Consequences of inflation phobia

updated: added the summation of the factors for a -1.5 deflation rate.

I’m sure most people have heard that increasing how much money is going around generally increases prices (and the opposite holds true). Economists have a formal method for explaining this phenomenon:

M * V = P * Y

The model’s variables are aggregates representing different aspects of the economy. M is how much money there is (though unclear as to what money is). V is Velocity which is s how quickly money is circulating, this variable can tell you quite a bit about the economy and confidence. P is the price level of the economy (Consumer price index is a proxy for consumer), and Y is the total output (Gross Domestic Product is a proxy).

You generally have to get it logged so you can work in growth rates which help tell you better where the economy is heading. So that gives:

m + v = p + y

To clarify, that means that if GDP grows by 10% then y would be 10%. Rearranging for the price level gives us:

m + v – y = p

Now it’s just a question of plugging the right numbers in to predict what inflation will be. Money velocity is expected to be dropping by about 2.5% because of broken financial institutions and lack of confidence in the economy. GDP growth rate in the Eurozone is up for debate but for the sake of argument let’s say its 2%. The ECB is unwilling to be expansionary (thanks to Germany’s hyperinflation phobia) so money growth seems to be about 3%.

3 – 2.5 – 2 = -1.5

So why is this bad? Because when people expect deflation, they end up waiting more (since they expect their money to buy more in the future). This means that economic activity decreases even further and sends the economy further down a depressionary spiral. This includes not only consumers but investors, since consumers won’t be spending, investors won’t find fruitful projects. This comes back in the form of less stuff and less employment. This is not to say that the marginal effect of a deflation movement from 1 to 0 is worse than one from 0 to -1, but generally speaking, the more deflation, the worse things will be. 

Money velocity and GDP can be affected by fiscal stimulus that is, government spending more money. You can also affect velocity by increasing confidence in the markets which makes people not hoard cash as much. But both of these seem unrealistic in the Eurozone with its lack of political union where everyone seems to be obsessed with austerity. An easier solution would be for the ECB to say we are going to increase how much money there is in the economy by 10%, since money is something they directly control this is very easy to do, just print more money, but that won’t even be necessary, as long as they say it out loud, investors and consumers will all know to expect inflation and will invest or spend in the economy.

A note: the expansionary monetary policy would also allow government debt to become more sustainable which makes the other options easier to do.

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Understanding Currency Areas and the Eurocrisis

I’ve been quite perturbed that most analyses of the Eurocrisis is done by politicians and doomsayer journalists to the extent that most of the content out there centers on the least likely events and fails to capture the spirit of the intellectual debate. Nice thing about blogs is that you can make things as complicated as you like, though in this case I will restrict myself and not use formulas or graphs for the sake of clarity.

Some helpful background

Devaluation is used as a mechanism to reduce real wages. The reason devaluation works is that workers fail to notice or respond to the inflation by raising their money wage demands. If wages were all tied to inflation(also known as indexation), as many multinationals do, the process would not work, and if some did and others didn’t, the process would disproportionately affect those without this adjustment. This power of devaluation is much more prominent the more the cost of living is reliant on the outside world and hence more likely to provoke a response from the labour force. From that point of view this makes the case for much larger currency areas since devaluation is possible without provoking a response. Devaluation can occur not only through monetary means but also by decreasing the cost of doing business which includes a decrease in taxation levels;

I would recommend reading my Unit of account post and Unit of Exchange post to fully understand the functions of money because they are directly relevant to this post.

The benefits of monetary union

These are microeconomic in nature and involve helping out small firms remain competitive as well as alleviating consumer burdens.

Transaction cost

The first benefit is a reduced transaction cost. Though fees on large currency transactions are quite small, currency turnover is extremely high, so cumulative costs can be higher than one might imagine. Although it’s easy to say that the transaction cost of a single currency is reduced, it is possible to overestimate the magnitude by which this is so. This mistake might be enabled by ignoring the fact that not all foreign currency loans are simply hedging exchange rate risk, indeed some of these are favourable because the foreign loans have a lower interest rate. Even so the reasons for this lower financing rate could not be related to the exchange rates whatsoever, an example of which is a multinational borrowing in the domestic market because its reputational capital can be leveraged into higher credit ratings. Additionally many of the potential perceived costs of foreign trade are simply rents extracted by financial institutions exploiting their economies of scale. This allocation of resources not only has an opportunity cost in terms of human labour but also causes inequality between industries by funneling money into finance.

As an example let’s consider a bid-ask spread (buying versus selling currency) of 0.05%. To the individual this might seem insignificant, but this is a very deceptive way of analysing the situation. Given that 600 billion in currency transactions take place in London, such a spread would represent 300million in costs per day. Even so, this element is frequently ignored by politicians because the savings might be negligible from the narrow view of an individual country, especially since a great proportion of the trading is done on behalf of foreign principals, this means that although monetary union would be a considerable savings cost, the UK perceives it as a booming export sector. Even so, the savings potential from a UK resident’s perspective of an EMU would be limited to transactions within the Eurozone. Academic estimates with all this taken into account estimate that the cost savings in transaction costs would be about 1% of EU income.

