To understand inflation, one must understand how money and resources are used by society.
For an economy to use resources productively, it needs vehicles for people to save money for the future with low risk, low transaction costs and with expectations of some real growth over time. By “real,” we mean “above inflation.”
There also must be vehicles for those who need to borrow money, whether for personal exigencies or profitable enterprise, to do so also at low transaction costs and with default risks to lenders managed. Lenders need to know that, averaged over time, they will get a real, above inflation, return on the loans they have made.
Furthermore, since the dawn of recognizable evidence, economic history shows that societies which, overall, limit current consumption so that surpluses can be used to expand future productive capacity grow faster and are more prosperous than those using up everything produced to meet immediate wants. Remember the ant and the grasshopper fable?
Ant economies achieve greater output and living standards than grasshopper economies. As in a one-time psych experiment, societies that can avert the temptation of the single marshmallow in front of them can then let their next generation produce more over time. Savings fosters better use of available resources, higher output over time and more satisfaction of people’s needs and wants.
Meeting the needs of households and businesses to save and to invest, and motivating society as a whole toward savings and physical investment for the future, require two categories of things:
First are well-functioning institutions linking savers with borrowers at low transaction costs and with risks identified and managed.
Second, there must be incentives for us to collectively let the marshmallow be, to delay satisfaction right now, so our kids can have better lives in the future. Moreover, there must be incentives that facilitate borrowing when prudent for the long run.
In market economies like ours, prices signal incentives for human decisions — hence the impact of today’s inflationary cycle.
Low prices — blueberries as a coupon special or six months interest-free financing on cars — tell us “these items are plentiful now. Buy them rather than something else.” Low interest rates tell us to buy bigger houses. They tell companies to build new distribution centers or buy new locomotives or spend $10 million developing ground-breaking software or a new medical device.
High prices, chicken up 80 cents a pound but ground beef is the same as a month ago, tells people to forget legs and thighs and make meatloaf instead. High interest rates tell people to make the Honda run another year and farmers to push the new hog barn somewhere into the future.
Modern industrialized economies like the United States don’t lack institutions — the intermediaries between savers and borrowers. We have a whole range, from traditional commercial banks to hedge funds to venture capital to cryptocurrencies. If anything, we have too many types of financial intermediaries, the risks of many we don’t really understand.
Where we fail right now is in proper incentives. Interest rates are “just a price,” as econ professors teach, but one differing from prices of everything else in that the supply of money affecting those rates can be changed in a second by central banks.
These central banks, and their vehicles to control the flow of money, developed over time to facilitate saving, borrowing and investing and to reduce risks from destructive financial panics that arose periodically in unregulated markets. Acting as “lenders of last resort,” they can stop bank collapses that could destroy people’s savings and halt commerce. Moreover, in normal times, they give smoothness and safety to financial flows.
Now consider what’s happening today. The U.S. Federal Reserve has fixated on its “preventing collapse” function for the past 20 years. In doing so, it has neglected its implicit function of ensuring that the price of money — interest rates earned or paid on savings or borrowing — establish healthy incentives for the longer run. These inherently must include positive “real,” or inflation-adjusted interest rates.
Saver-investors must, on average, get some real return for saving and investing. Otherwise they won’t do nearly enough of it for the good of society as a whole. Borrowers must pay a positive price when borrowing money. If they can repay for less, after inflation, than they borrowed, then too much money will be sought for frivolous consumption or for ill-advised business spending on facilities, machines or technology. All this fosters a grasshopper mentality.
Negative effects can compound. If saving is punished year after year and borrowing rewarded, with low rates, then more people will go on more cruises or buy more $60,000 pickups than they should. More steel will go into building cruise ships than is good. The list of examples of misallocated resources goes on and on.
Over long runs, real interest rates average out being positive even as they zig-zag with varying inflation and monetary policies. They were high in the 1980s as the Fed corrected its too-loose money of the 1960s and 1970s. Inflation was still high for some time, so before-inflation interest rates were sky-high by current standards. A 10 percent 30-year mortgage in 1986 was a real deal. Imagine that today.
Inflation, at least in the categories we measure for consumers, has been low for two decades. So nominal, before-inflation, rates can also be low. It is cheap to borrow. But financial firms that accept savings are desperate to find “yields” somewhere, so they don’t lose accounts to competitors claiming better ones. That creates risk.
Years ago, then-Fed Chair Ben Bernanke identified a global “savings glut,” as the problem, not faulty monetary policy. Perhaps. But some of those apparent savings were money created by the Bank of China and other Asian central banks. The hard truth for the grasshoppers on Wall Street remains that a spectrum of interest rates must return to long-term-trend levels. Lacking the courage to take away the punch bowl because the party doesn’t appear to be going strong enough will only delay the spillage when the legs of the table eventually get kicked out by circumstance.
St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.
Real World Economics: Moral of the story: save and invest - TwinCities.com-Pioneer Press
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