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The Beatings Will Continue Until Morale Improves

There was no new growth-related news today, but the markets continued to adjust to last week’s news. After getting smacked twice last week on the same news, markets seem to be shrinking from contact. Oil prices fell 1.5%, and other commodities besides metals (notably Softs and Grains, each down about 3%) were weak. Stocks dropped 1.1% and seem anxious to re-test the lows for the year which lie a mere 3% away and coincide with the 200-day moving average on the S&P.

Nominal and inflation-indexed bonds were both essentially unchanged, and volumes overall were light.

News off the Continent was also anti-climactic, but stocks in Peru dropped 12.5% on the victory of Hugo-Chavez-Facebook-Buddy (and former rebel) Ollanta Humala won a runoff election. This would seem like a one-off affecting only Peru, and perhaps it should be. Indeed other emerging markets ignored the first 9% or so but ended up closing lower. From a practical standpoint the vehicle for contagion is the fact that investors often participate in EM via funds and those funds will take a (small) hit because of Peruvian investments. To the extent that investors scale back EM positions as a result, it will affect many related (perhaps I should say “associated”) markets. Fortunately, Peru’s weight in the indices is pretty small, so even the 18% fall from the highs of last month will have only a small direct impact and the bigger effect is likely to be emotional. But this bears watching.

In a week with little in the way of scheduled economic news, it isn’t surprising to see previously-established trends following through. There is no economic data due tomorrow either, so I expect the beatings to continue.


I read an article recently entitled “Inflation as a Redistribution Shock: Effects on Aggregates and Welfare” that is interesting because of the non-intuitive conclusions it draws. Although the paper is five years old, it comes from the respectable NBER and one of its authors was in the Federal Reserve System when the article was written.[1]

The paper concerns the effects of unanticipated inflation. We all know that unanticipated inflation transfers wealth from lenders to borrowers (although anticipated inflation does not – if the inflation is anticipated, it is reflected in the nominal interest rate), and that also implies that unanticipated inflation causes medium-wealth households – who tend to be borrowers – to gain at the expense of higher-wealth households, and for domestic households as a group to gain at the expense of foreign (nominal) bondholders. The authors also found several redistributive effects among age cohorts, and overall; for example, even though unanticipated inflation has a ‘persistent negative effect on output,’ it surprisingly improves the weighted welfare of domestic households. From the paper,

“Despite the fact that inflation-induced wealth changes sum to zero across agents, the responses of winners (net borrowers) and losers (net lenders) do not cancel out. Among households, the key asymmetry is that net borrowers tend to be younger than net lenders.”

This leads to various effects on the supply and demand of labor and of savings that flow from the fact that a windfall received by the young causes different behavior changes than the (opposite) effect of a negative wealth shock paid by the aged.

But the really interesting part of the result is that most of the losers in a period of unintended inflation can be compensated fairly easily from the windfall that the government experiences (since the government of course is a huge lender). Again, from the paper:

“Thus, while the poor as a group experience a negative direct redistribution effect, this loss turns out to be easy to compensate, precisely because it does not take much in terms of transfers to improve the well-being of the poor.

“From a political economy perspective, these findings lead us to conclude that the government can adopt simple fiscal policies in reaction to an inflation shock which imply that the shock benefits a majority. Thus, policymakers may be tempted to inflate the economy not just because they take some direct interest in the fiscal position of the government, but also because such a policy may actually have wide support if the losers from inflation receive some compensation. It is intriguing to observe that the U.S. inflation episode in the 1970s started right after Social Security was first indexed to inflation in 1972. While this policy change is unlikely to have been the main cause of the episode, it certainly lowered the political cost of inflation…” [emphasis added]

And in their conclusion:

“Our findings therefore lead to some doubts regarding the conventional wisdom that low inflation is always in the best interest of the domestic population. There is a sizeable fraction of the U.S. population which would stand to gain if another inflation episode such as the one in the 1970s were to occur…

“One of our key findings is that the cohort welfare effects are highly sensitive with respect to the fiscal policy regime followed by the government…If the windfall is used to raise pensions, …the poor as well as the old middle class are compensated for all their losses, and most groups, apart from the very rich, stand to gain from inflation.”

