Comment Response Round 2 for Today

by robekulick

Another comment from someone I don’t know today! It’s been an auspicious day for my little blog. So Jonny writes:

“your analysis intrigues me…
but, if long term inflation seems imminent, wouldn’t corporations seek to maximize profits in the short-term?  while i admit inflationary lending can encourage spending, doesn’t the model fall apart when the disparity between rich and poor keeps increasing?
the poorest of a nation can be thought of as a lower boundary of an economy, and inflation certainly discourages long-term cash holdings for them.  even throughout the middle-class, this will be true to a certain extent. but applied to multi-national corporations and banking conglomerates, i believe this model lacks the utilities to accurately predict economic fluctuation.
as to an answer to the problems that face us now… i get the feeling economists are dancing around the real issue, which i am more convinced then ever is a problem with scaling:
billionaires don’t fear inflation.
the answer can’t be to create more billionaires (or even trillionaires).”

Income inequality is a huge issue, so before I respond, I want to divide the issue of income inequality into three issues:

(1) Income Inequality as a Moral Issue

(2) Income Inequality as a Long-Term Economic Problem

(3) Income inequality as it Relates to the Current Economic Slump and Monetary Economics

Issues (1) and (2) are huge issues which I’ll have to ignore for the moment. By ignoring them, I don’t mean to say they’re not important issues–they are, but they’re unrelated to the issue at hand.

So I have heard this line of argument before and so I’m very glad to be getting the chance to respond to it. There are three particular points I will make in response to this argument.

First, Jonny contends that inflation will hurt the poor and benefit the rich. I think empirically, the opposite is much more likely. As explained  by Ken Rogoff in the piece that started this string, one of the proximate causes of this recession is the indebtedness of the American consumer. However, one man’s debt is another man’s asset, and in general, the wealthy are the net lenders and the poor and middle class the net borrowers. (Think of all those banks trading in asset backed securities based on credit card receivables and mortgage loans). The thing about inflation is that since the vast majority of loans and other basic financial products are not indexed to inflation, inflation would likely reduce the real debt burden of the borrowing class while decreasing the value of the assets held by the lending class. Indeed, that is the mechanism by which it would help to induce spending by reducing the real debt burden.

Second, corporations maximize their profits subject to their constraints. By increasing the cost of holding dollars, corporations will face a situation where they either have to do something with those dollars or admit to investors that they have no use for those dollars and return them to shareholders. As that occurs, shareholders will sell their stock in corporations that can’t find good investment opportunities, because now their investments are essentially the same as holding cash, and investors don’t need highly-paid managers to hold cash for them indefinitely.  They can do that with a simple checking or money-market account. And of course, the value of pure cash will be going down, so the investors will be hungry for investments that return higher yields. Meanwhile, if the Fed also is buying risky assets from banks, banks will be less concerned about keeping money to insure that they meet their margin requirements. Banks exist for the purpose of making loans, and without the bad loans weighing on their balance sheets, their incentives will be to return to making the loans from which they make money. I should note on this point that it’s not as if banks are doing particularly well right now and this is to some extent because loans are their business. However, with the risk of a bank run over their heads, they are choosing to be cautious rather than to pursue profit as they usually do because insolvency is about the stiffest constraint there is.

Finally, the income inequality issue is really a proxy for the true issue of consumption inequality. It really doesn’t matter what the nominal value of a person’s money holdings are, what matters is how much they can consume relative to other people. In other words, the reason that income inequality is considered bad is because it means that poorer people have to consume less. The point when it comes to inflation is that a general increase in the price level might change millionaires to billionaires, but if at the end of the day those dollars are with proportionally less, nothing has really changed for them. Now, if this were the end of the story then inflation wouldn’t matter at all, but the problem with inflation is in a world where contracts are made in nominal dollars and where prices go up unevenly even if the general price level is rising, the burdens of inflation create real economic losses by reducing the efficiency of markets. But there is no a priori reason that inflation will necessarily increase potential consumption inequality, in fact, as I noted in my first point, it probably hurts the wealthy somewhat. Also, if inflation gets out of control, it hurts everyone, rich or poor. But since a revived economy would also benefit everyone, and a small amount of inflation shouldn’t cause too much economic discomfort, I think that the growing chorus of economists arguing for controlled inflation make a very strong argument.