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Fighting Inflation

and the Significance of Goats

Copyright © 2000, 2004, 2005, 2007 by David E. Ross

Ask anyone who tried to support a family or operate a business in the United States in the late 1970s and early 1980s: Inflation can destroy hopes, plans, and even lives. No, our inflation at the beginning of the last quarter of the 20th century was not even of the same magnitude that ruined democracy in Germany after World War I or that periodically sickens Brazil. Yet, we saw the following:

• Families struggled as the costs of food, utilities, housing, and other aspects of living galloped ahead of wages and salaries.
• Manufacturers initially prospered when they were able to sell their products at prices substantially higher than their costs. However, this windfall evaporated when those same companies found their revenues were insufficient to restock inventories of raw materials and that depreciation allowances were too small to replaced aged equipment and factories.
• Investments in the stocks of long-established large corporations — long seen as a hedge against inflation — declined in value when neither earnings nor dividends could keep pace with increases in costs.
• A life insurance policy purchased to replace the income of a family's primary breadwinner quickly proved inadequate. Fire insurance based on the actual cost of replacing a house or business was insufficient to rebuild in case of a loss. Liability insurance provided scant protection when the real costs of a claim became greater and greater. Generous pensions suddenly appeared skimpy without cost-of-living adjustments. Retirement savings were depleted far more quickly than anticipated when even a reduced standard of living during retirement cost more than the higher standard of living during employment.
• Interest rates soared when lenders sought to protect themselves from the decreased value of their principal, which they could not retrieve for several years. Credit-worthy individuals suddenly found themselves unable to borrow for mortgages, automobile loans, and other consumer debts; credit card interest rates passed a level that had previously been thought usurious. Established businesses discovered that they could not borrow to finance working capital, expansion, or even renovation because the cost of interest would exceed any profits the borrowed money might generate.

Yes, the Federal Reserve Board (FRB) is quite correct in its focus on preventing inflation. However, the tool chosen by the FRB — raising interest rates in order to weaken the prosperity that some believe will fuel inflation — will actually make inflation worse and not better.

How do higher interest rates and a throttling back on prosperity promote inflation?

• For consumers, higher interest rates translate into higher costs (the measure of inflation) for automobiles and goods purchased with credit cards. Higher interest rates mean higher housing costs, either directly through increased mortgage payments or indirectly through the higher rents that landlords must charge to pay their mortgages.
• For businesses, higher interest rates mean higher costs to finance inventories, new equipment, and expanded facilities.
• For the federal government, higher interest rates increases the cost of servicing the national debt. As the FRB moderates prosperity, tax revenues will be impacted and the demands for welfare will increase. All these will reduce the budget surplus and might even create a budget deficit. Many economists believe that the deficits of the late 1960s and early 1970s were a significant cause of the inflation that followed.

Of course, we must ask: "Is not welfare reform depending on full employment? Is not a budget surplus good for our national economy?"

The Needed Tool

The most important question is: "Cannot inflation be fought without creating inflationary increases in the costs of debt?" The answer happens to be "Yes"! During the 1950s, the FRB had statutory authority to regulate consumer credit. By regulation, the FRB mandated a minimum down-payment on consumer goods (including automobiles) and a maximum period for repaying consumer loans. Then as now, the concern was that a consumer shopping spree can fuel inflation.

If that statutory authority no longer exists, it must be reinstated without further delay, before rising interest rates push inflation further. However, the consumer economy is different today than it was in the 1950s. Then, most consumer debt was in the form of loans to buy specific durable goods (automobiles, washing machines, refrigerators, etc). Those were loans, each with a starting and ending date, each with the purchased item as collateral, and each with a fixed monthly payment. Today, most consumer debt is in the form of unsecured revolving credit card balances, with no ending date and with the monthly payment varying as payments are made and new purchases are charged.

