I'll gladly pay you Tuesday

August 28, 2011 1:57 PM

This Debt thread over the MeFi has me wondering: Am I completely off the mark to believe that easy access to cheap credit fuels inflation?

Here's how I see it:

Let's say I can get a credit card with a 5 thousand dollar limit with say, 5% yearly interest or something like that (Easy access to cheap credit!). If I am maxed to the hilt my monthly minimum according to one online calculator, my minimum payment is 70 bucks. I can carry that for the rest of my life, paying a crapton of interest, yes, but essentially I will end paying 70 dollars a month to essentially, rent access to 5 thousand dollars worth of goods and services. In my mind I see that as my credit multiplier, and it all depends on a whole lotta shady shit that can change at any time, but for these purposes, let's stick with easy access to really cheap credit.

Now, Let's say I can afford to pay 700 dollars a month towards my debt, I see that as having a credit multiplier of 50,000 dollars. Multiply that by say 10 million people. Now you have ten million people with 70 million actual dollars that can buy up to 500 million dollars worth of goods and services. What I see here that now there is a whole lotta money competing for goods, so prices go up.

Now reverse it, very few people can get access to credit, so maybe now that 70 million dollars before only has a credit multiplier of say, 150 million dollars. With less money chasing goods and services, prices fall.

Am I completely wrong here? Can someone explain it to me better, because I have always heard that printing money causes inflation, but I think it is actually printing "credit" that causes inflation.

posted by roboton666 to work & money (29 answers total)

This is arguably what happened in the housing market. It didn't lead to general levels of inflation, but it certainly did in housing prices. We are now experiencing the backside of that effect.
posted by scolbath at 2:06 PM on August 28, 2011

You are exactly right. Lower interest rates mean people borrow more, which leads to an increase in the money supply, which leads to inflation.

In fact this is one of the key ways the government keeps/attempts to keep the money supply at a reasonable amount. The Federal Reserve board looks at how much inflation is going on, and if it's too much, raises the interest rate.
(The Fed also has a mandate to try to keep unemployment low, and those two goals can sometimes conflict.)
posted by miyabo at 2:26 PM on August 28, 2011

Yes, absolutely: The issuance of credit creates new money (credit money) through the magic of fractional reserve banking.

See Steve Keen's blog for some financial models that include the banking system. For reasons best known to themselves (perhaps because it makes the models almost impossible to solve analytically and economics suffers from terrible physics envy) standard neo-classical economic models tend to ignore it altogether, which probably helps to explain why mainstream economics was completely blindsided by the credit crunch.
posted by pharm at 2:26 PM on August 28, 2011

(ok, that's slightly unfair: what neo-classical economics does do is pretend that the economy is at or near equilibrium at all times, which is completely insane, but again it makes the models tractable...)
posted by pharm at 2:28 PM on August 28, 2011

You're not wrong, at least as far as first-order effects go. Inflation means that there is too much money chasing too few goods and services. When the money supply increases it stimulates demand (people have more money to spend), which increases the level of prices.

There's a positive effect of this, though - people don't just spend money on consumable goods and services; they also invest part of that money, which leads to an increase in production and more goods and services. In fact access to credit can help people get out of liquidity traps where their production is limited by lack of access to funds. This is the reasoning behind the microcredit projects. So an increase in credit can be good for everyone. It's one of the ways economies get out of recessions.

A further thing I should note is that you distinguish between "printing money" and "printing credit". They're actually the same thing! Money is really just a government's promise to pay you ... other money. This is why people were worried about the US credit rating. The US government can always pay as many US-dollar debts as it wants, but by doing so it increases inflation and makes the US dollar (and hence US-dollar debts) less valuable, which breaks an implicit promise to the people who hold US debt.
posted by Joe in Australia at 2:36 PM on August 28, 2011 [1 favorite]

On the real world level, there was an explosion of credit in the last decade, but inflation was quite low, so something is wrong with your logic. And since the recession, interest rates have been very low, but inflation is also very low.

