An obvious problem with deflation is that it rewards frugality—to an extent that can harm the economy. My friend Jane, for example, never wants to buy a computer because she knows that she can buy it for a lot less next year. In a deflation, all sorts of prices are falling and this can create a destructive cycle. Falling prices encourage people to wait to buy, and this in turn reduces demand, which causes prices to fall even further. This is precisely the opposite of the effects of hyperinflation that encourage people to spend money minutes after they are paid.
A second problem with deflation is that people really hate taking pay cuts. While this seems obvious, the amount of hatred can be surprising, and the consequences severe. One striking example involves the labor negotiations between the workers and the management of Hormel Foods in the early 1980s. Hormel’s products include the meat product Spam, which inspired the name for junk e-mail. We teach this example in our negotiations class at the Harvard Business School, and the saga is recorded in the excellent documentary American Dream.
In the early 1980s, the areas surrounding Hormel’s plant in the midwestern United States were hit by a severe recession. Accordingly, Hormel plant workers agreed to temporary wage cuts. In the next contract negotiation, the workers and management met to reach a more permanent labor agreement. After some intense and protracted negotiation, management offered $10/hour, an offer that was less than a dollar below that contained in the pre-recession contract. The workers insisted that the new wage be at least as high as the wage in the previous contract.
With pennies per hour separating the two sides, the union went on strike. The results were devastating. The strikers were fired. Many of the fired strikers were forced to move out of the area. The company found plenty of replacement workers (the prevailing wage for similar jobs in the area was around half of management’s offer).
The Hormel strikers were unwilling to take a small wage cut even though the economic conditions were severe. The unwillingness to accept management’s offer led to severe disruptions in the workers’ lives.
What does this have to do with money and inflation? The relationship between inflation and the Hormel strike is as follows: Imagine that the workers were given back their old wages but that inflation has eroded the value of their wages to the level offered by management. Would the workers have gone on strike, lost their jobs, and moved out of state to prevent inflation from reducing their pay by less than a dollar per hour? No one can know the answer, but evidence suggests that the Hormel workers would have not gone on strike to prevent a few cents’ worth of inflation.
If inflation changes a decision, it is labeled “money illusion.” In most economic theory, workers are expected to react identically to a pay cut by management and the same effective pay cut due to inflation. If, however, workers treat the two situations differently, mainstream economists say that they are acting irrationally. (Behavioral economists suggest they are acting like normal people.)
In real world situations, one can never be sure of the causes. So perhaps there was more to the Hormel story than worker stubbornness. In laboratory experiments, however, economists can create artificial inflations and deflations. The results from recent experiments by the team of professors Ernst Fehr and Jean-Robert Tyran indicate that people do exhibit money illusion.12
A more mundane version of money illusion is the tendency for people to set watches and clocks a few minutes fast. The clock on my computer has been six minutes fast for years. If I were completely rational, I would immediately know the real time. Even after years, however, my lizard brain is still fooled by my fast clock. While I can rapidly calculate the correct time, my first glance takes the clock at face value. Consequently, I get out the door a little sooner than I would with a clock with the right time.
Money illusion is one reason economists believe that some inflation is good. Inflation allows the adjustment of prices without triggering anyone’s emotional stand against getting a worse deal. For example, increased competition from China might cause the “appropriate” wage for U.S. textile workers to go down. This real-wage drop can occur either through an actual pay cut (which is likely to be resisted) or through a wage increase that is less than the rate of inflation. The true economic impact is the same in both cases, but one is more palatable.
Wage rigidity appears to hold outside the laboratory as well, and some believe it was an important source of the extremely high unemployment rate during the Great Depression.13 Because of money illusion and deflation, some scholars argue that Depression wages did not fall to levels low enough to induce employers to hire more workers.
This Goldilocks view of inflation has been studied extensively by a large number of economists.14 In 1996, Larry Summers gave a talk on his views on the optimal inflation rate. Larry Summers is currently the president of Harvard University, and although still quite young, was a tenured economics professor at Harvard before holding a variety of nonacademic positions, including secretary of the treasury. In his discussion, he summarizes this sticky wage situation as follows: “You can’t get real-wage reductions without nominal wage cuts, making it harder to get the needed labor market adjustments.” For this and other reasons, Professor Summers concludes that an inflation rate of 1 to 3% “looks about right.”15
Yogi Berra and Milton Friedman Share a Pizza
Where do we stand in our monetary journey? First, we have learned that money is a financial tool invented to lubricate the economy. Without money we would be forced to use inefficient and complex simultaneous exchange as in the kidney transplantation market. Second, we determined the attributes of ideal forms of money, which helps us understand the progression of types of money. Third, we have learned the Goldilocks rule that some inflation, at a low rate, is “just right.”
A mystery remains, however, and it is the one that worried me in the 1970s. All of our knowledge about money and inflation is great, but what is the use if inflation is an uncontrollable monster capable of toppling presidents and destroying societies? Knowing the enemy may have some benefits, but it would be much better if that enemy could be shackled.