Given the reality of today's "plastic consumer borrowing", the following controls on unsecured revolving consumer debt would provide an effective tool against inflation:

• The minimum payment should be 20% of all new charges during the billing period plus 10% of the balance carried forward from the prior billing period.
• When a consumer fails to make the minimum payment by the due date, no further credit can be extended on the account until the account is brought current, even if the current balance is below the maximum credit limit.
• Credit limits must realistically reflect the consumer's ability to repay the debt in one year. A person earning $30,000 per year cannot pay $1,833 per month, which would be required to repay a $20,000 credit limit in one year at 18%.

These controls would have these results:

• Consumer debt would have an implied 20% down-payment requirement along with a overall payoff of less than a year. Such constraints would reduce the ability of consumer spending to fuel inflation.
• Currently, day-to-day living expenses can be financed for three or four years with current low minimum payments imposed by banks on credit card accounts (e.g.: $21 on a balance of $695). This is using medium-term debt to finance short-term expenditures. The next economic down-turn will demonstrate how unsound this practice is, a lesson apparently not learned during the recession of the early 1990s. Including 10% of the prior month's balance in the minimum payment would change this to using short-term debt (a year or less) to finance short-term expenditures. An economic down-turn would then be less serious than with the current situation.
• Banks would find that less capital is needed to finance unsecured consumer debt. They may find business loans to be a more productive use of that capital. Overall, interest and capital costs would go down, not up.
• Lower credit limits coupled with debt being paid off more quickly would reduce the involvement of credit card debt in personal bankruptcies.

For this to work most effectively, the practice of allowing consumers to access secured revolving loan accounts (e.g.: home equity loans) must also be curtailed. Instant extensions of secured credit via credit cards or checks should be prohibited. An advance from a home equity loan as a transfer of funds into a bank account should be subjected to a two-day hold to discourage its use for a purpose unrelated to the collateral.

Greenspan's Motives

The question remains: "What is wrong with prosperity?" While the answer should be "Nothing!", I remain concerned that Alan Greenspan and his friends do have an anti-prosperity motive. The problem is not with prosperity as such, it is with the growing spread of prosperity throughout the population.

Yes, economic growth has not yet touched everyone. Pockets of poverty remain in every urban area and in many rural areas. However, a growing proportion of the population is beginning to see itself as prosperous. Greenspan fears that, as economic power spreads, so will a demand for a share of political power. After all, while each adult citizen has a vote, the publicity that promotes candidates and sways votes is purchased by those who have discretionary income, by those who do not have to spend every dollar earned on food and rent, by those who can contribute money and time to campaigns.

Perhaps, Greenspan fears that dispersed economic well-being can only cause dispersed political power. And dispersed political power cannot be controlled by "spin doctors", "photo ops", platitudes, demagoguery, or special interests. Only by ending economic growth can real power be kept centralized.

Yes, I do see an elitist agenda, an agenda to fight against inflation using a tool that will increase costs while reducing economic growth. To Greenspan and his colleagues, this bitter economic medicine is acceptable because it will prevent the undermining of the political power of special interests.

22 May 2000

Goat Entrails

The New York Stock Exchange paused. Investors held their breaths. The whole world watched and listened. Alan Greenspan was presenting his semi-annual report to a Senate committee.

The sense of the report was familiar:

All the senators bought it. Not one serious question was asked. No one even seemed to notice the lack of concrete, definitive statements let alone question their absence from the report.

Economists from banks and universities rushed to tell us all what Greenspan said. Every investment advisor and analyst had an opinion. Reflecting a diversity of opinions about a vague report, the S&P 500 went up and then down.

Next week, Greenspan will pfumpf for a House of Representatives committee, and the charade will be repeated. Anyone who wants to find something in Greenspan's report about the future of interest rates, the stock market, or the economy would be better served reading goat entrails.

While Greenspan's report contains no real meaning, there is sense behind it. It is intentionally uncertain. Uncertainty is the enemy of prosperity, and prosperity scares Greenspan. If too many citizens share the affluence generated by prosperity, they will also want to share the political strength that affluence can buy. The political power of special interests would then cease. Greenspan fears such a diffusion and dispersion of power even more than he fears recession or even possibly inflation.

22 July 2000

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