As reported in the December 18 edition of Grant's Interest Rate Observer, the deputy governor of the Swedish central bank recently told a press conference that a just completed reduction in interest rates would fail to bring the rate of rise in the CPI back up to the bank's target of 2% (as of November, the inflation rate was running at minus 0.5%). This is a rare admission by a central banker of something which has been clear since the connection between the financial and physical worlds was severed in 1971 with the removal of any remaining official links between the US dollar and gold, that is, that governments prefer inflation.

Inflation results when the rate of growth in the supply of money is greater than the rate of real economic growth, and is often a byproduct of government spending in excess of its income. As a government takes on more debt in order to fund the vote-gaining promises of politicians and its own expansion, a large portion of this debt is monetised by the central bank and the nation's private banks. The money supply is thus increased, lessening the purchasing power of the national currency. For large debtors, a category into which most governments fall, a reduction in the value of money has the positive effect of reducing the repayment burden.

As well as the benefit of being able to repay debts with a currency that is worth significantly less than it was when the government borrowed it, inflation has other short term political advantages. The initial effects of inflation, such as rising wages and asset prices, can be quite pleasant and give the appearance of prosperity. Later in the inflationary cycle interest rates and business operating costs increase and price signals become confused, causing misdirected investment. Profits decline, unemployment soars, and the government feels obliged to take on more debt to fund ever-expanding welfare programmes. However, this will hopefully not occur until after the next election.

The government also increases its income via inflation. As wages rise in response to a reduction in the purchasing power of money, income tax revenue grows. An additional boost is received as people move into higher tax brackets due to wage inflation. In this case the individual tax payer will probably find that his out-goings have increased in proportion to his salary so that his net disposable income, after tax, has actually declined. However, inflation provides a politically acceptable means of generating higher tax revenues without the need to raise taxes.

Although governments prefer inflation to the alternative, they have an incentive to minimise the reported inflation rate. Many social security payments are adjusted each year based on the CPI, so a lower CPI will result in lower government expenditures. Also, a lower reported inflation measurement will create the appearance of fiscal responsibility and allow nominal interest rates to be maintained at artificially low levels. As such, most governments have manufactured price indices which are based on an extremely complex set of calculations. These indices not only take into account changes in the prices of a selected basket of goods and services, but also consider changes in labour productivity, product quality and product type. The calculations themselves are regularly revised, making comparisons to past times very difficult. As well as opening the door for manipulation of the reported inflation level, the method of inflation measurement employed by virtually all governments neatly shifts the blame for inflation from the government to the private sector. If the prices of goods and services are increasing at an unacceptably high rate then this must be due to greedy businessmen or militant unions or a foreign oil cartel. If a more objective and realistic means of measuring inflation was used, one which considered changes in the supply of money as the primary ingredient, then there would be no confusion regarding the source of the inflation. Such a method would also have the advantage of providing a consistent measurement irrespective of whether the effects of inflation were being observed in the prices of goods, services, property or stocks.

In the US these days inflation has become an absolute imperative for a reason apart from the indebtedness of the US government. That reason is the level of indebtedness of the US consumer. The average US consumer has accumulated large debts and has virtually no cash savings, with the majority of the borrowed money having been ploughed into the stock market. We now have a situation in the US where profit growth is non-existent and the average price earnings ratio of the companies in the S&P 500 index is far higher than it has ever been at any previous peak, yet the stock prices of most major companies continue to surge even higher. The reason behind this most unusual scenario (manias such as this only occur once or twice a century in any given market) is the US monetary authorities' profound fear of deflation. Had the bear market, which began in July 1998, been allowed to take its natural course, then a severe recession would have ensued. Personal bankruptcies would have soared, unemployment would have increased, tax revenues would have shrunk, and government debt would have grown. The resulting contraction in credit and escalation of loan defaults would naturally have caused the money supply to decrease. Apart from the obvious political fallout from such an eventuality, deflation presents another hazard for the incumbent government. Nominal interest rates cannot go below zero meaning that a sustained deflation would likely result in a period of high real interest rates. If such a situation were to occur then even those who had borrowed money at a variable rate of interest would be in trouble. Those debtors who had supposedly mitigated their risk by fixing the interest rate on their loans would be in dire straits. As a consequence of the extremely large amount of debt being carried by the US consumer, deflation would lead to debt default on an unprecedented scale. These defaults would, in turn, magnify the extent of the deflation. The US would then find itself in a Japanese-style predicament whereby its entire banking system would be insolvent. The bottom line is that when you have fomented a bubble, deflation is your ultimate enemy.

It is a matter of historical record that deflation was not permitted to occur in the US (or in Europe) during 1998. In fact, the collective feet of central bankers in the US and Europe were firmly planted on their monetary gas pedals throughout the second half of 1998. In the US the total supply of money increased at an annualised rate of over 17% between August and December. Since new money comes about as the result of a loan, an increase in the money supply can be equated to an expansion of credit. So, we had a dramatically over-valued stock market fueled by an enormous credit expansion and now we have an even more over-valued market fueled by a further expansion of credit. When this thing ends in disaster, as it inevitably must, the "fix" will no doubt be to once again inject a huge amount of money into the system. When this happens, some people might even begin to understand the true nature of modern money and decide to buy some gold. Stranger things have happened.

Milhouse
Hong Kong
12 January 1999

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