Inflation's Moral Hazard

Information from the most diverse sources sometimes coalesces and provokes reflection on a subject to which one has not previously given sufficient thought. This happened to me recently with regard to the effect of monetary inflation on human character. With many observers predicting a substantial rise in inflation as a result of various government spending programs undertaken to reverse the current global downturn, the topic is anything but academic.

I was reading The Innocence of Edith Thompson, by Lewis Broad, a book about a murder in 1920s London. Freddy Bywaters was a handsome young sailor, Edith Thompson an unsatisfactorily married woman. They had a torrid love affair, and Bywaters eventually stabbed Thompson’s husband to death as he walked home one evening from the theatre with his wife. Thompson’s love letters to Bywaters, prosecutors claimed, were an incitement to murder -- such an incitement that they rendered her a murderess herself. She was found guilty and hanged. Broad’s book happens to mention Thompson’s comparative prosperity. She managed a millinery shop and earned enough to put her in the middle class: “six pounds per week,” as the author puts it, “or twelve pounds in our debased currency.” A doubling of prices in three decades called a debasement of the currency? What would Broad have written if he knew what was to come in the years ahead?

Then I began reading Ursa Major, a study of Doctor Johnson by C.E. Vulliamy. It was hostile to the great man; but from the point of view of inflation, what was interesting was Johnson’s pension from the Crown. Worth £300 per year when granted in 1762, Vulliamy informs us, it would have been worth £800 at the time of Ursa Major’s publication in 1946.

But that £800, according to Broad’s book, would have been worth only £400 as recently as 1921. If we put these two stories together, it means that £300 in 1762 was the equivalent of £400 in 1921; or that in a century and a half, prices rose in Britain by about 33%, an overall rate so slow as to have been almost imperceptible year to year. Such stability must have seemed more a fact of nature than a consequence of human behaviour or policy, and therefore something that would last forever.

I can attest to a prolonged era of price stability from evidence in my own lifetime. When I was born, it cost one and a half times as much to send a letter as it did 100 years earlier. In my childhood, during the ’50s, we still used the same coins, with the same denominations, that people had used during the Victorian era. Occasionally, we would come across pre-Victorian coins. Their continued use was not absurd: Though prices had risen, they still bore some resemblance to what they had been in the earlier time.

I also remember the vast white £5 notes that my father kept in a roll in his pocket, only 100 or 200 of which would have been needed in those days to buy a decent house. And it was still possible for a boy like me to buy something with the smallest coin of the realm, a farthing, worth one-960th of a pound.

The regime of relative price stability soon collapsed. During the ’60s and ’70s, the sums of money of which everyone spoke increased, first by a little and then by a lot. All that had seemed solid, to paraphrase Marx, melted into air.

At the time, I gave no thought to the effects of this inflation, which tended to be discussed in purely economic terms. In a naive way, I assumed that since most people’s income tended to rise with inflation, there was nothing to worry about. I did not suffer personally because of it, nor did most of the people I knew. If a product once cost y and now cost 10y, what did it matter, so long as your income had gone up by ten times, too? Since people seemed better off, one could even assume that incomes had risen faster than inflation.

Yet this was a crude way of looking at things, as my father’s fate should have instructed me. He sold his business in the ’60s, at the end of the period of price stability that had reigned throughout his life, for what then seemed a large amount of money. He was a man who held a deep contempt for financial speculation with the result that he did nothing as inflation inexorably eroded his savings. He grew poorer through the remaining 30 years of his life, and might have sunk into poverty had he not moved into a house that I owned.

For a while, I was angry about what seemed my father’s improvidence. As the current financial crisis has conclusively demonstrated, however, not everyone is blessed with foresight, not even those whose livelihood depends on the claim of possessing it. My father was born of a generation that saw money as a store of value, a far from dishonorable notion. And as I reach the age when inflation might cause me some embarrassment, my sympathy with my father’s plight has grown. I am no longer young enough to fight another day, economically speaking: The destruction of my wealth by inflation would be final.

Like my father, I am not particularly avaricious; on the other hand, I have no vocation for poverty and share the prejudice of most of mankind that a loss of capital and a sharp decline of income are much to be feared. In an era of price stability, a man of my disposition could judge with a degree of certainty how much money he would need for each year of his retirement. The calculation of how much principal he would require now, in order to yield that amount of money in interest each year in the future, was relatively simple and would yield financial tranquillity.

That kind of tranquillity about one’s financial future is more difficult for most of us to achieve now. U.S. president Ronald Reagan and British prime minister Margaret Thatcher brought raging inflation under control during the ’80s, but they could not reverse the public’s loss of confidence in money as a store of value. People must today try to foresee not only how long they will live but also the reigning economic conditions of the next 40 years. And this, to quote Doctor Johnson in another context, “requires faculties which it has not pleased our Creator to give us.”

