To the Editor:
There is a creature, a pestilence, lurking, day and night. It eats everything in sight. It has grown fat in its excess, and has created quite the mess. It infects our minds with dread too horrible to bear. With despair we ask What next, what to expect, how do we get out of this; this pandemic that affects all of us?
Well, I don’t really know…. sorry.
So, what is this all about? Very simple, prices, and generally rising prices, aka inflation. This is nothing new, its been around since the beginning of economic exchange, trading this for that. Yet, it is relative prices that make the economy tick. That is, the price of X relative to the price of Y. This influences what people buy and what they don’t, and ultimately influences what gets produced or not, how resources are used.
Severe inflation really hurts, but we can easily put up with low inflation like we have had for many years until recently. But it has been getting increasingly uncomfortable and now seen as a problem.
Moderate inflation actually helps the economy, makes it easier for relative prices to adjust when demand for some products is increasing faster than others. Central banks have set about 2 per cent overall as a tolerable rate to help this happen. When this damps down demand a bit, it helps to keep overall inflation in check. So the market tends to keep itself under control. When this is not enough, that is when central bankers get involved. This is what is happening now. The Bank of Canada is making it more expensive to borrow, so the cost of carrying debt is becoming more costly. More costly, less demand, the higher the cost, the less demand. It hurts, and of course some are critical of this approach. While it does hurt, it works.
What is in the background ? What central bankers fear most is the prospect of accelerating inflation to the point of hyperinflation. An important role in this is people’s expectations. If we expect inflation, we behave in an attempt to reduce the pain. For example, we might buy more of some things in anticipation of higher prices later, or demand higher pay. Both just drive inflation higher, creating a positive feedback loop causing prices to rise faster. It can happen, and two well-known examples are Germany in 1922, when inflation rose to as high as 29,500 per cent a month and more recently Zaire (now Congo) in 1991, at 114 per cent per month. It’s been worse in other countries. Money becomes increasingly worth less and progresses to being worthless.
I recall a conversation with a great uncle many years ago, about the tale behind an old high denomination German Mark. It was soiled, and his story was that the value of the mark had become worth less than toilet paper – which had become in short supply, hence the substitution. In the case of Zaire, is a photo of an envelope I received in 1991 and notice the number of stamps on it. It was covered front and back in stamps worth 500,000 Zaires each for a total of about 40 Million. A Zaire had been used the way we use a Canadian dollar. Imagine having to put $40 Million on an envelope.
In the face of accelerating inflation, this is the motivation for central bankers putting the breaks on the economy by increasing the interest rate. Yes it is painful, but better than the alternative. As my dad used to say, sometimes you have to be cruel to be kind. In his case he was talking about pruning in the garden.
Lurking under all of this is what I call the church of the presumptuous assumption. In other words, we all have faith that money has value, and as long as all of us believe, money will continue to have value in exchange for things, and the economy hums along. If we all lose our faith, the whole thing can crash.
Some are sceptical that what central bankers are doing is wrong and will hurt the economy. Some seem to think the Governor of the Bank of Canada should be fired. Will what they are doing cause a deflation and recession? I doubt it.
What is a credible risk is the current posturing of a group of Republicans in the United States Congress, threatening the U.S. capacity to borrow to pay its debts. If there was to be a default by the U.S., we would be looking at the worst-case situation. There would be a general loss of faith in the American dollar. Let’s hope that those who understand the system prevail.
Keep the faith and hope for the best,