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  • Martin Schmalzried

Inflation and price stability: why Central Banks have it backward


The current obsession with “price stability” and inflation targets of modern central banks, and particularly the European Central Bank (ECB), is so ingrained that it is a near religious doctrine which cannot be questioned. But the present situation, with zero to negative interest rates coupled with very low inflation, or even deflation in some cases, calls for a re-assessment of what actually is inflation and the associated concern over price stability.

The necessity for price stability is easy to understand. How could an economy function properly if there is constant uncertainty about prices? How could businesses plan ahead if they have no idea how much goods/services they need to operate their business will cost? Of course, the complex derivatives market and various insurance schemes can compensate somewhat for that uncertainty, hedging against the sudden rise of certain commodities like oil or raw materials. But in a situation where everything fluctuates chaotically, on a systemic level, that cannot be hedged against (hence the quote from AXA CEO that a world with a 4°C temperature rise is “uninsurable”).


How price stability should be achieved is much less obvious. And reducing price stability to inflation is way too simplistic. So let’s examine inflation in a bit more detail. Most mainstream economists would measure inflation by looking at the evolution of a basket of goods (called the CPI or consumer price index) and simply spew out a percentage. But the mechanics of inflation are much less clear. How does inflation even occur in the first place? The simple answer is that inflation is the result in the discrepancy between the amount of money in an economy and the number of available goods/services. If the monetary mass grows too much compared to goods/services, inflation skyrockets. If the monetary mass shrinks (in the event of a credit crunch for instance), prices go down and you get deflation. Both situations are bad for an economy. The 2% obsession is deemed the right compromise, to encourage people to spend so they don’t hoard their money, but not to the point where they want to quickly get rid of any money they hold and convert it into hard assets.


Still, there is a misunderstanding of where inflation initiates from. How do economic actors come to the conclusion that they should raise their prices? Do they look at demand charts which they would interpret as a proxy for the monetary mass and in case demand increases they would raise their prices owing to the inability to create more goods/services? Economists too readily assume that economic actors are “rational”, the famous “homo economicus” paradigm. But it’s hard to find evidence for this. Inflation often looks more like an uncoordinated guessing game of companies trying to predict the future and anticipate future demand or future rise/fall in prices, to make sure their cash flow stays at decent levels than a rational coordinated and informed decision. Other actors simply increase prices to make up for budget deficits. States providing public goods/services can increase prices of public goods/services simply to rake in more tax revenue to compensate for poor budgetary management. But such a theory will not help us understand inflation or indeed, influence it. If it rests on human psychology or factors which are unique to each company/State, then good luck to model or predict anything or indeed, influence inflation via such remote and blunt policies as central bank interest rates.


Let’s first examine some common misconceptions and myths about inflation.


Inflation happens when the monetary mass increases too much compared to the available goods/services.


This one may be intuitive, but it is wrong. Take the following example: imagine if tomorrow, all banks decided to add a zero (multiply by 10) the amount of money available on every single account of every single person. Would that lead to inflation? Some economists would say yes. Prices would instantly follow and be multiplied by 10 as well. But calling it “inflation” is misunderstanding what it actually means. Inflation means that you can buy less with the current available money in the future than in the present. In this example, every single person retains the exact same purchasing power as before. Why? Because the new money injected into the economy was distributed symmetrically. Inflation thus only happens when money is injected asymmetrically into an economy, and someone gets to the “fresh” money first, before it trickles down to others (every person’s expenditure is someone else’s income). So take the following example: if banks only added a zero to the bank accounts of half of the population, how would that translate in terms of inflation? Would inflation be 1000%? Not really. For the half that got the fresh money, from their relative perspective, they are experiencing deflation of around 1000%. Things got temporarily cheaper. Unless of course prices adjust and are multiplied by 5 or so. Then they only experience a 500% deflation. The people that didn’t get the “bonus” are experiencing a huge inflation however.

This is one of the reasons why the current money printing strategies don’t cause inflation. If the money never reaches the people, and the money gets hogged by a select few actors who use the money for other things than buying consumer goods, then it’s other price indexes which will go through the roof, like stocks for instance, or existing real estate. And of course, this will inevitably increase inequalities. This state of affairs is of no fault to institutions like the ECB however. Given its current unwillingness or inability (that still remains unclear) to distribute money in a symmetric way, it cannot help but generate these unwanted side effects since it doesn’t exert a granular control over how the money it creates flows through the economy.


Of course, the example above only works in a closed economy (with no imports/exports) and with no debt. Adding a zero to all accounts would wreak havoc in terms of imports and exports, and even if done symmetrically, in a debt based system, would cause real inflation since everyone could easily repay their debt (since everyone has 10 times more money, but the debt, unless adjusted to inflation, is 10 times cheaper to pay back) which would instantly translate into a lot of demand side pressure, triggering huge inflation. But keep in mind the effects of debt on inflation as it will be key in the following steps.


