Inflation is Good For You : The Frontal Cortex

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Jonah Lehrer is a contributing editor at Wired. He's also written for The New Yorker, Seed, Nature, the Boston Globe and is a contributor to Radio Lab. He's the author of Proust Was A Neuroscientist. His new book is How We Decide.

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Inflation is Good For You

Posted on: December 16, 2006 1:57 PM, by Jonah Lehrer

Is inflation really so bad? The great scourge of the American economy - and the economic phenomenon that gives Greenspan and Bernanke nightmares - turns out to have some pretty progressive side-effects. This paper is from the December 2006 issue of the Journal of Political Economy:

This study quantitatively assesses the effects of inflation through changes in the value of nominal assets. It documents nominal asset positions in the United States across sectors and groups of households and estimates the wealth redistribution caused by a moderate inflation episode. The main losers from inflation are rich, old households, the major bondholders in the economy. The main winners are young, middle-class households with fixed-rate mortgage debt. Besides transferring resources from the old to the young, inflation is a boon for the government and a tax on foreigners. Lately, the amount of U.S. nominal assets held by foreigners has grown dramatically, increasing the potential for a large inflation-induced wealth transfer from foreigners to domestic households.

Keep this in mind the next time you hear about how wage growth for the middle class threatens to ignite an inflationary cycle.

Hat Tip: Marginal Revolution

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Comments (6)

William Greider's book "Secrets of the Temple" makes this point excedingly well. It also chronicles how secretive, powerful and corporate-friendly the Federal Reserve is.

I think your post has inspired me to read it again.

Posted by: cope | December 16, 2006 2:20 PM

I don't mean to sound snarky (really), but the idea that creditors prefer (and are enriched by) low inflation, while debtors prefer high inflation isn't exactly new: that's what Bryan's "Cross of Gold" speech was all about. That such a paper would be seen as a challenge to the prevailing mindset (or for that matter, need to be published) just shows how depauperate our political and economic discourse is.

Posted by: Mike the Mad Biologist | December 16, 2006 10:06 PM

As a young (ish) middle class person with one gigantic mortgage, all I can say about inflation is BRING IT ON!!!

Sheesh, my parents took out a �6000 mortgage in 1973 for their house, which ended up as less than a year's pay before 1980!

The interesting thing is that although inflation can cause problems for business, it has the advantage that it makes pay cuts for a struggling business that much easier (i.e. a 5% rise vs. 10% inflation), because 'absolute' pay cuts - -5% in 0% inflation - are almost illegal.

It works well with general human psycology - humans tend to naturally apply a fairly high discount rate (20-30% or so) to purchase and investment decisions; this probably results from evolution in broard terms (cavemen were unlikely to live to pension age..). So in a low-inflation, low-interest-rate environment, people in aggregate tend to over-borrow if allowed.

Posted by: Andrew Dodds | December 18, 2006 4:25 AM

Mike,

The core idea of this paper is indeed old and is covered in your typical macroecon course. The paper's significance comes from doing quantitative calculations for the particular data set to see how the details of the distribution work out.

Jonah,

It's not as progressive as you think. The benefit goes nearly entirely to the middle class, with very little going to the poor. If you look at Table 4, you'll see that the poor segment has about a 1% gain under both scenarios, while the middle class gains 9.9% and 32.8% and the rich lose 58.9% and 71.6%. This makes sense since the primary beneficiaries are home owners with fixed rate morgages and the primary losers are holders of bonds. The poor tend to be neither, so they're largely uneffected, as you can see in the table.

However, there is a larger and very troubling intergenerational effect - namely that unexpected inflation is a major intergenerational transfer from the old to the young, since the ratio of fixed rate debt to fixed rate investments tends to go down as people pay off their morgages and buff up their retirement savings. As you can see on the table, this effect overpowers the income effect - the young and rich do better with inflation while the poor and middle class elderly do worse.

Also, unexpected inflation (expected inflation is incorporated into the nominal rates - the inflation in the paper is unexpected) is bad in its own right since you're creating uncertainty. Uncertainty about whether the gov't will create or not attempt to counter inflation will get factored into interest rates as a risk premium for the lender. The lenders are no better off since the risk premium simply offsets the drawbacks of increased risk and the debtor has to pay a higher interest rate so they're no better off.

Posted by: MattXIV | December 18, 2006 4:36 PM

Great comment, Matt. Thanks. I certainly am not advocating a return to the glory days of stagflation. Inflation can clearly (and easily) get out of hand, for the reasons you mentioned. I just linked to the paper to highlight the fact that fighting inflation (in the form of higher interest rates) has adverse consequences. I do believe that the post-Volcker Fed has gotten a little too eager to supress inflation. Given that our economy is currently oversaddled with foreign debt and households with expensive mortgages, a little more inflation might not be the worst thing in the world. (The alternative, I suppose, is a much higher rate of personal foreclosures and bankruptcies- something that's already happening - and an ever larger share of our national debt being bought by China.) Of course, using inflation to help the youngish middle class is, at best, just a short term solution, since we need China to finance our debt, and the next generation of homeowners will be punished by lenders that are more wary and risk averse.

Posted by: Jonah | December 18, 2006 4:52 PM

The foreign debt issue is actually a very good reason not to inflate. The core problem is that the government spends more money than it has - currently, it can get away with this and have the global markets pick up its debt because other countries don't think we'll try to inflate away or default on our debt. Some countries aren't so lucky and would have already have had a fiscal crisis. However, this puts us in a sticky situation since a sudden sell-off of that debt would cause the dollar to plunge relative to other currencies, causing even more inflation, since imports would cost more dollars and exports would command more dollars. We already need to worry about things that are beyond our control triggering a sell-off - like a recession in the countries that hold the debt or other well-managed currencies competing with the dollar as the currency holding of choice. A change towards a more inflationary policy would be exactly the type of thing that could trigger one of those sell-offs.

Our fiscal and monetary policy is bound by our creditor's opinion of it, a milder version of the situation many developing countries get themselves stuck in when they take on more foreign debt than they can pay off and end up relying on the IMF to loan it money to cover the debts, which in turn mandates fiscal austerity measures. The lesson is that gov'ts shouldn't take on more foreign debt than they can pay off in the first place, and one day if we're lucky some of them might actually learn it.

Posted by: MattXIV | December 18, 2006 6:35 PM