Come back inflation, all is forgiven

The removal of the Swiss Franc’s artificial currency ceiling with the Euro last night, and the Swiss currency's subsequent rise of around 17% – from 83 euro cents to above parity – has heightened already elevated concerns about deflation.

The removal of the Swiss Franc’s artificial currency ceiling with the Euro last night, and the Swiss currency's subsequent rise of around 17% – from 83 euro cents to above parity – has heightened already elevated concerns about deflation.

The simple fact is that the euro is toxic again and the Swiss franc is an attractive alternative, but the increase in the latter’s value will cause immense damage to Switzerland’s export and tourist industries, with costs in the Alpine state suddenly 20% higher relative to the countries around it. Wages will need to be cut and people naturally won’t like it.

But to understand how deflation works, we need to take a step back. An economy is financed by people taking capital, putting it to work and promising to pay it back. This can be done in two main ways – either by a participating in profits (like shares) or with the return of a fixed amount (like cash and bonds).

The trouble begins when the capital turns out to be less productive than expected. The bonds then become a millstone around an economy’s neck, with companies forgoing profits and investments, and desperately cutting costs to keep the bondholders happy. Wage reductions can have particularly damaging impacts on confidence, further reducing profits and prices. Unchecked, economies can spiral downwards and experience sharp contractions.

To turn things around, the holders of cash and bonds need to recognise that they have less capital than they thought and accept a devaluation – which is typically achieved by central banks printing more money and engineering a sudden spurt of inflation.

Never again

As you can see from Chart 1, this cycle went round and round in the United States for 300 years until the Great Depression in the early 1930s had policymakers saying never again.

The solution has been to allow a steady drip of inflation. The base case is that money is devalued by (a targeted) 2% a year, and this is made up by an extra 2% of interest and an extra 2% in wage increases, but in times of difficulty the extra interest and wages can be held back, reducing the 2% cushion or even running below the rate of inflation.

The evidence is that people are much happier with flat wages and a sneaky 2% devaluation via inflation than they are with an explicit 2% cut in their wages, so the swings in confidence are reduced.

Occasionally the drip of inflation can turn into a gush and people start expecting increasingly large wage rises (as happened in the 1970s) – but this can be controlled by labour policy and is at least better than the deflationary alternative.

Brutal truth

This is where we are at the moment, with a desperate fight by central bankers around the world to keep deflation a bay, with money printing, ‘pygmy’ interest rates (and until recently in Switzerland) currency ceilings.

The main people who lose out in this scenario are of course the savers, who must suffer low interest rates and a devaluation of their life savings. But this is the brutal truth of economics: cash and bonds are promised a return based on what people think the underlying capital will be able to earn, but the money to pay the interest ultimately comes from investing the capital in the real economy.

Banks do their best to estimate future returns from the real assets and bundle it up into savings products, but the truth is that the underlying returns are inherently unpredicatable, and a little inflation is needed to adjust them, while maintaining the fiction for savers that they’re getting steady returns. It's either than or an occasional nasty haircut – I know which I'd prefer.

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