Why we must stop fearing inflation

According to Alan Greenspan in Friday's Financial Times, the biggest threat to the world economy is a resurgence of inflation. That's right. While the rest of us worry about ever-increasing unemployment, shrinking global GDP, declining trade, collapsing demand, Greenspan tells us the real nightmare is none of these, but instead the potential prospect of inflation—even though this year it will probably be under 2 per cent.

This should not surprise us. Throughout his career, it has been the interests of the financial sector that have most concerned the former Fed Chairman. And it is the rentier class that suffers most from inflation.

Indeed, it is a sign of their dominance that the rest of us, for whom inflation can actually be beneficial, have been conditioned to fear it. If you lend money, like banks and financiers, inflation means you are being paid in depreciated cash. But if you borrow money, as do most households and entrepreneurs, inflation is a subsidy that stimulates investment and demand. Inflation penalises lenders and benefits borrowers—and most of us, by the way, are net borrowers.



Perhaps this is why Paul Krugman, Brad DeLong and Ken Rogoff all suggest that higher inflation may be the only medicine that will cure the financial crisis. By increasing the value of real assets and reducing the cost of debt, inflation cleans up corporate and household balance sheets and so stimulates spending. But if money is squirreled away, as it is today, neither consumed nor invested, aggregate demand is inadequate and the economy shrinks. By letting real interest rates go negative, inflation stimulates investment, increases demand and thus allows the real economy to grow. Right now, then, inflation should not be feared, but rather encouraged.

John Maynard Keynes tells us that there are two kinds of businessmen: entrepreneurs who provide real goods and services and the financiers who lend them money. Most neoclassical economists ignore this vital distinction but Keynes knew that the interests of these two classes are often opposed. Inflation damages the rentier but aids the entrepreneur.

As long as wages rise as fast as prices, inflation does not have to penalise workers. The long-criticised 1970s saw real wages rise faster than they ever have since. Inflation fundamentally is a tax on wealth: holders of liquid assets and lenders of capital get repaid in depreciated currency. They lose. But inflation also creates winners. As money looses value, the price of real assets inevitably rise. While deflation makes investment more expensive (you have to pay your debts in ever more valuable money), inflation creates an incentive to turn cash into real productive capital goods.

Keynes aspired to “the euthanasia of the rentier.” In the postwar decades, his dream came true. Banks were like utilities, their profits not outlandish, the financial sector rewarded in line with the rest of the economy. This policy regime was spectacularly successful. Reinvested profits modernised the economy. Growth was massive. Real wages more than doubled in less than a generation.

But for the past 30 years, policymakers have put the interests of finance first, before the interests of entrepreneurs and certainly before the interests of workers. And compared to the golden postwar age that preceded it, our era has seen anaemic growth, increased inequality, repeated bubbles and busts. Despite the increasing financialisation of the economy, despite interest payment rising from 1 per cent to 16 per cent of GDP, real investment has declined. And it is real investment that is the ultimate engine of growth.

Greenspan’s obsession with inflation reflects his conviction that what is good for the banks is good for the rest of us. But financialisation has hurt the economy, making huge profits for a handful of bankers while doing little to promote real investment and make us more productive. Our policymakers need to focus on the needs of the real economy, not on the desires of the financial sector. And perhaps the first step is to stop fearing inflation.