Just looking at the logic, I see two problems.

1. It's not borrowing that creates money, it's fractional-reserve banking. If you borrow $50K from a guy who kept cash in his mattress, you have $50K that you didn't have, but he has $50K less in his mattress. If you borrow it from a bank, it has $50K less in its vaults... only it doesn't really, it has about $46K less because it only has to keep a small fraction of deposits actually on hand.

2. Your key assumption is that "there is a whole lotta money competing for goods" because of credit. But the $50K you spent (plus the money spent by other borrowers) increased demand, and so producers are making more goods. So the actual inflation rate is hard to predict.
posted by zompist at 2:37 PM on August 28, 2011

zompist, you can't view the US as a closed economy: the US & Chinese economies are joined at the hip & much of the inflation that would otherwise have happened in the US was "exported" to China, who for mercantilist reasons were intent on preventing the rise in value of the Remnimbi relative to the Dollar that would otherwise have been inevitable given the trade deficit between the two.

You can also see the inflation showing up in asset prices that aren't include in the CPI: Energy costs (oil, gas) for a start.
posted by pharm at 2:50 PM on August 28, 2011

You can also see the inflation showing up in asset prices that aren't include in the CPI: Energy costs (oil, gas) for a start.

This is a commonly held myth. CPI, known as headline inflation, absolutely does include energy and food costs.

Perhaps you are confusing CPI with the Personal Consumption Expenditures price index (PCE), known as core inflation, which is a separate measure used by the Federal Reserve to calibrate economic activity.
posted by JackFlash at 3:15 PM on August 28, 2011

...which probably helps to explain why mainstream economics was completely blindsided by the credit crunch.


Blindsided? How do you figure? Plenty of economists were writing op eds predicting doom in the form of the inevitable bursting of a real estate bubble as early as 2002.
posted by patnasty at 4:13 PM on August 28, 2011

The idea that access to credit, specifically low inflation, fuels inflation is one of the core doctrines of the Austrian School of economic thought.
posted by valkyryn at 4:24 PM on August 28, 2011

*Low interest dammit.
posted by valkyryn at 4:24 PM on August 28, 2011

A crash course. With encore.
posted by valkyryn at 4:26 PM on August 28, 2011

On the real world level, there was an explosion of credit in the last decade, but inflation was quite low, so something is wrong with your logic.

I imagine that's because the increase in credit was counterbalanced by 30+ years of wage stagnation.
posted by patnasty at 4:32 PM on August 28, 2011

there was an explosion of credit in the last decade, but inflation was quite low, so something is wrong with your logic.

That's debatable. There's a strong argument that inflation was merely disguised by rising asset prices. Gold is around $1,800 an ounce, a 500% increase in the last decade, and housing was up 150% between 1987 and 2007.
posted by valkyryn at 4:51 PM on August 28, 2011

Awesome, Thank you so much everyone!
posted by roboton666 at 5:01 PM on August 28, 2011

Taking gold as an inherent measure of wealth rather than a volatile natural resources is an error pointed out by, among others, one Adam Smith two hundred years ago.
posted by zompist at 5:04 PM on August 28, 2011

...how do you measure its worth? Just by the pleasure it gives.

_{/Yukon Cornelius}
posted by justsomebodythatyouusedtoknow at 5:30 PM on August 28, 2011

A big reason lax consumer credit did not inflate the prices of most consumer products is because manufacturers also had access to easy credit, which they used to invest in efficiencies (read: factories in Vietnam, robots, IT), which help them lower the cost of the products they sell (and thereby be more competitive in their industry). These efficiencies helped to offset increased commodity prices. But eventually, if commodity prices keep increasing and there are no more efficiencies to invest in, companies have to cut labor costs in order to maintain profitability. These laid off people stop buying products, and stop making their mortgage payments. You see how this works.