Inflation is just a monetary phenomenon linked to excess money in the economy


This one is also wrong. Not that inflation doesn’t happen in such a way, but limiting it to this phenomenon lacks understanding of other ways via which inflation manifests. It is obvious that if every person had a magic printer allowing them to print fresh money, it would lead to hyperinflation. But focusing on events in history where governments have abused the money printing press and debased their currencies makes economists and monetary policy analysis blind as to how inflation, the regular type, appears in the economy, and how to influence it in a subtle way rather than a “money printer gone mad” way.





Inflation can be measured via CPI (consumer price index)


This final one also is inaccurate. Measuring inflation by checking whether consumers have access to the same amount of goods/services from an index or basket over time is highly simplistic. It only looks at price and it only looks at the present, thus discounting many criteria which are highly important. First, the selection of goods/services included in the index are controversial. Should housing be included? What about stocks? If all families should save up for their retirement, then stocks should be included, and then inflation would likely be much higher. Second, the price of a good/service is only an imperfect proxy for inflation. What about the quality of the good? It’s expected life span? For instance, if an agro-business manages to lower cost of production and thus the price, but the resulting good is much worse in terms of nutritional value and health, prompting the necessity to take medication for an increase in certain illnesses associated with such a bad quality product like diabetes or obesity, does it count as inflation or deflation? Finally, inflation via CPI doesn’t look at the future. For instance, how do you price in externalities of companies which pollute our planet in order to provide cheap goods? The cost for society, in the long term, when factored in, would mean that inflation is already very high, but measuring the price of a product without externalities would signal price stability or even deflation in some cases. A simple metaphor are special mortgage loans where you only pay the interest the first five years, and then you have to start repaying your capital which makes the level of your installments skyrocket. If you put the price of that mortgage in an index, it would look like deflation the first five years, then hyperinflation once the higher level of installments kicks in. The same can be said about the impact of long term pollution and climate change. You don’t really see the effects on prices for a while, until you suddenly do, to a point where no central bank policy can stabilize the situation.


So what is inflation then?


The basic premise of the present article is that inflation is the direct result of the level of interest on loans. Economists might smirk at such a statement, but they understand it backwards. In mainstream economic theory, raising interest rates should lower inflation since it discourages spending and encourages savings whereas lowering interest rates should boost inflation since it encourages spending and discourages savings.

Well, actually, it’s the exact opposite.


Let me show you how via a very simple example.


Take a basic economy with a business selling goods to consumers. Assuming that productivity is stable, if the business’s production capacity is at a maximum, imagine that the business takes out a 100€ loan at 10% interest rate to finance the purchase of all it needs to produce certain goods, to be repaid the next day (so 110€). If it managed to produce 10 goods, how will it price those goods? A minimum of 11€ each, since otherwise it would not be able to repay the interest on the loan.


In other words, the interest on existing debt is what sets prices, or at least a floor on prices, not consumer demand. It's a "cost push" phenomenon where the cost is directly influenced by the cost of borrowing money or interest rates, as opposed to the theory that consumers are willing to indebt themselves silly and spend like there is no tomorrow because interest rates are low.


This explains quite simply why central banks can go negative on interest rates and still obtain no inflation. If you go negative on interest rates, you simply allow businesses to roll over their existing debt cheaper, thereby saving on the interest rates that they needed to pay, thus removing any incentive or need to increase prices to remain solvent. On the contrary, they can keep prices constant and pocket the spread resulting from the lower interest rate loan or pay the profits out to shareholders, who might simply keep the money invested without spending it. The reason why economists can’t understand this relationship is because it’s not a “straightforward” one like their idea of increasing/decreasing spending, which is immediate. In the “real world” (as opposed to their theoretical models), businesses take out multiple credits at different interest rates, overlapping in time, which means that while some businesses have to raise prices in order to pay for older debts at high interest rates, because they are unable to refinance their loan (typically the case for SMEs), other businesses can lower their prices thanks to cheaper loans available to them at that point in time (typically the case for Zombie corporations, or any corporation which presents a systemic risk to the financial system), and so you can get a lot of different signals in terms of inflation depending on the situation of the business, its current financial commitments and its ability to access cheap credit at low, no or even negative interest rates.