The real mystery of inflation is that there is any mystery at all. There is no magic behind the cause and control of inflation. In The Wizard of Oz, the magic of the land is revealed when Dorothy pays attention to the man behind the curtain. Similarly, there are people who determine the inflation rate. Far from being an uncontrollable beast, inflation is a tame dog both created and completely controlled by monetary authorities.
Milton Friedman appropriately gets credit for the academic understanding of inflation. As in many other areas, however, Yogi Berra captured its essence without a Ph.D. in economics. When asked how many pieces he wanted a pizza cut into, Berra replied by saying, “Just four, I’m on a diet.” (Whether he actually made this joke is subject to dispute. Berra claims to be misquoted frequently. He coauthored a book titled I Really Didn’t Say Everything I Said.)
Regardless of its origin, the joke recognizes an obvious truth. A pizza contains the same number of calories regardless of how it is divided. Thus, the choice of the number of slices merely determines the size of each slice, not the size of the overall pizza.
Professor Friedman made the same discovery when it comes to the value of money. The decision on how much money to create doesn’t have much effect on the overall size of the economy, but it does have an enormous effect on the value of money. He wrote, “Inflation is always and everywhere a monetary phenomenon.”16
When the amount of money is increased, the result is inflation. Inflation destroyed the value of seashells in Papua New Guinea. When their “money supply” increased because of the importation of planeloads of seashells, the value of each seashell decreased. Similarly, the German hyperinflation was caused by a massive increase in the supply of German marks.
Inflation is simple. When more money is created, the value of each piece of money declines. That is inflation.
What about the U.S. inflation of the 1970s? I w
as particularly scared by news reports that suggested inflation was some mysterious force. As Figure 5.2 shows, this inflation was not mysterious at all. It was, to quote Milton Friedman, “a monetary phenomenon.”
The inflation of the 1970s was caused by a rapid growth in the money supply. Just as there is no mystery (to those in the know) for the cause of inflation, there is no mystery for its cure.
FIGURE 5.2 1970s’ U.S. Inflation Was Created by “Loose” Money
Source: U.S. Federal Reserve
In 1979, Paul Volcker became the chair of the U.S. Federal Reserve. With inflation running at about 13% a year, Chairman Volcker decided to stop the insanity. He slowed the growth of the money supply, and by 1983 inflation was down to 4%. Time magazine’s cover from October 22, 1979, pictured Volcker under the heading “The Squeeze of 1979.” This squeeze cranked up interest rates so that some rates exceeded 20%. Imagine getting a car loan or a mortgage in such an environment, and it is easy to see how tight money slowed the economy and reduced inflation.
It’s Good to Be the King
In The History of the World, Part I, Mel Brooks remarks, “It’s good to be the king!” The king has unique powers to achieve his goals (either nefarious as in the movie, or noble). Similarly, the Federal Reserve has unique rights that allow it to control the money supply, and through the money supply, to control inflation.
The injection of money into an economy can have a powerful effect. A simple personal example came when I was living in western Uganda in the summer of 1997. I was spending some time at a chimpanzee research station run by Harvard professor Richard Wrangham. Things were going fine, but I decided that I couldn’t rely upon the station’s truck for transport, and that I needed to buy my own vehicle.
Accordingly, I had my parents wire funds to a local bank so that I could purchase a motorcycle. With the help (and protection) of several of the research station’s employees, I negotiated the purchase of a used motorcycle at the exorbitant price of $2,400.
As I rode the motorcycle along the local roads, people would greet me and then laugh to each other. They found the situation funny for many reasons. First, I was ridiculously large for the small motorcycle. Second, I had paid at least $1,000 more than a local would have paid (in Swahili, they said that I paid the “Mzungu,” or European, price). Third, there were stickers on either side of the bike that showed a hunter with a spear. I was unaware that the spear was metaphorical, and that these stickers were public service messages to exhort the people to use condoms. So I became a mobile source of humor.
The actual purchase took place as follows. After reaching a deal on price, I went to the bank, took out the $2,400 in local currency. I was acutely aware that this represented close to a decade’s wages for the locals. I had guards on either side as I took my backpack full of bills and picked up my condom-advertisement machine. The previous owner asked me to hurry so that he could return the funds to the bank before closing time. In fact, he then returned the bills to the exact same bank manager who had given them to me earlier in the afternoon.
As I lay under my mosquito netting that night, I marveled at the power of electronic entries in the banking system. My parents sent an electronic message to a bank in western Uganda. Less than 24 hours later, I had a motorcycle and the electronic bookkeeping showed that the motorcycle’s previous owner had credit for $2,400. So by just moving a few electrons, I now controlled a motorcycle.