Accounting costs

Foreign flows being converted into a common currency for the consolidated balance sheet inherently introduce greater variability in forecasts of share prices and increases capital market volatility.

When evaluating risks of currency splitting we must be able to partition the arguments for what it does and doesn’t do. Any individual entrepreneur is likely to be less enthusiastic of any prospect if an additional risk of currency fluctuation is introduced. However when dealing with multinational firms this risk is not necessarily as large as it appears since a true multinational would have flows in both currencies and opportunities to finance from institutions in both currencies and so the risk is likely to be overstated if we just look at the variance of the exchange rate. If the company has accurate forecasts of these future cash flows it may even hedge, but this is a return to the previous point that this process funnels money into the financial industry. Perhaps most importantly we may overstate the cost of the currency risk because even if the foreign currency value does depreciate, this will be partially offset by the fact that the foreign production will become more competitive and in the process, increasing prospective cash flows. However these options are not present for smaller companies, which have to rely on financial institutions ability to mimic these advantages and generally are likely to reduce competitive forces within the economy since it offers more than just an economy of scale advantage to bigger firms.

Insulation from monetary disturbances and reduced political pressure

Given multiple currencies, it’s possible that the domestic prices are sticky (don’t adjust fast enough). This stickiness might lead to unnecessary and temporary fluctuations in the real exchange rate due to speculative bubbles.

Finally without the option of protectionist policies from myopic politicians, we reap the benefits from the most agreed upon economic policy of all: free trade.

Costs of monetary union

These are macroeconomic in nature (more about patterns of adjustment to disequilibrium) and would hence be up for rigorous debate. Some schools of thought, like the Austrian school of economics might even dismiss them completely and blame this thinking for the business cycle by enabling the allocating of resources to be done in a manner that does not reflect the preference of consumers, implying an inevitable crisis.

Monetary flexibility

This is perhaps the main cost being referred to. Currency union makes regions less able to respond to macroeconomic imbalances through specific monetary policy. This belief is mostly credible in the monetarist sphere of thought since fiscal stabilization is a very plausible alternative to most interventionists (and perhaps the only choice when interest rates hit the zero bound, ignoring of course the more unorthodox methods being suggested).

Monetary flexibility also includes financing government spending via inflation, by reducing the burden of public debt (e.g. if your currency is worth less, government bonds are worth less and easier to pay back). Though some would question such indirect measures of taxation as not being transparent it is an important option for extreme times such as wars. However EU wide tax and transfer systems reduce the need for this. Similarly seigniorage revenue in a common currency area (the ability of new money to buy goods and services) would need to split in very equitable ways.

Labour mobility is king

These arguments are all rendered irrelevant by one thing, a sufficiently high labour mobility (people willing to move across the currency zone).

To give an example lets imagine the price level dropped in a country by 10% and that foreign goods are responsible for 50% of the cost of living, so real wages have increased by 50*10%=5%(since you can now afford your previous lifestyle with less money). However given that the people can now buy more but their productivity has not changed this will make firms less competitive and apply downward pressure on the economy which will increase unemployment, bankruptcies and so forth. With sufficient labour mobility, employment will be restored without transitional unemployment because people will fleet to the new high wage country until the supply of people brings wages back to equilibrium.

The question as to how the existence of labour mobility comes about is of course a different one. Although Economists usually perceive it as a requirement for an optimal currency area, it is likely that action must first be taken to increase the labour mobility. Indeed since the Euro was introduced an increase of labour mobility has occurred within the Eurozone and the crisis has further fuelled this trend.

However it is obviously still insufficient and more could be done to encourage this trend, reforms to this end would include: a single language being used in business, transferable pensions, lower transportation costs(from country to country), standardized unemployment benefits, common legal systems…etc; This encouragement is not only important for Europe but also for the US where empirical estimates show that about six years are required for labour mobility to substitute the failure of wage levels to fall. From this point of view you could argue that even the US should be a candidate for monetary disintegration. I would also add that policies that encourage home ownership, which are taken by most governments are likely to reduce labour mobility.

Of course there is also the matter that entering a common currency usually leaves countries open to speculative attacks by investors. Though this has already been experienced by the EU in the early 1990s and paying any attention to this now is merely a sunk cost fallacy.

Expectations and Politics

Fixed exchange rates could theoretically offer many of the benefits of union without the costs. Though the assumption here is that the countries can keep this indefinitely, and if it would have been done indefinitely they would have just joined the monetary union. So in practice fixed exchange rates have a problem of credibility, how long will they keep doing this? In some cases the market will use immense capital to attack these fixed exchange rates and break down the regime.

Although this analysis is economic, it is impossible to ignore the effects of political framing on the markets. From the very outset the framing of North versus South has had an enormous influence on the markets and has greatly impeded the ability of governments to take action. When it was presented that the crisis is a result of Greek fraudulence and profligacy, it becomes difficult to aid them from a political point of view. If the crisis was framed in terms of economic interdependence and not of morality aka, helping the lazy Greek (some economists disagree with that stereotype) it is likely that bond spreads within the EU would not be as high as they are now and more credibility could have been given to weaker governments, as it is now stronger governments are able to retain market confidence. The more these benefits are spread out, the more consumers of these advantaged countries will lose out in terms of an increase in cost of living.

