Inflation is Bad, What about Asset Price Inflation?

You may be surprised to know who wrote "By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some." The author is one of the finest economists of the twentieth century, an economist much mistreated by both his enemies and his followers, John Maynard Keynes. The quotation is from one of my favorite books, The Economic Consequences of the Peace. (Thurston Veblen reviewed the book with an ideological prism that seems quaint in retrospect.)

Note Keynes was an inflationist only in the starkly deflationary post-World War I Britain which returned to the Gold Standard at the pre-war parity. This policy forced Britain into a difficult deflation of prices and a real economic adjustment of heart wrenching dimensions. The alternative was to have Britain devalue the pound, undermine London's position as the world's capital market, and effectively default on its war debt (i.e., "Here we will pay you back the war debt, but with pounds that buy less in gold.") Britain chose economic and human disaster over financial disaster, although the choice was less obvious than my words suggest.

Why is inflation bad? It creates arbitrary redistributions of wealth and it distorts incentives. The lesson our current financial custodians fail to understand is that over expansions of credit sometimes result in the inflation of asset prices rather than the inflation of commodity prices: it inflates the prices of stocks rather than flows. But that also is unfair. They may perceive that positive conclusion. What they may fail to understand is its normative implication that asset price inflation is bad: that it too creates arbitrary redistributions of wealth and distorts incentives. Anyone who doubts that should look to the asset price bubbles of the late 1980s (house prices in New England and California); the dot com bubble of 1995-2000; and the housing bubble of 2004-6. Each created arbitrary redistributions of wealth. Each distorted incentives and created a misallocation of resources. Misallocations of resources can not be undone without pain.

In 2002 through 2004, Alan Greenspan worried about deflation: Commodity prices might fall! As the comedian in the Catskills might say, "We should have been so lucky already!"

Corrections made 1/31/2011