This is why volatility in energy prices are so problematic -- price spikes can set the whole system tumbling. And the more leveraged the system, the more sensitive it is to volatility.
posted by blargerz at 5:42 PM on August 28, 2011

Blagerz: in the business world, this would equal more money chasing an ultimately fixed amount of resources, so even that should lead to inflation. That being said I can understand gaining efficiencies through automation, but thinking it through, once the credit goes poof for everyone there are fewer dollars to purchase more goods which theoretically should amplify deflation, since the efficiencies are now a permanent part of the manufacturing chain, but I suppose you could slow the robots down to keep down the slack in your inventory...

Sheesh, it really is way more complicated than my puny brain can deal with.
posted by roboton666 at 6:40 PM on August 28, 2011

Yes, it leads to inflation, but the point I was making was: it's not immediate (there is a lag time between commodity inflation and end product inflation), it's not 1:1 (increased input costs don't usually lead to equal end-product price increases), speculation driven commodity spikes aren't sustainable (eventually a wall is hit that companies/consumers cannot bear, especially in hyperleveraged environment -- so prices revert to a mean), and remember that increased commodity prices just create more incentive to excavate more of that resource, which increases supply, a downward pressure on price).

To your second point, once credit goes poof, yes that is deflationary. And yes, all those companies who invested in efficiency are often able to drop prices harder and faster than the non-efficient in order to accommodate the consumer's decreased buying power. This is a good thing for the consumer (except for the whole laying people off issue).
posted by blargerz at 7:34 PM on August 28, 2011

zompist: "1. It's not borrowing that creates money, it's fractional-reserve banking."

Bzzt, wrong. In your example, the Bank of Mattress has a claim for $50k, and you have $50k. You spend that on services from the guy down the street, who pays off expenses puts the remaining $48k under their mattress. There's now two deposits in the system from an original $50k savings, and if it keeps going will more than double the money supply. This is how fractional reserve banking induces inflation.

It's also how changes in saving vs spending induces inflation. It's not like you burn dollars when someone spends them on your services! And I leave it as an exercise to the reader to determine whether installment payments (I'll pay you in 36 monthly payments to build me a new car, etc) represent inflationary pressure.

Anyways, yes, changes in lending lead to changes in inflation rates. The current head of the Federal Reserve, Bernake, has published on this financial accelerator and decelerator and the relationship with inflation. As you've deduced, the opposite is also true; fewer dollars available in loans means lower demand.
posted by pwnguin at 6:38 AM on August 29, 2011

Am I completely off the mark to believe that easy access to cheap credit fuels inflation?

Yes.

zompist: On the real world level, there was an explosion of credit in the last decade, but inflation was quite low, so something is wrong with your logic.

The missing piece of the puzzle here is the central bank (in the US, the Federal Reserve), which uses monetary policy to maintain employment and inflation at stable levels. When demand is too high, unemployment is too low, and core inflation starts to rise, the central bank raises interest rates, cooling down the economy.

Thus it's the central bank that determines the level of inflation, not access to credit.

Core inflation from 1960 to 2011.

From a 1995 interview with Janet Yellen:

... the Federal Reserve can, I think, make a contribution on the employment side by mitigating economic fluctuations--by stabilizing real activity. I thus translate the "maximum employment" proviso of the Federal Reserve Act as a mandate for the Fed to lean against the wind, stimulating the economy when the economy is in recession or unemployment is clearly in excess of the NAIRU (the non-accelerating inflation rate of unemployment--the minimum rate of unemployment consistent with stable inflation), and restraining the economy through tighter policy [i.e. higher interest rates] when economic activity is pushing against the limits of capacity with inflationary implications. This is what the Federal Reserve has traditionally done and it is what I think the Fed should continue to do.

More background information on monetary policy here.
posted by russilwvong at 10:38 AM on August 29, 2011

Thus it's the central bank that determines the level of inflation, not access to credit.

