Thursday, October 23, 2008

How Inflation Undermines Financial Security

Members of Congress have started to discuss a new round of economic stimulus measures. I am opposed to this in principle — untargeted economic stimulus has never solved anything more than the most mild recession, and what is needed now is not a boost of economic energy, but a change in direction. Another problem with the fiscal stimulus being considered is the inflation it is likely to cause. The federal government is already looking at a budget deficit the likes of which we have never seen. Budget deficits contribute to inflation, and if we add more borrowing and spending to what is already a record deficit, we are likely to see inflation to a degree that few of us have ever experienced, at a sustained annual rate of 20 percent or more, and perhaps much higher for shorter periods.

This kind of inflation is more than just the annoyance of paying higher prices and the hidden tax that takes away the value of your savings. It undermines all the financial arrangements that are supposed to provide us with financial security.

With high inflation, when you have to wait for money, it’s almost like not getting it at all. If the inflation rate is 20 percent, and you have to wait one year to get a payment, by then, the money will buy only 83 percent as much. If your cost of living adjustment comes only once a year, you may be living in poverty in the weeks before the increase. If a hurricane destroys your house, by the time the insurance company agrees they have to pay you, the money you get may be just half of what it takes to build a new house. You might have thought you had saved $3 million for your retirement, but after three years, the money might be only worth $2 million if the rate of inflation is much higher than the interest rate you are earning. These are some of the financial arrangements that lose much of their punch in periods of high inflation:

  • Money-back guarantees
  • Insurance — every kind
  • Savings and financial investments
  • Long-term contracts
  • Royalties for authors
  • Litigation
  • Advance reservations

Consider the effects of high inflation on health insurance. Health insurers are notorious for taking a long time to pay. Inflation gives them an incentive to pay even slower. But your physician has to pay in advance for all the supplies used to treat you. If your insurance company takes a year to pay your physician, it might not look like much of a problem to you, but your physician might go broke.

All this is troubling, but for the stability of the economy, the most troubling implication of high inflation is its effect on deposit insurance. The FDIC, which insures most U.S. bank deposits, is just one bank failure away from going broke. The FDIC can borrow from the U.S. Treasury, but the Treasury is also already frighteningly close to insolvency. If your bank fails in this unusual situation, the FDIC might not be able to pay back the amount of your deposits until after Congress agrees on a budget. In other words, it could take a year or two. And by then, the money you get won’t be worth so much. It’s a powerful disincentive against putting money in the bank — and with interest rates on savings that are already lower than the rate of inflation, and about to fall further, the incentives to keep money in the bank are almost nonexistent. But of course, if everyone takes their money out of the banks, the banks will all fail.

The banking system is a screwy system in times like these, a financial house of cards built on the savings accounts of savers who aren’t really being paid anything to participate in the scheme. The Fed should be raising interest rates to give people an incentive to keep their money in the banks — and even more important, Congress should be sending half a trillion dollars urgently to the FDIC so that you won’t have to worry about possibly losing most of your money in the event that your bank fails.

Most of all, though, Congress has to give up on the idea of massive deficit spending as the solution to every problem. It’s the deficit spending that makes inflation inevitable, so by spending less freely, Congress can rein in the most destabilizing effect in the economy right now. It is easy to be overconfident when inflation has been kept relatively under control for two decades. Yet no country that has pushed deficit spending to the limit the way the United States has this fall has ever avoided the perils of inflation. It is foolish to imagine that this time will be the one exception.