The idea that monetary union requires fiscal union has been spouted enough but it doesn’t go far enough. In addition to the measures that would encourage labour mobility, common deposit insurance, financial regulation, true lender of last resort abilities from the ECB and a federal constitution that overrides state power would all go a long way to unifying Europe.

Of course in ordinary times it is true that countries are able to borrow more than they would have otherwise due to the credibility of their neighbours, creating an incentive for governments to be unsustainable. In turn this increased spending creates inflation and boosts real wages (and hence, standard of living) to levels that don’t reflect the competitiveness of the country.

However, in another light all this talk about restricting countries from defaulting and requiring German taxpayers to bail out other sovereigns is nonsense. US states and local governments have defaulted in the past as John H. Cochrane’s puts it: “A currency is simply a unit of value, as meters are units of length. If the Greeks had skimped on the olive oil in a litter bottle, that wouldn’t threaten the metric system.” Too much is done to enable bailouts either in more direct manners (ECB buying government bonds in the secondary markets) or indirectly (ECB lending to banks that lend money to the governments), which is not helping sustainability and will require hoards of EU taxes to fix or the Euro will be inflated away.

Governments and the ECB have been pressuring banks to keep buying their debts, the ECB is more of culprit since it gives conditional liquidity injections. These banks become more and more dangerous as this effect continues, Cyprus’s recent bank troubles are but a demonstration of this instability.

Possible endings

We could possibly kick the can down the road with just more bailouts but eventually wishful thinking will end and the true choices will emerge.

One of these is fiscal and monetary union, federal government issuing controls on government budgets and allowing for some of the above frictions for labour mobility to be eliminated.

The other is monetary union only, this would mean governments need to be able to default like companies, and banks would be allowed to treat sovereign debt like any other debt (something BASEL 3 doesn’t help with).

And the most costly option is the breakup, probably after a crisis and inflation. This would be seriously debilitating to all contracts that would have to be converted to a currency that doesn’t exist and would lead to immense capital flight and economic damage. Once again in the words of Cochrane: “The euro, like the meter, is a great idea. Throwing it away would be a real and needless tragedy.”

Redistribution of hours?

It seems pretty intuitive that we work for money, otherwise we would work for free, that’s not to say that everyone is miserable at their work but the goal is monetary is it not? So with that said doesn’t it seem strange that the wealthier people are, the more they work? Over the years more and more hours have been allocated to an increasingly smaller proportion of the population. This seems unintuitive…as you gain more economic security… the more work you have to put in to retain it? Does it not make more sense to seek social security(take care of kids, be a good husband, etc) next? It seems we got lost somewhere along the way.

So lets think about this skewed distribution of hours. Do we need more hours to do work because work is getting harder and harder to do? Not likely, technology ensures that we do what used to take hours in fractions of seconds and merely with the touch of a button. So productivity is up, yet real wage stagnation has ensured that in the US people to have work more and more hours to keep up with inflation. In Europe working hours have been reduced but there is still more room for improvement(especially in the UK). So with these facts in mind lets ask some incremental questions.

What is a job? Is it not a function in society that requires a number of hours to (hopefully) achieve a certain GDP output? So lets look at the economy in hourly terms. It seems we have trouble expanding our hours(create new jobs) but reduce our hours with ease(technology). Redistribution of wealth is often attacked because it is said to create moral hazard for those who don’t work. So what about redistribution of hours?

Lets say the economy had a certain number of workers, working 40 hours(the current UK average) and an unemployment rate of 20%(its not as high as it might sound if take into account part timers looking for full time and discouraged workers). What if we could redistribute those hours to those 20% so we could have 32 hour working weeks? This would be an especially effective measure to help people cope with recessionary periods where the unemployment rate rises. In the long run this kind of redistribution will result in there being  less inequality and probably more community involvement.

So what stops this from happening? The main obstacle is that some jobs are very hard to replace so training costs for some companies could dramatically increase. Additionally workers insurance programs will also guarantee an increase in costs, making this a losing proposition from the company’s point of view. This is where government can come in, especially since its mandates(worker’s inurance) discourage this from happening. Government can subsidize companies specifically to just the right amount so this becomes a profitable proposition, something like tax cuts for meeting a certain weekly quota in employee hours.

Some argue an altogether drop in working hours without thinking about GDP, an incentive of that might be more environmentally friendly economy. here‘s a lecture on that if your interested.

Some Answers to my own questions(if you have questions ask them in the comments):

Should this be mandatory?

This should not become a mandate policy because some people just like working and there might not be a reasonable substitute for their work, resulting in a potentially large GDP loss. Some people just don’t value social life as much (Mckinsey employees work 70 hour weeks, though their social work life balance reporting is very low).

Are people potentially equal?

Of course one of the main assumptions is that the people who are unemployed have just as much potential for productivity as those who are not.

What about the minimum wage?

Minimum wage structure creates some complications, especially when calculated in hours(not to mention that its currently probably too low for a reasonable standard of living). However practically this would be overcome by the fact that we would not mandate this policy.