Inflation Zero-Sum and Variable-Sum Games

[moda0306]

I often like to think of policy in terms of whether or not it consists of merely rearranging the pieces... taking from Peter to pay Paul, or actually provides some sort of systemic value (roads, military, etc).

With inflation, or the purposeful expansion of the money supply by the fed, I've solidified my thoughts on this a bit.  I think there are both zero-sum and variable-sum aspects to feds activities.

For instance, looking at the "who does inflation hurt/help" argument, I think it's easy enough to take wages, bonds, etc, and put them in the contract category

Zero Sum Game: Contracts already entered into: Fixed-Payment Contracts (bonds, wage agreements, etc) are formed with future inflation in mind.  An aggressive, unpredicted inflationary action by the fed will hurt bond holders and wage-earners (depending on the length of the term of the contract) will suffer.  Not to put these two in the same camp, though, because wages tend to be a relatively short-term contract, while bonds often go on for years if not decades.

Even "asset holders" are usually only affected in terms of how the inflation affects the contracts surrounding their assets.  An owner of stocks usually represents someone who has invested a fixed amount in an asset today for variable future return tomorrow based on the prices/quantity of the products they can sell.  If those prices rise as a result of an unexpected rise in the monetary supply, this is usually what helps the asset-holder... because they made the "contract" to buy the machinery assuming the price they'd be able to sell the product for would be X, but it turned out to be X*1.05.

So really this all seems to be a zero sum game.  A bond holder will lose as much as a borrower wins.  Any contract between two people will benefit one side as much as it harms the other.  But this is all in a vacuum. 

People now have to go forward making contracts, and this is where a variable sum game can creep in.  Also, if the affects of money policy are too wild on either side of the existing contracts, it could lead to default, also getting us into a variable sum game

Variable Sum Game: Uncertainty & Systemic Risk

Eventually, if future price expectations are uncertain enough, people will cease to even contract business with each other, which is bad for the overall economy, not just one contract holder vs another.  This is, taken to its extreme, what hyperinflation is.  Also, if the change in the economy is such that one side can't complete an existing contract, then that also may create a variable sum game result where both sides are worse off (even the person who defaulted, because we're assuming the monetary policy changed his position to a degree where he would have been).

Further, though, Variable Sum Games can initiate in the private sector.  For instance, the additional money injected by the fed, if offset by deleveraging by the private sector, could create the "uncertainty" above that inhibits contracting business, but as a result of the private-sector deleveraging, not the fed printing.

If you look at the same type of contracts that were talked about in monetary policy before as a gauge as to where the uncertainty is being placed, that can be a good tool.  For instance, one could look at bonds before the monetary event vs after, or wages & hiring contracts before the monetary event and after, to see what kind of evidence there may be of uncertainty going forward, and what can be done to calm that uncertainty.

So there's a couple of points I'm coming to with these thoughts:

1) The vast majority of "bond" contracts, due to our fiscal & especially private sector balance sheet position put the zero-sum-game benefit to the residents of the United States if we generate inflation.

BUT, some will say, this 1) is unfair (even though the contracts were formed w/ both sides KNOWING the fed would expand the money supply to keep full employment if need be), and 2) creates uncertainty in markets, to which I was speaking about above.

...so this brings me to #2...

2) The uncertainty, if judged by the "contractual friction" (my term for uncertainty's effect on commerce) that exists today that didn't exist yesterday, would seem to indicate that the true uncertainty that's causing people to be afraid to engage in contracts is NOT the collapse of our medium of exchange, but that we won't be able to get enough of it to pay the bills we've already contracted to pay.

So, to put on my anti-inflationist hat one more time, it would seem that not only would expanding the money supply benifit us in the US (at the expense of our creditors overseas) on average (as well as those in debt vs holding bonds in the US), but the uncertainty is here as a result of a deflationary shock, not in the form of whether the dollar will hold its value, if using the contracts being formed today as an indication of where that uncertainty is.

So even in acknowledging the Variable-Sum piece, it appears that the uncertainty in our contractual relationships is coming in terms of demand and jobs, not currency having value, which would indicate that we can improve our position with some inflation... at least IMHO.

[moda0306]

Keep in mind, by "needing inflation" don't mean that it'd be good to have oil go up $20 a barrel.  That might happen as a result of fiscal & monetary expansion, but that, of course, isn't helpful.

By "inflation" I mean fiscal & monetary expansion, which may not actually result in an increase in CPI, commodity or otherwise.

[Lone Wolf]

I don't share this view of inflation as benign (if not a benefactor!)

Remember that inflation does not fall evenly on everybody in the economy.  People like the poor, retirees, and savers get by far the worst of it.  Banks and the Federal Government are, of course, the biggest beneficiaries of inflation -- they are closest to where the money is being shoved into the system.  They are the ones that get to bid up prices with their increased purchasing power.

This short video is a nice little overview of the process, how it came about, and how uneven and disruptive it is.

[moda0306]

I can't watch the video yet, but it really helps to walk through the variable and zero sum game sides of this.