There seems to be no choice, then, but for everyone to have constant regard to his own pile, and to try to outwit the economic moth and rust that threaten to erode all but the largest fortunes: He must speculate, or risk losing nearly everything. The question of whether it is best to hold shares, or bonds, or property, or some combination of them, is constantly before him. Further, funds’ managers and investors do not always have the same interests. A man trying to preserve a competence learns to trust neither himself nor others.

Many times I have received advice to borrow as much as I could so that I might buy the best and most expensive house possible. And for many years it seemed good advice, for what could be more advantageous than to buy an appreciating asset with depreciating currency? It was a painless way to become rich.

I did not take the advice. I remained sufficiently a child of the regime of constant prices that I found it difficult to imagine how a sum that seemed vast now would seem trifling in just a few years. Even so, I borrowed within what I thought to be my means, and thereby accumulated assets of a value that I could not have obtained by the steady buildup of savings. The curious result has been that at no point in my career could I have afforded to buy the real estate that I now own, whose value greatly exceeds my cumulative income over the years. If my borrowing had been bolder, the value would exceed my earnings even more.

My situation is no different from that of millions of others. And since we are all richer than we should otherwise be, is there anything to complain about? The problem is that this “richer” represents a curious kind of wealth. I must live somewhere, and everywhere else has appreciated in value, too. I don’t live any better in my house than I did before simply because it is worth three times what I paid for it. Its increase in value is thus of no use to me, unless I want to sell it to live in a less valuable house and invest the difference.

But for many years, people have treated rising property values as if they were the real thing, and the government has supported this belief by allowing extremely easy credit. My bank gave me some good examples not long before the crunch.

I still remember the letter that the bank sent me when I was a student, pointing out with considerable asperity that I was almost £3 overdrawn and asking when I would correct this serious irregularity. Nearly 40 years later, I briefly overdrew my account again and wrote to the bank, explaining that I would clear the balance in a few days. Unusually, the bank called me: a banker wanted to see me, and would like to come to my house.

When he arrived, I repeated that I would pay off the overdraft in less than a week’s time. “Oh, we don’t want you to do that,” he said. “I’ve come here to ask whether you want to borrow more money.”

“What for?”

“Well, a nice new car, or perhaps the holiday you’ve always dreamed of.”

I was astonished. The bank was encouraging me to indebt myself for an asset whose value would swiftly melt away -- or for one of no resale value whatsoever.

Some time later, I was thinking about buying another house, for which I would need a short-term loan. Passing my bank, I entered and inquired about how I would arrange such a loan. Within five minutes, the bank had offered me a sum that was 20% larger than the single asset that it had evidence that I owned. I came away feeling that the bank was careless to the point of frivolity. The bank was nationalized two years later and its three million shareholders wound up virtually expropriated.

During those fat years, a man could sit at home watching television and imagine that he was growing richer thereby. I remember an eminent professor’s telling me that he was making nearly $1,000 per day merely by owning a very large house in a fashionable area. The government could not have been better pleased, for the majority of the population felt prosperous as never before and attributed their affluence to the government’s wise economic guidance.

But asset inflation as the principal source of wealth corrodes the character of people. It not only undermines the traditional bourgeois virtues but makes them ridiculous and even reverses them. Prudence becomes imprudence, sobriety becomes mean-spiritedness, self-control becomes betrayal of the inner self, patience steadiness becomes inflexibility. And circumstances force almost everyone to join in the dance.

Except in one circumstance: the possession of a salary and a pension that the government promises to index against inflation. This is the situation of public-sector workers and is a pyramid scheme, too. But meantime, such employment will seem a safe haven, and the temptation will be for government to expand it, with the happy consequence -- for itself -- of increasing dependence. And dependence, too, undermines character.

It is no coincidence that the Western leader most worried about a new bout of inflation is German Chancellor Angela Merkel. If there is one thing that Germans agree about, it is the necessity of a sound currency. The hyperinflation of the 1920s brought about a German change in mentality as great as the one caused by the First World War, with what disastrous consequences 50 million dead might attest if they had voice. The solidity of the deutsche mark was the great German achievement of the second half of the 20th century.

Inflation is not a bogey for everyone -- not for those who wish to restructure society, for example. But for the rest of us, the consequences of its full-blown return are not likely to be good: for inflation is not an economic problem only, or even mainly, but one that afflicts the human soul.

This piece originally appeared in National Post

This piece originally appeared in National Post