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Inflation is overstated in the long run going backward and yet understated in the short run going forward

February 27, 2012

How can I possibly hold two such apparently contradictory views simultaneously? Simply put I don’t believe in inflation as it is commonly understood. Of course nobody really ever defines the word ‘inflation’ before starting to talk about it, but the intuitive idea is that stuff gets more expensive than it used to be.

If that’s the definition, then I believe “stuff” is getting cheaper all the time. That’s because our economy is really good at producing substitutes. New stuff is cheaper by definition. Take your favorite all-purpose electronic tablet. Just ten years ago it did not exist and its price was therefore infinite. One might object that straightforward Econ theory predicts the price of a good to rise as it becomes more and more scarce. But in fact we never run out: at the first inkling of a price increase we find a substitute and toss the old for the new. There are of course notable exceptions, such as healthcare and education, but those are services and there too the innovations and “new ways” of doing things could be underestimated.

What this discussion points to, however, is that prices are moving in every which way direction. Some are going up, some down, and what really matters is their relative trends. Trying to aggregate such immensely vast array of inter-relationships into a single percentage number is patently absurd. Not only that: our tastes and desires change over time, so it’s only correct that the distribution of prices continually change.

But what about the activities of the central bank? Can’t they create hyperinflation by printing money like crazy? Can’t they create hyperdeflation by crazily not printing enough money? Possibly. The central bank is just a bank, it mainly gives money to other banks that then juggle it among themselves, so what? Actually whatever new money trickles out probably only contributes to disrupt the monetary signals that have already emerged and in any case such leakage would be highly concentrated in space. The analogy is with the BP oil spill of a few years ago. There’s no doubt that it polluted a lot of water, but the ocean is a truly vast entity and the overall impact was diluted. The modern US economy is likewise enormous, especially with it’s ability to create “new” ways to extend credit, new leverage strategies, etc…It’s questionable whether the central bank is actually having an impact at all.

Still pollution is pollution, even if localized, it can still be pretty bad and at the margin make things overall worse. Because of its impossible task most of the central bank activity can be equated with pollution. In the short run going forward this amount of smoke and disruption can matter and can be understated.


From → Inflation

One Comment
  1. I have now changed my mind on this, since I started reading Scott Sumner.

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