FT Alphaville " On price stability during an "abundance shock" Everybody loves price stability. Everybody expects price stability. Everybody believes price stability is something they are entitled to. But what if price stability comes at a cost? What if the act of enforcing price stability transforms what should be a variable into a constant at the cost of bleeding variability and volatility elsewhere? What if price stability isn't what we thought it was. These are the very perceptive observations of Steve Randy Waldman at Interfluidity. We absolutely loved his post on the idea that stabilising prices is immoral. It borrows a bit from market monetarism, but is fairly unique (at least to our knowledge) in the way it communicates these ideas. To summarise, what Waldman is saying is that the corrective action taken by central authorities to ensure price stability always ends up benefiting one party over another. In an inflationary environment, brought on by supply shocks (or expectations of supply shocks), measures to keep prices grounded tend to reward the secure members of society over the insecure. Inflation by its nature, after all, rewards the debt laden, while harming savers and anyone who lives within their means. So when a supply shock hits and prices rise - itself the effect of a reduction of the supply of goods and services - the central authority intervenes to reduce aggregate demand by raising interest rates or conducting other monetary operations which limit the amount of credit or money in society. Or alternatively by hiking taxes. This very clearly benefits one group of people: Who are these people? Can we identify them? People who benefit from nonincreasing prices are people who hold nominal-dollar assets. That includes most obviously creditors - people with money in the bank, bondholders, etc. - but also people with stable employment but little bargaining power to pursue raises. These groups would see their purchasing power fall in an inflation. If the government restrains prices by reducing aggregate demand, it helps these groups by shifting costs to others. If prices are stabilized via monetary policy, debtors pay: both the increase in interest rates and the reduction of aggregate demand increase the burden of repaying debts. If prices are stabilized via increased taxation, then obviously whoever bears the incidence of the new tax pays. In both cases, marginal workers pay, by enduring an increased likelihood of becoming unemployed or a diminished likelihood of finding a job. You get the picture. Yet, if price stability benefits the above group of people during a supply shock, it stands to reason that it also hurts another group of people at the same time: debtors, taxpayers and marginal workers to creditors and secure workers. Which is why Waldman notes that price restraint policy is actually a type of insurance for creditors and secure workers. They know the government or central authority will act to defend their purchasing power in the event that prices runaway from themselves due to a supply shock. So what happens in deflation, a situation which effectively results from an "abundance shock" rather than a supply shock? Waldman calls it a "happy shock" which we quite like as well. Naturally, it's the reverse scenario. Price stability policy ends up rewarding the debtors and insecure member of society at the expense of secure creditors. As Waldman explains it (with our emphasis): But suppose that the state targets a price level or an inflation rate symmetrically? Then don't the losers from potential price restraint become the winners from potential price support when the state acts to prevent deflation? Absolutely! Under a symmetric price targeting regime, if by monetary policy, debtors enjoy the benefit of a positive supply shock in terms of lower interest rates and increased aggregate demand from which to draw income. If by fiscal policy, the benefit of the happy shock is distributed to whoever captures tax cuts and to recipients of government transfers and expenditures. Whether monetary or fiscal, an antideflationary response to a supply shock implies an increase in aggregate demand which helps keep marginal workers employed. Creditors and secure-but-stagnant job-holders lose out, as the increase in purchasing power they otherwise might have enjoyed via deflation is distributed to other parties. Of course, the zero bound complicates matters some what. When zirp hits, the benefits which would usually be given over to debtors and the insecure via price stability action during a "happy shock" become constrained. Aggregate demand cannot be indefinitely stimulated if rates cannot fall below zero and if the money pumped into the system becomes clogged up due to liquidity traps. All of which makes the price stability insurance policy far more effective at rewarding the secure during an inflationary period and than the insecure during a deflationary period. Hence, Waldman observes, the benefits of price stabilisation accrue disproportionately to the largest creditors and to holders of high-salary secure jobs (even without an abundance shock). This he believes makes it a very regressive type of social insurance. We tend to agree. Nobody has noticed this of course because it's been obscured by the monetary veil, as well as society's general acceptance and reliance on a world of price stability, which they see as good. In other words we have become far too used to the dollar being the constant in the equation. And yet, let's not forget this entire scenario may stem from what Waldman calls a "happy shock." That's too much supply and too much capacity. We thus wonder, in an environment where abundance prevails in this way, does it not make sense to start changing some of the variables for constants and vice versa? Also to reconsider what CPI really should be?. After all, it is CPI (goods ex food and energy) which anchors the dollar, not the dollar which anchors CPI. Thus it stands to reason that anything not included in CPI, but which doesn't experience the same rate of supply increase as those goods that anchor CPI to the dollar (goods which are increasingly produced abroad at low marginal wages), may in relative terms appear to experience supply shocks, when really they're only experiencing slower supply growth to those items which decisively determine price stability. Hence they come across as inflationary. Indeed, it may be their relative scarcity, rather than overt scarcity, to other goods that then create the conditions for asset bubbles to be formed. Mostly because the system rushes to add to supply - which is not at all constrained - in order to achieve the same rate of supply as is apparent in goods which are used to stabilise the dollar. And in this way we end up with a glut of housing inventory and commodities - all items which price stability mechanisms neglect. The overall point being that price stability may have far reaching negative consequences in a society in which abundance, not scarcity, increasingly prevails. Though let's not forget this is ultimately a "happy" shock too. As well as a scenario that arguably allows for a helluva lot of extra credit to be pumped into the system too. Related links: Stabilizing prices is immoral - Interfluidity Beyond scarcity series - FT Alphaville The collective good of demand needs YOU! - FT Alphaville This entry was posted by Izabella Kaminska on Tuesday, June 26th, 2012 at 12:51 and is filed under Capital markets, Commodities. Tagged with beyond scarcity, cpi, price stability.