers to import larger shares of their goods from abroad. And prices, and even wages, are much more flexible than in the 1920s, when unions were better able to exact inflation-matching pay rises and the technology to change prices rapidly didn’t exist.

Central banks’ ability to control the price level may have been exaggerated. While the heavy hand of high interest rates can crush growth and inflation, as Paul Volcker and Bernie Fraser demonstrated in the US and Australia, fine tuning the level appears a little farcical. Central banks don’t control the speed with which money circulates nor, despite perception, have they much control over the quantity of money. Banks create money. Not strictly true — their customers create money when they bind themselves to the bank by taking out a loan. The banks are the middle man who facilitate it. Steve . When they grant a loan, they credit both the asset and liability side of their balance sheet — a process that has precisely nothing to do with the policy of the central bank, indeed any third party.

** End of article