My motorcycle purchase created a whole cascade of effects. The previous owner was now rich with the proceeds of his sale. He used the money to buy a variety of products. The sellers of those products in turn purchased more goods. By injecting some money into the economy of western Uganda, I created a mini wave of prosperity. In my case, Uganda’s prosperity came at the expense of some in the United States. While I was $2,400 richer, my parents were $2,400 poorer. This was a zero-sum game where gains were offset by losses.
Being the king of the monetary world, however, the Federal Reserve plays by its own rules. For me to get money, my parents had to lose money. When the U.S. Federal Reserve buys something, no one’s account is reduced. The Fed controls the electronic system of bank credits. Thus, the Fed can increase an account by $2,400 or $240 billion with no offsetting reductions. While the Federal Reserve uses its power to buy U.S. Treasury bonds, and not motorcycles, the effect is the same as my mini wave of prosperity.
Except, the Federal Reserve can create money from nothing. It simply pays for its purchases by crediting the seller’s account. While private transfers are zero-sum activities, the purchases of the Federal Reserve are not.
Through these monetary operations, the Federal Reserve determines the growth rate of the money supply, though the decisions of other people impact the effect of monetary operations. For example, the speed at which people spend their new riches has implications for the economy. Even after taking account of the “velocity” of money, the Federal Reserve controls the money supply and thus determines the rate of inflation.
Reading the Body Language of the Federal Reserve
In Rounders Matt Damon plays a reformed poker shark forced back into gambling by circumstances. Damon’s poker prowess lies in his ability to read other players and thus know what cards they have. Most professionals agree that the ability to size up opponents is a crucial skill needed to win at competitive poker. In these games, knowledge of human nature, not of the mathematical odds, provides the key advantage.
Predicting inflation also requires understanding the human actors controlling the situation. The rate of inflation is determined by the growth of the money supply. In the United States, the Federal Reserve controls the money supply. To make predictions about U.S. inflation, therefore, one must have a good idea of the future actions of the Federal Reserve.
Many people are willing to make bold predictions of future inflation rates. On one hand, you find books about how to protect yourself in the coming deflation. On the other hand, some foresee an inflationary world where investors must buy gold to protect themselves.
I remain unconvinced by those who make clear predictions about a future inflation or deflation. U.S inflation rates will be determined by the future decisions made by the Federal Reserve. A prediction of inflation must be based on future decisions of the monetary authorities. Furthermore, the current chairman, Alan Greenspan, was born in 1926, so he might not even make it to the end of his current term in June 2008. Thus, all longer-term investments will be affected by the inflation rate determined with a new chair of the Federal Reserve.
Consider the historical period between World War I and World War II. Between the wars, Germany experienced a hyperinflationary depression, while the United States had a deflationary depression. The German monetary authorities created huge amounts of money and destroyed the value of the German mark. The U.S. monetary authorities did not create inflation—quite the contrary, U.S. prices declined throughout the Great Depression.
These extremely different outcomes suggest that the people in power determine the inflation rate. Although this may appear obvious, it is possible that the German authorities had no alternative. Similarly, some believe the current Japanese monetary authorities are powerless to prevent the current deflation. To the contrary, Milton Friedman believes that the Japanese can end deflation by simply increasing the money supply. I side with those who believe that the individuals in charge of monetary policy determine the inflation rate, constrained, but not controlled, by circumstances.
Thus, a good prediction of inflation requires detailed understanding of the forces that will pull and push the people who determine inflation. Furthermore, as in high-level poker, inflationary predictions depend on the ability to predict human behavior. While it may be possible to predict the behavior of the next Federal Reserve chair, even before she or he is appointed, I have not seen a convincing prediction.
Missouri on My Inflationary Mind
Missouri is the “show-me” state, where residents are reported to wait for proof a
nd not act on promises. When it comes to inflationary predictions, I suggest a show-me attitude. Rather than speculate on the future actions of monetary officials who have not yet been selected, a preferable financial strategy is: (1) based in the facts, and (2) likely to perform well in either an inflationary or deflationary world.
First, let’s look at the monetary facts. Figure 5.3 depicts U.S. money supply growth over the last decade. Monetary growth has accelerated, so the facts provide some support for those who predict rising inflation. Monetary changes create inflation only after some time, and the Federal Reserve may have planted some seeds of inflation that will sprout in the years to come. Both gold prices and the value of the dollar confirm that inflation may be stirring. Gold has risen from $250 an ounce to over $400 an ounce. Over a similar period, the dollar has fallen significantly against many currencies and to an all-time low against the euro.17 These moves suggest that the Federal Reserve’s loose money policy is decreasing the value of the U.S. dollar.
The inflationary case is not, however, complete. First, money supply growth over the last decade is still slower than the rates of increase in the 1970s. Second, money supply growth has slowed. So perhaps the Federal Reserve’s policy is perfect. This optimistic view is that the Federal Reserve created lots of money to soften the effect of the bursting stock market bubble. Now that the economy may be emerging from that dour period, the Federal Reserve is easing up on money growth. If this optimistic scenario is correct, then inflation need not reappear.
Mean Markets and Lizard Brains Page 12