the plan for the future

Inflation and interest

3 December 2022

Buying power of $1 over time (1913-2020)
Buying power of $1 over time (1913-2020)

The graph above shows the decline in purchasing power of the US dollar since 1913, often cited by critics of central banks. In 1913, the Federal Reserve came into existence. During the nineteenth century, prices rose and fell, but in the long run, there was no inflation. During booms, prices rose, while during depressions, they dropped. You can see that the purchasing power of the US dollar increased during the Great Depression of the 1930s. Since then, governments and central banks have preferred inflation over hardship. The graph may appear dramatic, but on average, the inflation rate was 2.5% per year over this period.

There are three types of inflation. Cost-push inflation occurs when prices rise due to increases in the cost of wages and materials. Demand-pull inflation happens when prices rise because of a shortage of goods and services. Monetary inflation occurs when prices rise because there is more money in the economy. In short:

total inflation = cost-push inflation + demand-pull inflation + monetary inflation

Most of our money is bank debt. When you take out a loan, the bank creates money. You must return the loan with interest. If the interest rate is 5%, and there is € 100 circulating in the economy, then the debtors must pay back € 105 at the end of the year. That is not possible unless they borrow more. The extra € 5 often comes from people, businesses and governments that borrow more. But if they do not borrow enough, other borrowers can't repay their debts, so central banks have to print the shortfall to prevent a financial crisis. It is explained in The road to serfdom. Banks and central banks create money, causing inflation over time, which appears necessary because of interest.

The alternative is letting market forces take over. The United States didn't have a central bank in the nineteenth century. Banks went bankrupt from time to time when lenders couldn't repay their debts. And because banks lent money to each other, other banks could fail too, and depositors could lose their savings. And a financial crisis can affect the economy. As a result, periods of frantic economic activity alternated with severe recessions and depressions. It is called the boom-bust cycle. Interest charges contribute to that, but by adding money to the economy, central banks allow debtors to repay their debts.

Central banks aim for some inflation but not too much. Inflation reduces the value of debts so that interest charges cause less trouble. As such, inflation counters the effect of interest. If the interest rate is 5% and the inflation rate is 3%, then the real interest rate is 2%. The remainder is taken away by inflation. But high inflation can undermine trust in the currency, so central banks often try to keep total inflation (the sum of cost-push, demand-pull and monetary inflation) in the vicinity of 2%. They create money to produce monetary inflation to get at that number. Without interest on money and debts, this may not be necessary.

The inflation number is not always the same as what you experience. The number supposedly reflects the costs of living for an average person. And your situation may be different. Inflation has been low between 2000 and 2020, experts say. But we didn't notice it. That may be because of 'quality adjustments' in the statistics. For instance, computers have more computing power than a few decades ago, but their price has not risen accordingly. Economists argue that the prices of computers have gone down. If models of the 1980s, such as the Commodore 64, were still available today, they may cost only € 10. But no one uses such a computer anymore.

Similarly, regulations improve a product or reduce the harm done to the environment but also make them more expensive. More and better treatments become available, making the cost of healthcare rise. Economists argue that you get better quality, so the higher price of healthcare is not inflation. Corporations also try to upgrade their products and turn them into 'experiences' to charge more for the same and increase profits. In this way, you pay for management bonuses and investor dividends, but you get nothing of substance in return. And so we see higher prices despite the low inflation in the statistics.