Getting money right

It must be puzzling and exasperating to the general public that economists still seem so clueless about perhaps the most important and central topic in economic policy, the money system. Yet a lot of economic news is about the problem of money – not having too little but the money system. The Fed has been trying to use unconventional monetary policy (“quantitative easing”) to boost the US economy out of its deepest recession since the 1930s. Gradually winding down that policy is now being blamed for financial crises in various emerging economies. The European Central Bank has been struggling to hold the Eurozone together through a mixture of statements and actions that have brought criticism from Germany’s constitutional court for being too extreme and from many governments of struggling southern European economies for being too little.

Money and monetary policy undoubtedly matter. The extreme of monetary failure comes in two version: inflation and deflation.

Extreme inflation, known as hyperinflation, is the more dramatic and the one that leaves the greater folk memories. The ghost of Germany’s Weimar Republic hyperinflation of 1921-23 still influences modern policymakers. In his 1919 best-selling critique of the Treaty of Versailles The Economic Consequences of the Peace, John Maynard Keynes attributed to Vladimir Lenin, the leader of the Bolshevik revolution in Russia, the quotation: “the best way to destroy the capitalist system [is] to debauch the currency.” (The full history of that quotation and its origin in a newspaper interview with Lenin are described here). Keynes observed that the damage done by inflation was that it is confiscation of property by the government which is both arbitrary (depending on whether you are a debtor or creditor) and unfair. By undermining normal relations between borrowers and lenders “the process of wealth-getting degenerates into a gamble and a lottery.” Keynes’ point was the the inflation seen across Europe arising from government attempts to fraudulently pay off their wartime debts might have been designed by Lenin, so potentially damaging to the capitalist system were the results. This was not just speculation; Lenin was quoted in an article appearing in the Daily Chronicle in London and The New York Times as saying that the destruction of capitalist relations by inflation was “the real reason why our presses are printing rouble bills day and night, without rest.” (The British historian E.H. Carr later argued that the Bolsheviks discovered the power of inflationary finance by accident rather than having a pre-conceived plan).

But hyperinflations in history tend to follow, not cause major political and social breakdowns. The collapse of government authority and order are what in most cases precede the extreme inflations, for example those following the first and second world wars and the more recent Zimbabwean hyperinflation. The only major counterexample is the Bolivian hyperinflation of 1983-85, which followed systematically weak government finances that were increasingly funded by the central bank printing money. A balanced budget stopped that inflation very quickly.

The other form of monetary failure is less dramatic but potentially just as disastrous: deflation. Falling prices sounds rather appealing, since you can buy more with the same money. But two things tend to happen once deflation sets in. First, people delay buying things because they expect them to keep getting cheaper. That leads to falling aggregate demand and persistently weak economic growth, reinforcing the tendency for prices to keep falling. Second, falling prices make debtors worse off, since most debts are fixed in nominal terms. A nominal debt of say £1,000 is more onerous to service if prices are falling since the real cost of repaying the debt rises. Although there is an equivalent gain to creditors, the effects are not symmetric. If deflation develops in an economy with lots of debt then the rising burden of debt service causes debtors to cut their spending, or to default. Creditors may spend more but typically that effect is much less than the lower spending of debtors.

This debt deflation spiral reinforces the effect of deferred consumption. The result is either sluggish growth, as in the case of Japan, or a complete slump, as in the US and Germany in the 1930s. Though slower and less spectacular then hyperinflation, chronic deflation is just as disastrous or even more so, in its human cost in unemployment and in the damage it does to the credibility of the economic system.

Gideon Rachman, in his regular Financial Times column today, quoted a former aide to French President Sarkozy as saying “Monetary policy mistakes can destroy a society.” He was talking about the Euro and that is certainly not a problem of inflation. European policy makers are haunted by the wrong ghost.


  1. Imtiyaz

    Why do we need economic growth? If to cover rising populations, then perhaps falling Euro birth-rates should ‘encourage’ a new normal stasis? Innovations born of improvements in technology and the application of mgt science might then fill some of the ‘growth gap’. Whilst deflation as a symptom of a slowing economic engine sounds alarming, perhaps it could be an auger that the engine requires resizing to a new population trajectory – less consumers feeding the machine; importing new consumers to Europe may not be the answer; the transition to an engine sized for a low/no population growth rate may not be easy and perhaps some innovation is required on new economic models to be tested against this. I’m no economist so do forgive any logical gaps – but here’s my tuppence in the hat…

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