Not long ago, I wrote a column in defence of central banks. Some readers were quick to disagree. Central banks had failed to maintain “the real value of our fiat currencies”, wrote one, urging me to ponder how inflation had eroded the true value of savings over the decades.
A glance at Venezuela, where inflation over the past year has been more than 100,000 per cent and the economy is breaking down, reminds us that this is no idle complaint. Central banks must keep inflation under control. But what does “under control” mean? How much inflation is too much? And — a question only an economist could ask — how much inflation is too little? It goes without saying that hyperinflation is an economic catastrophe, so the first thing to check is whether hyperinflation is likely in an advanced economy — or indeed a competently governed country of any sort. It is not.
In 2012, economists Steve Hanke and Nicholas Krus assembled a list of every confirmed episode of hyperinflation in history. There weren’t very many: 56 in total, mostly in the 20th century, to which we might add recent outbreaks in Zimbabwe, Iran, Venezuela and perhaps North Korea. France suffered a bout in the 1790s, but most instances of hyperinflation occurred either in central European states after the first world war (including the infamous crisis in Weimar Germany), or during or immediately after the second world war (including Hungary, history’s worst example of hyperinflation), or in the eastern bloc as the Soviet Union disintegrated.
Hyperinflation does not strike at random, and it does not happen because central banks briefly slumber. It must be manufactured by the relentless printing of money, generally as the last resort in the face of political dysfunction alongside a severe fiscal crisis. Perhaps it is rash to say so, but I think we can set aside fears of hyperinflation in an advanced economy today. If it ever does happen, it will be only one element in a far more comprehensive economic disaster.
But the readers who emailed to complain about inflation did not express concerns about hyperinflation. They are worried about low-level ambient inflation, the kind that central banks not only tolerate, but actively seek. Central banks do not try to maintain “the real value of our fiat currencies”, but to erode them, typically by 2 per cent a year. They have often been explicitly instructed to do so by elected politicians.
Are those instructions wise? Even 2 per cent inflation will halve the value of money in 36 years. That seems bad, but let’s try to pin down why it might matter. It may help to remember what it is that we expect any good currency to do.
First, we want it to serve as a medium of exchange, allowing me to pick up a loaf of bread without having to persuade the baker to swap it for a copy of The Undercover Economist Strikes Back. Inflation at 2 per cent a year — or 5, or even 20 — does not prevent money serving as a medium of exchange.
The second, and perhaps most fundamental, role of money is as a stable unit of account. It helps us understand the economic forces around us, whether a particular product is expensive or cheap, without resorting to a calculator. Hyperinflation destroys that. “Are we ruined or in clover?” asks a character in an Erich Maria Remarque novel set in the Weimar hyperinflation. No one knows. But moderate inflation will not boggle minds on a trip to the shop.
Inflation does more obvious damage to money’s third role, which is as a store of value. If you stick your currency under the mattress then inflation will hurt you. It will also hurt if you have a non-indexed pension, or cannot find a high-interest savings account. Normally, however, a well-functioning financial sector offers returns to compensate for inflation.
That has not been the case since the 2008 financial crisis, of course. But the pain savers are feeling is not because central banks have carelessly let inflation take off. It is the result of a deliberate policy of low interest rates to stimulate spending and investment. Perhaps this policy is a mistake, perhaps not. But it would be wrong to view it as a dereliction of duty.
Another source of pain is governments’ fondness for using inflation as a way to grab a bit more revenue, by taxing nominal interest payments. It’s an insult for savers, but let’s be realistic: the tax would be levied somehow anyway. Inflation is sometimes the taxman’s chisel, but he has other tools.
It is surprisingly difficult to find any serious costs to low levels of inflation. In contrast, the benefits are easily stated: more room to stimulate the economy in a recession, and more room for real wages to adjust if they must. Olivier Blanchard, during his time as chief economist of the IMF, even floated the idea that the inflation target should be 4 per cent, not 2 per cent. He is by no means alone in that opinion. Like a low dose of aspirin, a low dose of inflation is unlikely to do much harm — and it can prevent an economic heart attack.
Written for and first published in the Financial Times on 8 Feb 2019.