Naked Economics Wheelan, Charles (books to read for 13 year olds TXT) 📖

whole loan in 1923 with fewer marks than it cost to buy a newspaper. Even today, it is not possible to get a thirty-year fixed mortgage in much of Latin America because of fears that inflation will come roaring back.

America has never suffered hyperinflation. We have had bouts of moderate inflation; the costs were smaller and more subtle but still significant. At the most basic level, inflation leads to misleading or inaccurate comparisons. Journalists rarely distinguish between real and nominal figures, as they ought to. Suppose that American incomes rose 5 percent last year. That is a meaningless figure until we know the inflation rate. If prices rose by 7 percent, then we have actually become worse off. Our paycheck may look bigger but it buys 2 percent fewer goods than it did last year. Hollywood is an egregious offender, proclaiming summer after summer that some mediocre film has set a new box office record. Comparing gross receipts in 2010 to gross receipts in 1970 or 1950 is a silly exercise unless they are adjusted for inflation. A ticket to Gone with the Wind cost 19 cents. A ticket to Dude, Where’s My Car? cost $10. Of course the gross receipts are going to look big by comparison.

Even moderate inflation has the potential to eat away at our wealth if we do not manage our assets properly. Any wealth held in cash will lose value over time. Even savings accounts and certificates of deposit, which are considered “safe” investments because the principal is insured, are vulnerable to the less obvious risk that their low interest rates may not keep up with inflation. It is a sad irony that unsophisticated investors eschew the “risky” stock market only to have their principal whittled away through the back door. Inflation can be particularly pernicious for individuals who are retired or otherwise living on fixed incomes. If that income is not indexed for inflation, then its purchasing power will gradually fade away. A monthly check that made for a comfortable living in 1985 becomes inadequate to buy the basic necessities in 2010.

Inflation also redistributes wealth arbitrarily. Suppose I borrow $1,000 from you and promise to pay back the loan, plus interest of $100, next year. That seems a fair arrangement for both of us. Now suppose that a wildly irresponsible central banker allows inflation to explode to 100 percent a year. The $1,100 that I pay back to you next year will be worth much less than either of us had expected; its purchasing power will be cut in half. In real terms, I will borrow $1,100 from you and pay back $550. Unexpected bouts of inflation are good for debtors and bad for lenders—a crucial point that we will come back to.

As a side note, you should recognize the difference between real and nominal interest rates. The nominal rate is used to calculate what you have to pay back; it’s the number you see posted on the bank window or on the front page of a loan document. If Wells Fargo is paying a rate of 2.3 percent on checking deposits, that’s the nominal rate. This rate is different from the real interest rate, which takes inflation into account and therefore reflects the true cost of “renting” capital. The real interest rate is the nominal rate minus the rate of inflation. As a simple example, suppose you take out a bank loan for one year at a nominal rate of 5 percent, and that inflation is also 5 percent that year. In such a case, your real rate of interest is zero. You pay back 5 percent more than you borrowed, but the value of that money has depreciated 5 percent over the course of the year, so what you pay back has exactly the same purchasing power as what you borrowed. The true cost to you of using someone else’s capital for a year is zero.

Inflation also distorts taxes. Take the capital gains tax, for example. Suppose you buy a stock and sell it a year later, earning a 10 percent return. If the inflation rate was also 10 percent over that period, then you have not actually made any money. Your return exactly offsets the fact that every dollar in your portfolio has lost 10 percent of its purchasing power—a point lost on Uncle Sam. You owe taxes on your 10 percent “gain.” Taxes are unpleasant when you’ve made money; they really stink when you haven’t.

Having said all that, moderate inflation, were it a constant or predictable rate, would have very little effect. Suppose, for example, that we knew the inflation rate would be 10 percent a year forever—no higher, no lower. We could deal with that easily. Any savings account would pay some real rate of interest plus 10 percent to compensate for inflation. Our salaries would go up 10 percent a year (plus, we would hope, some additional sum based on merit). All loan agreements would charge some real rental rate for capital plus a 10 percent annual premium to account for the fact that the dollars you are borrowing are not the same as the dollars you will be paying back. Government benefits would be indexed for inflation and so would taxes.

But inflation is not constant or predictable. Indeed, the aura of uncertainty is one of its most insidious costs. Individuals and firms are forced to guess about future prices when they make economic decisions. When the autoworkers and Ford negotiate a four-year contract, both sides must make some estimates about future inflation. A contract with annual raises of 4 percent is very generous when the inflation rate is 1 percent but a lousy deal for workers if the inflation rate climbs to 10 percent. Lenders must make a similar calculation. Lending someone money for thirty years at a fixed rate of interest carries a huge risk in an inflationary environment. So when lenders fear future inflation, they build in a buffer. The greater the fear of inflation,