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(This text is also posted under articles)
A few decades ago inflation rates where much higher then they are today. There have been some progress since then and many economists today agree that too much inflation is bad.
But they still seem unable to let go of the concept that inflation is necessary for economic growth. Most central banks today still strive to maintain a consumer price index increase of a few percent each year. So why are they doing this and is it necessary?
In this text use the Austrian definition of inflation, that means inflation is an increase in the money supply.
The contemporary definition of inflation is an increase in the consumer price index, which I will just call an increase in prices. It should also be noted that increasing prices for goods and services is a necessary side-effect of inflation, if there is more money in the market trying to buy the same goods then prices of those goods will increase.
The most common arguments for why a small steady increase in prices is necessary are as follows:
1) If goods get cheaper consumers will post-pone buying capital goods to buy them cheaper in the future. This will reduce consumption and make the economy stagnant.
2) With an increasing amount of goods and services available there is an increasing demand for money to be used for exchanging these goods and services. As GDP increases so does the demand for currency.
3) Inflation can help to increase the flexibility in wage levels making it easier for the labour market to adjust to changes. If you give someone an increase in wage that is smaller then the inflation rate they will in fact get a smaller wage, but will be much more likely to accept this without objecting then if you where to cutting there wage in absolute numbers.
4) Inflation is necessary to cover deficits in the governments finances.
The first argument, that consumers will hold on to there money if prices constantly decrease rather then increase, has some rather obvious flaws. There is a cost involved in buying something in the future rather then today. Take a car for instance, if you buy it a year from now you will have to spend a whole year without the comfort of a car. If this wasn't something you though was a problem you would never be considering buying a car in the first place.
So for it to make any sense to wait you must assume the car will drop more in price then what it would be worth to you to have it now, rather then a year from now.
Even if you make the decision to cling to your old car for longer then you would have without the decreasing prices that decision will have saved you some money or you wouldn't do it.
That money that you save by getting a few more miles out of your old car could then be used for something else in the economy, it doesn't simply vanish. It also seems far more likely that such money would be better utilized under that scenario then if you where to spend it on buying a car today simply because it will be more expensive tomorrow.
With steady decreasing prices consumers will still buy plenty of goods and services, just look at electronic sales and the queues for the new iPhones. Consumers might not replace capital goods as fast as under inflation but if that is the case it will only create more value that can be put into other uses.
George Reisman argues that decreasing prices will stimulate consumption rather then create a deflation trap where people hang on to there money. “In other words, the effect of falling prices caused by increased production on the degree of saving and provision for the future should be assumed to be neutral, because the prospect of greater future buying power of the monetary unit is offset by the prospect of greater future prosperity. “
In short this means that consumers ability to purchase products for less in the future will increase there current purchasing power and the net result should be that they buy more. People also have vastly different time-preferences and reasoning behind their temporal decisions, so it doesn't seem likely this will create some kind of cycle where everyone is hoarding at the same time.
This first argument then, can only hold true in a state of temporary absence of inflation. Not with a permanent and steady decline in the price level.
The second argument, that more money is needed to exchange more goods, is based on the assumption that prices must be steady or increase. As I have shown above this is not the case.
Instead of compensating for the increased demand of a medium for exchange by creating more money we can simply let the mechanics of supply and demand regulate the price of money like any other commodity. If there is a need for more money to use in exchange the price on money will go up, this is the same thing as saying that the price level on goods and services will decrease. If you have 1 gold and 1 egg in the economy (assuming gold only have monetary use and value) 1 gold = 1 egg. When you produce another you will get 1 gold = 2 egg which gives ½ gold = 1 egg.
In order for this scenario to create a problem the price of money must increase so much that physically dividing whatever commodity we use as money in such small units becomes impractical. However if this where to happen the market will simply introduce a second commodity as money with less value per physical unit.
The third argument, that inflation is necessary to facilitate wage cuts, is true in most of the western counties. But wage cuts aren't something that is made impossible by natural economical laws, it is for the most part made impossible by government created labour market regulations.
In a fully deregulated labour market firms could easily solve these problems without having to rely on the subterfuge of inflation. So the true solution to this problem is to deregulate labour markets rather then introduce inflation.
The fourth argument is also valid and probably one of the main reasons why central banks keep creating inflation and why politicians and economists working for them make up arguments that inflation is necessary.
Changes in the price of money caused by inflation are not like changes in the price caused by supply and demand. When inflation is involved there is a delay in the price change while the new money works there way out in the economy. That means that whoever uses the new money first can buy things for old low prices, while the persons that get access to the new money last have to pay higher prices. Not surprisingly the initial recipient of most new money is the government. Central banks issue new money by buying debt from the government, the money is then spent by various government agencies. Some of the new money is also inserted directly into the banking system and the banking system have the ability to create its own money through credit expansion so it no surprise they advocate preserving the statu quo.
Unless you want a overblown welfare state there doesn't seem to be any valid arguments for inflation. In fact it is only harmful to the economy by creating the business cycle and artificial incentives for over-spending as well as making funding overblown nanny states even possible.