Um, the central bank determines the level of inflation by targeting rates, which affects the interest people pay on all sorts of loans. In effect, the Fed tightens and loosens credit for everybody.
posted by blargerz at 2:27 PM on August 29, 2011

russil/blargerz: This is the "story told to children" version of economics that sadly neo-classical economists appear to have mistaken for reality. It's bunk. The fact that the neo-classical economics world hasn't noticed that the empirical evidence (and published research) doesn't match their models is an indictment of the field as a whole frankly.

russil: Surely the stagflation of the 70s alone is evidence that the idea that the Federal Reserve can control both inflation and demand in the economy with the single tool of varying short term interest rates is completely out to lunch? Even without that real-world experience, fundamental control theory states that you *cannot* control multiple outputs of a system, eg inflation and employment levels, with a single control input: It's just not possible.
posted by pharm at 3:56 AM on August 30, 2011

The missing piece of the puzzle here is the central bank (in the US, the Federal Reserve), which uses monetary policy to maintain employment and inflation at stable levels.

That's the orthodox theory, anyway. To say that this is controversial is putting it mildly.
posted by valkyryn at 6:03 AM on August 30, 2011

pharm: Surely the stagflation of the 70s alone--

Good point, I should have stated that monetary policy has been largely successful in preventing inflation only since the 1980s (when Paul Volcker brought interest rates up to 20% to kill inflation). Prior to that, mainstream economists thought that there was a tradeoff between the stable level of inflation and employment (the Phillips Curve), and the Fed let inflation accelerate too much.

Since then, though, monetary policy has been successful in preventing inflation, targeting a "natural" rate of unemployment of about 5% in the US. In 1994, for example, the Fed hiked interest rates seven times. This period is sometimes called the Great Moderation.

Is there counter-evidence you're thinking of, where interest rate hikes have been unable to prevent inflation? I'm thinking of Canada (where John Crow killed inflation in the same way as Volcker in the early 1980s) and Germany (where the central bank's monetary policy led to Britain exiting the European Monetary System in the early 1990s: high interest rates in Germany led to high unemployment in the UK because the pound was tied to the Deutschmark, "breaking the peg" after George Soros's attack lowered the unemployment rate).

The link between unemployment and inflation is that when unemployment is too low, this leads to upward pressure on wages, which can lead to a wage-price spiral. Conversely, when unemployment is high, there's going to be no pressure on wages. This is why the Fed focuses on core inflation (as opposed to commodity prices).

If interest rates were arguably too low, leading to inflation in asset prices and the housing bubble, this would be a case of the Fed having the power to pop the bubble (by hiking interest rates earlier), but failing to do so. It's not an argument that interest rate hikes would have been ineffective, only that they weren't used.
posted by russilwvong at 6:41 AM on August 30, 2011

If you're going to set the terms of the argument to exclude the counter-examples, what's the point?

Also, you've ignored my point that control theory makes it quite clear that you cannot control both inflation and employment with a single input. If more economists actually studied (say) engineering and thus were conversant with the analysis of complex systems they might be a little less arrogant about the predictive capabilities of their theories.

Now, if you were to argue that a central bank acting in cohort with the state using both interest rates and fiscal inputs (tax / spending changes) can manage to target both low inflation and full employment, then I might agree that it's possible, but much harder to pull off than the usual facile economic models imply, given that people do not in fact act as economic theory says that they "ought" to.
posted by pharm at 8:07 AM on August 30, 2011

pharm: --control theory makes it quite clear that you cannot control both inflation and employment with a single input.

A reasonable point. The Bank of Canada and the European Central Bank target the inflation rate only, not employment. A good background paper.
posted by russilwvong at 9:50 AM on August 30, 2011

I have no opinion on the substance of the debate, but I can assure you that macroeconomists are very, very familiar with control theory. In fact, I've never heard the Fed's dual role mentioned without a disclaimer about the absurdity of their mission.
posted by miyabo at 8:01 AM on August 31, 2011