Unless banks are paid a premium for the bonds they sell during monetization, I really don't think there's much benefit being given to them at that point.  Wealthy (not in need of work) bond holders will be hurt by inflation to the same degree that the borrowers benefit.  Like I said, there may be some disruption, but right now all evidence points to the disruption already being there and much more in the form of unemployment, lagging asset prices, and heavy debt loads in the domestic private sector.  This would indicate that the variable sum game, at this point, actually means we'd benefit, stability-wise, from expansionary monetary policy.

Not to mention we're obviously net-borrowers in terms of financial assets (as a country), and that wins us the zero-sum game piece of the argument.

I find the acknowledgement of poor private sector balance sheets, negative trade balance, high unemployment, and low interest rates to be completely in opposition to the idea that monetary and fiscal expansion would be bad for us, as a whole.  Many wealthy bond-holders would be hurt, but these guys have made a killing in the past few years, far in excess of what they expected to when entering into a contract denominated in a currency with a dual mandate, including full employment, so we simply would be reversing the mass redistribution of wealth that likely happened in 2008 from borrowers, business owners, and home-owners to wealthy bond holders.

[moda0306]

Also, what does it mean that "government benefits?"  If that just means "the private sector gets scared and confused," I could agree with you in the right circumstances, but government is an entity... it can't "benefit" from something.  Banks at least have shareholders that benefit.  Do government employees or politicians benefit from inflation?

I think when we run into problems with ANY monetary event, it comes down to whether we're causing instability and uncertainty that weakens the economy.  Right now, all evidence is pointing to that instability and uncertainty coming from MANY more sources before inflation.

If you take away the instability associated with unexpected monetary events, all you're doing is moving value around, from borrower to lender or one contract holder to another, but often only in small doses.

[stone]

I think the point of inflation is to shroud the monetary system in contrived complexity. Complexity confers an advatage to those with specialized understanding so that they can exploit everyone else. Remember inflation occures at very different rates for different things. Wages, house prices, oil, legal fees, medical insurance etc etc have all increased by radically different amounts. Inflation encrypts the transfers of wealth from some people to other people -nothing more nothing less IMO.

[Lone Wolf]

but government is an entity... it can't "benefit" from something....  Do government employees or politicians benefit from inflation?

Of course!  Whether you're involved in some crony capitalist boondoggle like Solyndra, someone that is enriched by the military-industrial complex, or just another politician that wants to get re-elected and "build monuments to yourself" (to borrow from Harry Browne), it's obvious that you benefit from having the service of a printing press.  This benefit comes at the expense of those outside the public sector, particularly those furthest away from the newly-minted cash.

Consider a neighborhood that has a prolific counterfeiter in it.  This counterfeiter enjoys nothing more on Earth than pork rinds.  In fact, he just prints money night and day in his basement to buy nothing but pork rinds, which quickly disappear down his fat pie-hole.

The pork rind vendor doesn't feel a thing.  In fact, he's richer than ever!  Millions and millions of dollars are flowing through his shop.  With all this money, he can get into real estate, which he bids up.  He's also a big fan of cars, so he starts buying those up as well.

How's everyone else doing?  The people furthest away from this new money just see that their wages haven't risen but that houses and cars are now sky-high and completely unaffordable.  (If nobody ever figured out that there was a counterfeiting operation going on, no doubt they would blame "the free market". 

I think when we run into problems with ANY monetary event, it comes down to whether we're causing instability and uncertainty that weakens the economy.  Right now, all evidence is pointing to that instability and uncertainty coming from MANY more sources before inflation.

All the more reason not to add the destabilizing, redistributive effects of inflation.  It certainly didn't make the 1970s any more fun.

Before you decide that inflation is "not such a bad guy after all", consider Nazi Germany's Operation Bernhard.  The Nazis, in history's largest counterfeiting operation, printed up perfect counterfeit British pounds by the truckload.  The plan was to load up the Luftwaffe with these notes and drop them all over England, triggering hyperinflation.  Happily, the Allies liberated the camp where these notes were being produced before the plan could be put into effect.

The fact that the Nazis thought it would be more damaging to the British to drop counterfeit currency on on them than it would be to drop bombs tells you everything you need to know.

[moda0306]

The fact that the Nazis thought it would be more damaging to the British to drop counterfeit currency on on them than it would be to drop bombs tells you everything you need to know.

Very interesting story, really... but in no way shape or form does it tell people everything we need to know.  I hope that was just a figure of speech.  Further, they did drop bombs... so maybe it was just another idea with which to "hedge their bets" on where to aim their resources at destroying Britain.  

All the more reason not to add the destabilizing, redistributive effects of inflation.

That is, if the inflation is destabilizing.  I don't think it will be, IF in combination with good government, not giving all the money to the pork rind vendor.  This would be done in the form of fiscal & monetary expansion aimed very broadly, in the form of tax cuts (I like the payroll variety) and infrastructure (something government already does) stimulus, and maybe some stimulus checks to boot..