Well, oh my as my sainted aunt might have said. This is an interesting thought process, because the conventional wisdom (and what the Fed has said many times through many different mouthpieces) and research generally holds that aggregate social effects of an inflationary period are negative, at least partly because of economic frictions created by rapidly-changing prices. But these authors illustrate that isn’t necessarily true when one considers the different effects that inflation has on different economic actors, and the way government can respond.

It isn’t like the Fed needed any more ammunition to risk an inflationary debacle; they’re doing that already. But it is worth thinking about whether we might have it all wrong, and that all the talk is mainly meant to ensure that the inflation remains unanticipated. What if the Fed was actually trying to cause a general inflation? Especially if you’re one of the “very rich” who would be sacrificed in that situation, it is worth considering that possibility!

[1] Although in itself this isn’t particularly noteworthy. The Federal Reserve System is far and away the most popular single U.S. destination for economics PhDs.

  1. Frank R
    June 6, 2011 at 6:07 pm

    I disagree. Entitlements (I hate that word!) like Social Security are partially (the price inflator understates inflation) adjusted only annually and are backward looking. Therefore, in a situation of rising inflation, recipients will always be behind the curve. The very rich (banksters and political cronies) get first access to any new monies generated by goverment spending and therefore the most benefit, much like Mises’ ‘Ruritanians’. As we move down the food chain, the benefits get substantially diluted and less equitable. And, the banksters get to dump their bad loans on the rest of us before they default. Heads they win, tails we lose.

    • June 7, 2011 at 6:33 am

      I think the authors’ point, though, is that the old poor are vastly better off WITH Social Security than without, and moreover the government could make changes to correct whatever problems there are at a comparatively low price (at least, compared to the windfall the government receives from inflation).

      Banks do very well because they are heavily indebted. But the rich bankers themselves are usually heavy owners of debt and will lose a great deal of real value in an inflation (although there will always be exceptions, like the guy who owns 12 homes and no Treasuries).

  2. Fred Scharar
    June 6, 2011 at 9:26 pm

    If inflation increases, wouldn’t interest rates follow? Higher interest rates would result in gov debt service problem get even worse!

    • June 6, 2011 at 11:03 pm

      Hi Fred! Yes, it would make the debt service problem higher in nominal dollars, but the principal problem (that is, the principal that had to be repaid) would be much less and the debt service problem itself might not be as bad as you think. Consider as an extreme case the situation where the government suddenly adds a “0” to the currency, inflating the price level instantly by 10x, but then makes a credible promise to not inflate further (say, they decide to adopt the Euro, which they don’t control). In that case, interest rates will not increase at all – expectations for future inflation haven’t increased – but the price level has multiplied 10x. So the government has 1/10th the real debt, and the same (nominal) debt service.

      The bigger problem is that many of the government’s liabilities are ‘real’ in nature (e.g., Medicare, which essentially is a promise in units of medical care, not dollars). However, the government could abrogate those promises with a stroke of the pen, and it wouldn’t even be considered a default…

      Nice to hear from you!

  3. Matt XIV
    June 8, 2011 at 11:32 am

    I think the problem with this strategy would be creating unexpected inflation without creating ever increasing amounts of expected inflation. Lenders will get wise to the central bank saying that they’re going to target a given inflation rate and then expanding the money supply even more to beat expectations, which will create a positive feedback loop for expected inflation as lenders price the efforts to beat the official targets into their estimates, requiring the central bank to beat the targets by ever greater levels to create unexpected inflation. This cycle would likely only break down when the expansion of the money supply translates directly into an equivalent amount of excess reserves since there’s nobody left worth lending to, making the broad money measures, and thus prices, controlled by endogenous factions. That would leave a situation where inflation that’s as high as endogenous factors will allow it to be and a central bank whose targets aren’t considered credible, and thus will have a very difficult time bringing it back down.

    • June 8, 2011 at 12:06 pm

      Good point. This was a single-shock model and the expectations effects were pretty optimistic.

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