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Inflation's worst consequence

| Wednesday, Feb. 23, 2011

Inflation is harmful.

Unfortunately, the worst way that inflation harms the economy receives insufficient attention.

Most people understand that unanticipated inflation transfers wealth from creditors to debtors: Debtors repay creditors with dollars worth less than anyone anticipated at the time the creditors lent money to the debtors. In this way, inflation imposes an arbitrary tax on creditors.

Other well-known problems with inflation include the fact that inflation moves taxpayers into higher income-tax brackets even though their real incomes haven't risen, and the fact that inflation confiscates, year in and year out, purchasing power from persons living on fixed incomes.

But the biggest problem with inflation is that it interferes with the system of communication that markets use to inform workers, investors, entrepreneurs, businesses and consumers about how they can best achieve their economic goals given the underlying economic realities. That system is prices.

For example, suppose unrest in the Middle East makes supplies of oil there a lot more difficult to access. The world price of oil will rise, as will prices of gasoline, plastics and other products made from oil. The higher price of gasoline will prompt drivers to conserve more fuel, while the higher price of plastics will cause some producers to switch from using plastics in their products to using substitute materials such as aluminum.

The higher price of gasoline signals drivers to do exactly what drivers should do in a world in which petroleum has become more scarce: Use less stuff made with petroleum.

The same is true for the higher price of plastics. When the price of plastics rises relative to the prices of aluminum and other substitutes for plastics, producers -- seeking to keep their production costs low -- switch from using inputs made from a now relatively more scarce resource (petroleum) to using inputs made from resources that have become relatively less scarce than petroleum (such as bauxite used to make aluminum).

Prices inform people how to act in ways that take account of the always-changing underlying economic realities.

Inflation introduces misinformation into the price system. The reason is that not all inflationary prices changes occur simultaneously. When new money is injected into the economy, it is always injected through particular channels (usually through the banking system). The first prices to rise are of those goods, services and assets on which the new money is first spent. What is significant is that these prices rise relative to prices in those parts of the economy where the new money has yet to reach.

Producers, investors and consumers react to these rising prices just as they would react if these rising prices were caused by changes in the real economy -- such as falling oil supplies -- rather than by nothing more "real" than government creating new money out of thin air.

Let's say that the first people to get new dollars created by the Fed are people who have an especially strong love of apples. When new dollars fall into these apple-lovers' pockets, these people will buy more apples. The price of apples will rise relative to prices of other goods and services. This higher price will be read by producers as a signal that consumers' real demand for apples has risen -- that consumers are now willing to give up consuming some other things so they can consume more apples.

So producers will shift more resources into apple production. Some land that was once used as pear orchards is now used as apple orchards. Some workers who once picked pears now pick apples. Some shipping crates that otherwise would have been fashioned to hold pears are instead fashioned to hold apples. Research that otherwise would have been devoted to improving pear-orchard yields is devoted to improving apple-orchard yields.

But, in fact, consumers' real demand for apples didn't change. The amounts of apples that consumers as a group want to consume relative to the amounts of other goods and services is no higher than before. Yet the inflated price of apples causes too many resources to be allocated -- economists say "misallocated" -- to apple production.

This reality is unveiled as the new money works its way into the rest of economy. First spent disproportionately on apples, the new money eventually spreads itself more or less evenly throughout the economy. As it does so, the prices of other goods and services rise. While at first the price of apples relative to other goods and services did rise, when the prices of all other goods and services later rise, the price of apples relative to the prices of other goods and services will again be the same as it was before the Fed injected the new money.

Economic decisions based upon what was thought to be a higher demand for apples are now revealed to be mistaken. Undoing such mistakes takes time -- a process that I'll discuss in my next column.

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