The 70's inflation was bad.  The 1930's deflation and unemployment was awful.  Which does today look more akin to?  Both were fast, hard changes in expectations by the public, and no matter whose fault it was, it was the fact that investments beforehand proved to be inadequate to provide stability during those times.  People with stock-heavy investments and business owners were hammered in the depression due to a sharp change in the price level, demand and in expectations (and, yes, I'll hand you, some awful regulations by FDR).  Someone who held long-term bonds in 1970 to get them through retirement years was screwed by 1980.

Also, I'd add that if we can imagine a society where we knew there'd be 10% inflation, annually, until the end of time.  Some would say that's horrible inflation (and in most cases I'd agree), but this inflation is known, expected and understood by all.  It probably would get baked into wages, bond rates, etc, and eventually become irrelevant.

It's the unexpected change in price levels (and not just of CPI, but of individual assets), unexpected changes in regulation, unexpected changes in demand, etc, that have truly damaging effects on our economy, because contracts were already made without knowing the change would happen, and now contracts going forward have a degree of uncertainty.

Prices don't just "rise."  People actually have to buy things.  Those people buying things is "demand," which also happens to be something our businesses are in dire need of, or at least before they'll hire.  In fact, when they made their investments, they most likely thought demand would be considerably higher (as well as inflation), so saying that inflation will destabilize things right now seems odd to me.

[stone]

moda, inflation is irrelevant only if it is entirely predicatable (as you say) AND acts evenly accross all prices. The greatest effect of inflation IMO is that it does not act evenly across all prices. To my mind it is the ratio of asset price inflation to wage inflation and CPI that is the overwhelming effect of the great moderation period.

[moda0306]

One natural cause of asset-to-wage differential in inflation would be peoples' expectations of future prosperity to be able to continue to pay the same or higher real wages.

If expansionary monetary policy is, in fact, better for the economy in the short AND long run, you would expect to see an asset-to-wage differential widen, as a perfectly natural affect of proper economic management.

This isn't to say the housing bubble was legitimate price increases, or that we properly gauge future prosperity, but I just thought I'd point out that it's actually the nature of proper governance to see people be more optimistic about the future.

[stone]

moda, I think it only comes into focus (for me anyway) when you think of wealth as being a share of the global claim over other people's time and land. When you think about it like that, then asset price inflation doesn't seem benign to me. The same pot of stuff has growing claims over it. That means that your personal work is less valuable. It takes more work to get your fair share of the planet (planet earth/world population).

[moda0306]

That does help, though "wealth" is a variable sum game.  This is very often the argument of the right... that while there is not INFINITE wealth, that there is a variable amount of it given the inputs.  When there's not enough of a medium in exchange in an economy for people to build wealth (aka, work) at their full capacity (meaning how much they WANT to work) then you have less wealth being generated than what could have been.  Every day not worked is a day of value-added lost.

Of course, people can resort to fixing their own cars and bartering if there isn't enough money to engage in transactions to reach full capacity, but this is inefficient and signs of a pretty sick economy.

[stone]

Moda I think it is important to disentangle asset price inflation from growth of assets. If farmland or pre-existing housing stock or pre-existing rail roads or oil fields, increase in price; then that is asset price inflation. New capital goods such as new factories, computors, inventions or whatever adding to the global wealth is not asset price inflation.

[moda0306]

stone,

I agree, and since what we've seen since 2007 is massive unexpected asset price deflation.  Is your point that inflation naturally much more quickly finds its way to the assets instead of the wages?

[stone]

moda I don't think it can be said to be "natural". It is very carefully set up to work in that way. The tax and subsidy system at every point directs inflation towards assets.

[moda0306]

stone,

It's still a natural phenominon for people to value assets higher as a percentage of wages if they think future employment (value-adding activity) opportunities will be prevalent.

I agree that when the government focuses stimulus, laws (or lack thereof) or tax cuts/credits on assets instead of people, you get that affect (housing, for example).

This is where I disagree with tax & spending policy, not necessarily the monetary & fiscal expansion in and of itself.  I split them into two seperate issues because they are.

For instance, the suggested jobs bill is almost completely made up of payroll tax cuts, infrastructure spending, and unemployment extension.  With the exception of the latter (though it's still believed to lower unemployment in times like this) the other two are very much focused on employment, and therefore wage levels.

[stone]

moda, isn't the saying "globules of fat rise to the top  in the economy as in a stew". Unless the fat is skimmed specifically from the top, the net effect of the expansion will be to transfer power to the top. The jobs bill looks like a sensible spending plan. I'm just saying that it needs to be matched with a tax on assets so as to prevent a redistribution of relative wealth to the most wealthy.
A stated aim of the Thatcher economic policy we in the UK had from 1980 onwards was to increase asset prices. Property tax was replaced by a poll tax, mortgage tax relief, transfer of tax to VAT (sales tax) etc etc all nurtured asset price inflation. Basically if you can tilt your fiscal policy so as to favour asset price inflation, then you get an inflow of foreign money to fuel the asset price inflation. Rather than having a currency value based on the balance of trade, it is based on the balance of asset price inflation. It gives a sort of free lunch. If you start off from a prosperous equitable base such as the USA in 1980, then you have a few decades of hollowing out capacity before the scheme has hollowed out all that there is to hollow out and unravells.