In the last month, we have heard a lot about quantitative easing, a method that is currently being used by central banks of Japan, England and USA to combat the credit crunch. Japan first tested the method during their lost decade. Lately, European Central Bank has come under a lot of pressure from analysts who claim that it is falling behind the curve and failing to rescue European economy by quantitative easing. Main goal of the method is to increase the amount of money in circulation and thus start inflation, which will then send the information to producers that certain goods are in short supply, thus needing increase production, so they will employ more people and increase economic growth. Latest increase in the SDR, agreed during G-20 has similar goal. SDR is a virtual basket of large world currencies.
What is Inflation and why do we want it so much?
If we increase the amount of water in the lake, without widening the lake, the level of water is going to increase. Money works the same way. If we increase the amount of money, without increasing the amount of goods, level of prices will increase. Money starts losing value, prices of goods are increasing. The biggest losers of unexpected inflation are the savers, while the biggest gainers are the spenders, as the goods cost more and more. This adjustment is short term, but in high inflation can be very sharp. Then, people adjust and start expecting inflation.
When inflation is expected, people adjust and include inflation in their plans. Business people see that their product is not competitive, but they calculate that at current inflation, it will be in three years, so they invest today to lock in today’s prices. If they save, it will cost them much more in three years time. Consumers do not want to stay behind and watch the inflation eat their earnings, so they rush to the shops and spend it all, as tomorrow they can buy less with that money. In the short term, this increases the economic growth, as people spend the majority of their income. Long term effects of inflationary growth can be observed in the case of former Yugoslavia, where everybody lived happily in the short term, buying property on loan that was quickly worthless, and enjoying inflationary growth.
What about deflation?
Deflation is just the opposite. If the amount of money decreases or the quantity of goods increases, the level of prices decreases as well. The main gainers during unexpected deflation are the savers, as their savings are worth less, while the main losers are spenders. Deflation thus increases savings which in the short term depresses economic activity. This means that in the short term, there are more unemployed and less tax receivables for the state, which causes problems to the state budget.
Is there a middle way?
The answer is yes and no. There is no method that would keep all the prices at the same level all the time. And it is neither desirable. There is a way to keep the real value of the money that would send entrepreneurs reliable signals regarding the relative rarity of goods. Currency whose amount is fixed and unchangeable is the solution that sends such signals. If we are producing too much of goods A, their price will fall and people will start removing the capacity to produce those goods. Analogously, is we are producing too little of goods B, their price will increase, thus encouraging the people to invest more in producing the goods B.
The way to keep the quantity of money constant and thus keeping the value of money is the same as with the publicly traded companies. If the quantity of shares outstanding is constant, shareholders keep all of the excess value that the company creates, so they are worth more. If this company issues new shares, it has partly diluted old shareholders, especially if the old shareholders have purchased shares at a higher value that the new ones, so there is less of excess value created by the company left for the shareholders. Nobody is encouraging publicly traded companies to keep on issuing new shares year after year. On the contrary, shareholders are avoiding them. Yet the countries are doing exactly that with their currencies.
Throughout history we can see that only real excess value (savings) can be the basis for sustainable economic growth and economic development. Any other growth, such as inflationary or credit based growth, has quickly been proven to be unsustainable, as people have been spending the excess value on unnecessary goods and thus have been destroying the foundations for the economic growth. If the quantity of money is stable and unchangeable, there is no danger that the country or the central bank will, by increasing amount of money in circulation, inflationary dilute our savings. This security increases saving and, in the long run, sustainably increases economic growth.
This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading Slovenian Investment Magazine KAPITAL, on 14.04.2009. Original article is available at the following URL:http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6654