In the two graphs above, you can see that inflation and interest rates are highly correlated, except that the relationship between the two is direct and not inverted as in most economic models. To think that raising interest rates lowers inflation is like thinking that it’s the tail that wags the dog. The only reason why raising interest rates, in the end, lowers inflation is simply because it causes so many bankruptcies and puts so many people in financial difficulty that eventually, inflation falls. In other words, inflation stops at a certain point when raising interest rates because of the deflationary effects of putting so much stress on an economy. It’s like saying that by chopping your arm off, you have successfully healed your broken bone. Technically, you don’t have a fracture anymore. But you’re missing an arm. The same applies to economies hit by higher interest rates to stifle inflation. Inflation falls because the economy loses an arm, not “thanks to” higher interest rates. You could say that basically, interest rates have a direct relation with inflation, except above a certain threshold (when interest rates are too high) which puts an end to inflation through an economic crisis, and also, possibly, below a certain threshold. Once interest rates go negative, then we are in uncharted waters and there is no telling how inflation will react. We see some of the perverse effects now already, where there is an inflation of certain assets and the stock market, but no inflation in consumer goods. How would consumers react in case a negative interest rate is applied to their savings? I don't really want to find out. What is clear, is that micro-managing the economy through interest rates can only go so far. It is a strategy which is far from subtle, much like trying to kill a mosquito with a sledge hammer, and could end up doing more damage than good.


So all in all, if you set profit margins as stable over time, then inflation at a certain point in time should track the evolution of the aggregate level of interest that businesses have to pay at that moment (or the cost of money). For instance, if you took 10 businesses and calculated the average interest rate they need to pay to service their loans, then inflation on the goods they sell would track the total revenue of the companies, minus their profit margin and all other costs. Interest rates or the cost of fresh money is directly factored into the operational cost of companies and therefore invariably affects prices.


Now, I’ve written above that consumer demand doesn’t affect inflation. In fact, it doesn’t, except in exceptional situations like this pandemic. Typically, consumers have rather steady consumption patterns, with "incompressible" costs, food, leisure, transportation, energy… all being rather smooth except in cases of external shocks. Advertising, marketing and social conditioning molded people into steady consumers in order to serve the needs of a “system”. People don’t grow an extra stomach to eat twice more food, or grow a third hand and second pair of eyes to look at two smartphones at once. Demand is rather artificially created via advertising, social pressure and the likes than real “needs”, which are met by most people living in modern western democracies. But there is another factor which affects consumer demand: interest rates. If they remain high, or if consumers are at high levels of debt, this affects their purchasing power, and thus inflation.

Today, we have the perfect storm:

  • A high level of (private) indebtedness which puts pressure on demand, on top of the fear sparked by future uncertainty owed to the virus which prompts consumers to turn into squirrels saving every nut in preparation for winter.

  • Very low interest rates which create a disincentive to raise prices thanks to the cost savings of rolling over existing debt with cheaper loans.

  • A lot of the excess money created is sucked out of the economy via dividends, “bonuses”, and serve only to inflate the prices of assets, exacerbating inequalities. Normally, fresh money injected into the economy should be converted into goods/services and decent salaries for workers, allowing them to consume those goods/services produced. If money leaves that virtuous circle and stagnates in the pockets of the ultra-rich, then there is no way inflation will pick up anytime soon.

So in summary, inflation can be better understood as the discrepancy or imbalance between the demand for money and the demand for goods/services. There is a natural demand for money which stems from the fact that the current monetary system is debt based. Next time you open your bank account, and look at your balance, realize that 95% or so of the total balance of your bank account is someone else’s debt with varying maturity. Part of it may need to be repaid tomorrow, some of it in a year, and another bunch in 10 years or more. So if every consumer stopped spending, someone, somewhere, could not repay his/her loan.

Price stability is reached when the demand for goods/services tracks the cost of money or the “demand” for money, which is directly linked to interest rates and the level of indebtedness of an economy.


There is no easy way out of the current crisis, and price stability is likely to take a big hit in the future, as most policies ignore the mechanics explained in this article. And as the saying goes: you can lead a horse to water, but you can’t force it to drink. But central banks seem certainly ready to try! That is a risk brought about by CBDC (Central Bank Digital Currencies), which could enable central banks to easily charge negative interest rates on people’s accounts to “encourage spending” to revive inflation without triggering a bank run for cash.

One alternative would be to think of a way to inject money into the economy in a way which respects symmetry, and at the same time, solves certain problems like consumer confidence which lowers demand. Helicopter money, in this respect, comes close, but not close enough. While symmetry is respected, a “one off” check doesn’t solve the psychological fear of future uncertainty and acting like a squirrel. Proof can be seen with the Fed’s check sent to American households. A sizeable chunk of it landed into Bitcoin, which is a sign that many people have lost faith in the monetary system and prepare for a debasement of the currency or worse.


The Relative Theory of Money, on the other hand, may prove to be a much more sustainable and viable solution to stabilize prices and our economies. Let’s see what the future brings!

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