Inflation's benefits, despite Sarah Palin

The centre ring event at this week's G20 circus in South Korea will be tag-team beating of U.S. central bank chairman Ben Bernanke. It has already started.

"With all due respect, U.S. policy is clueless," Germany's finance minister is widely quoted as saying, though some dispute the translation.

China's Xinhua News Agency, a voice for the Chinese government, spoke for many countries when it said Mr. Bernanke is "not able to carry out responsible currency policies."

Russia, that bastion of economic stability, has ordered that Moscow must be consulted before the U.S. central bank does it again.

And these are only the things people said in public.

What they are all talking about, of course, is last week's announcement that Mr. Bernanke's central bank, the U.S. Federal Reserve, will create and inject $600 billion into the U.S. currency pool, hoping it will push the economy up and the dollar down.

As the world's top economists and financial thinkers weigh in, one of America's big thinkers has stepped into the ring too. Sarah Palin.

While Ben Bernanke is on the floor being kicked, Sarah Palin has piled on.

"We shouldn't be playing around with inflation," she said. I didn't actually hear her say it, I read it in the Wall Street Journal. But in my mind's ear there is no G on "playing."

Inflation is good

I agree that Ben Bernanke may not know what he's got himself into. I agree that dumping half a trillion dollars into the world economy may cause more problems than it solves.  I even agree with the new Brazilian president-elect who said previous competitive devaluations have led to war.

When Sarah Palin starts dissing inflation, someone's got to stand up and speak for the other side. Because inflation is good.

But when Sarah Palin starts dissing inflation, someone's got to stand up and speak for the other side. Because inflation is good.

Inflation is not absolutely good, of course, and certainly it has a bad reputation. I mean, you don't have to go back to prewar Germany, as Sarah Palin did, to see the damage it can do.

In the early 1980s, North American inflation was running above 13 per cent.  If you were an elderly person living on a fixed income, that really hurt. A case of cat food that cost $100 in 1970 would cost you more than $300 in 1985, according to the Bank of Canada's inflation calculator.    But certainly, when compared with deflation, its evil twin, inflation is a wonderful thing. And it is especially good at a time like this.

What inflation does is lubricate an economy. And to explain that, I have to introduce a highly sophisticated piece of economic vocabulary. "Sticky."

Sticky, strangely, refers to prices that don't want to move. They stick.

Two very well-known examples are house prices and wages, both of which tend to be "sticky downward." Which, translated from sophisticated economic vocabulary to normal Canadian English, means "they don't like to go down, eh." (For a correct translation, non-Canadians should remove the "eh.")

Wages get stuck

No one ever wants to accept a cut in wages. But in a complex economy, wages must constantly adjust in comparison with other wages and in comparison with other prices. Without inflation, wages stick. With inflation, no one takes a cut. Some just get a little more than others.

Same thing with house prices. Say you live in a Vancouver shack that you just bought for $600,000. When everyone begins to realize that the shack market is overpriced, you might think the price of your shack would fall gradually to $500,000. But without inflation, that's not what happens.

The reason is that, rather than sell out at the current market price, homeowners say, "I own a lovely $600,000 home. I'd rather not sell it at all than sell it for less than its value. And it is not a shack."

So without inflation, generally the first sign that house prices are falling is a decline in sales, because only people who really have to unload are willing to accept sharp declines in the perceived value of their houses.

If you are a homeowner or a wage earner, it may seem that inflation is just a way of tricking you to take a financial hit. And that may be true. But it also allows markets to adjust, rather than grinding to a halt.

But once again, inflation would come to the rescue. With an inflation rate of five per cent, it takes only four years for something that used to be worth $500,000 to become something priced at $607,000. Do the calculation yourself. That way the homeowner gets his price, and the market adjusts to the new reality.

If you are a homeowner or a wage earner, it may seem that inflation is just a way of tricking you to take a financial hit. And that may be true. But it also allows markets to adjust, rather than grinding to a halt.

Inflation's lubricating effect does not just hurt the little guy. Another big advantage of inflation is less loved by banks and rich folks. That's because people laden with debt — Canadians and Americans for example, not to mention the U.S. government — get to pay off their loans with inflated money. In effect, their loans shrink. It is especially nice if the interest rate they are paying is locked in for a long time, like many American home loans (but not lines of credit).

The final advantage of inflation is that it gets capital moving. Right now we know that companies are sitting on mounds of cash. When inflation is happening, the best thing a company can do is get rid of that cash and spend it on something. In other words, rather than holding the cash because you know it will become worth more (as happens in evil deflation), your best course of action is to invest it before it inflates away, because every minute you hold cash it is worth less when inflation exerts itself.

That's not to say inflation is a cure-all. As the Germans found out, and as Canadians discovered during the 1980s, inflation can get worse and worse if you let it. At some point, it has to be stopped with higher interest rates.

But for people who are retired or saving for retirement, higher interest rates aren't all that bad. In fact, in many ways, they're good.

But I don't have to defend higher interest rates from Sarah Palin. At least not yet.