posted
I have sometimes heard it put that a low but nonzero level of inflation encourages investment, because sitting on your money effectively means losing it. Well, I've been thinking, and this doesn't seem to make sense to me; so I'm hoping an economist can set me straight. Consider: I have 100 dollars, which right now buys me 100 loaves of bread. If there is 1% inflation, then next year I can buy 99 loaves of bread; so if I'm not going to spend those 100 dollars right now, I had better find an investment giving me at least 1% interest. (For the sake of argument, we'll assume that I don't care between 100 loaves of bread now, or 100 loaves next year.)
Now suppose there is 1% deflation instead; that is, if I sit on my money, next year I can buy 101 loaves of bread. Well, that means that I can invest my money at any interest rate at all, even a slightly negative one, and still be ahead! So it seems to me that investments with return rates of half a percent, or a tenth of a percent, are going to be rational in a deflationary regime, but no good during inflation. But I see no reason we should only encourage high-return investments; there could well be people who prefer extremely safe but low-return uses of their money. Under inflation, they don't get to invest - they are forced to spend now, or they'll lose money.
So, is this argument for inflation a bad one, or is my analysis missing something?
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posted
Inflation is not the optimum method to encourage investment. It is hard to control because it is subject to too many variables. Tax policy is the best way to do it. You give tax incentives to make the desired investment (privately owned residences, retirement accounts; Urban business; etc. )and those investments happen just like magic.
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posted
It might be an argument for investing but it's swamped by other reasons. If you get 10% return on an investment, which is possible, that would be 10% better than letting your money sit in the bank regardless of inflation or deflation rate (unless it gets really extreme).
But if inflation gets horrible you would be well advised to invest even in things that don't increase in value, so yes, I think you are right that inflation increases investment. It also has other costs and benefits I am sure.
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posted
Anticipated inflation does not encourage or discourage investment.
You do not come out ahead by investing at a negative real interest rate: no matter what inflation is or is not, you will have less at the end of the investment than you would have had given another course of action (not investing, in this case). The value of an investment is not judged against how much actual cash on hand you have now, but on how it affects your net present value, which includes the future value of your assets.
Of course, inflation is never fully accurately anticipated, particularly in the long term. For a while, it was thought this would necessarily lead to higher inflation being correlated with less investment, and the view is still that this is generally true in the extreme, though not necessarily from any causative effect: high inflation countries also tend to have bad investment environments. Any inflation rate 'near zero' is much more complicated.
Some work shows that there seems to be a relationship between the sensitivity of net operating income to inflationary changes and their effects -- in one range inflation decreases investment, and in another it increases it, though decreases tend to be more dramatic than increases.
There are several tensions with inflation -- the change in interest rates (discouraging investment with positive inflation) and the cost of capital (encouraging investment with positive inflation). To see the latter effect, imagine you're going to purchase a new machine for your factory at some point. Right now the price is $100. Due to inflation, the price will be something like $108 in a year's time. This makes you more likely to buy now. That's capital investment right there.
There's one major effect on inflation, though, that's caused by tax rates. Changes in inflation rate change effective tax rates, which change the incentives to save. To quote "Inflation, Tax Rules and Investment: Some Econometric Evidence," by Martin Feldstein in Econometrica, "inflation will raise capital intensity . . . if the rate at which savers are taxed is less than the tax rate on borrowers". Generally speaking, individuals are savers and businesses are borrowers, so if personal income taxes are lower, on the whole, than corporate income taxes (some of which might not be explicit; regulations can introduce a virtual tax, for instance), then investment will increase.
Posts: 15770 | Registered: Dec 2001
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quote:You do not come out ahead by investing at a negative real interest rate: no matter what inflation is or is not, you will have less at the end of the investment than you would have had given another course of action (not investing, in this case). The value of an investment is not judged against how much actual cash on hand you have now, but on how it affects your net present value, which includes the future value of your assets.
Ok, ignore what I said about negative interest rates. Focus on an interest rate of 0.1%. If inflation is 1%, this is a bad investment, right? But there could conceivably be efficient investments with that interest rate, if they were sufficiently guaranteed. In a deflationary regime, though, 0.1% interest is better than sitting on your money or spending it right now.
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posted
And I strongly disagree that tax policy is a good way to encourage investment. If something is not worthwhile to invest in without the government artificially giving you more money for that investment, it does not become more worthwhile to invest in when the government does, it merely means the government is making it worth your while at the cost of money from someone else that makes you like the investment more than it is actually worth.
Imagine two investments, the first of which returns X, and the second of which returns X + 2.
In the basic case, a person will choose the investment returning X+2. That person invested in will be happy, and the economy will grow by somewhat more than X+2 (the investment would only be offered if it made for the person offering the investment at least as much as the return on the investment). Say no one even offers the investment paying X because X is substantially below good investment returns.
Now the government pays anyone taking the first investment 3. The second investment, which was marginal, is now sub-par, so nobody offers it. The economy is slightly more than X better off, because that's how much the investment was worth to the person offering it, and the 3 extra that the person doing the investing received were taken from someone else, redistributing money (and we're not even getting into the issues of transaction costs for taxes).
So with the government incentive, the economy is at least 2 worse off than it would be without it. Furthermore, money has been redistributed away from those doing production, so there's less incentive to offer investments actually bringing high returns (you're less likely to get investors) and more incentive to offer investments that are worse for you (since the government will make people more likely to invest in them).
The analysis never changes even if we assume all investments are taken or several other alternatives.
Now, if there's some externality making the first investment worthwhile to people as a whole but not to people who might offer it, that's something to think about. However, the situation arises more rarely than people might think, government intervention is rarely properly tuned, still creating negative effects, and there are better approaches than tax incentives.
The absolute best way that's been empirically discovered to improve investment is to reduce burdensome regulations (needed regulations are fine, I'm mainly talking about ones like those that are effectively bribes to areas of the government or work solely to protect current members of the market against new entrants), establish strong property rights, and provide protections against criminal business practices.
Posts: 15770 | Registered: Dec 2001
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The nominal interest rate doesn't matter, all that matters is the real interest rates. Yes, .1% nominal will be a negative real interest rate given positive inflation, but a positive real interest rate given negative inflation. So what? What matters is the real interest rate, both to the borrower and the lender, not the nominal one. The economy is benefitted by investments with positive real interest rates, not positive nominal ones.
Lets see if this explanation works better. It will also provide a case for some deflation to decrease investment, in a simple model. For someone to offer an investment means the amount invested will earn them at least the amount they pay out (they think).
In an economy with inflation, real interest rates can be anything. If a person thinks an investment will net them even the tiniest percentage in real dollars, they can offer a nominal interest rate slightly greater than the rate of inflation to match that real return.
In an economy with deflation, real interest rates are effectively restricted. Any real interest rate below the absolute rate of deflation would require a negative nominal interest rate, which almost no investor would take since they have higher growth due to deflation by sitting on their money. It only makes sense to offer a real interest rate higher than the absolute rate of deflation, which means endeavors with a small positive real return are not being made.
Of course, this is complicated by the presence of virtually guaranteed interest rates higher than inflation, but we'll leave them out of the picture for now .
Posts: 15770 | Registered: Dec 2001
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posted
Hang on, I'm not sure I get that. Again let inflation be 1%. You are saying that if the real rate of return on investing in you is 0.1%, you can offer to borrow at 1.1%, if I understood you correctly. Now then, that benefits me, because next year I get back 101.10 dollars, and am very slightly better off in terms of loaves of bread. You, however, have taken my 100 dollars, turned them into machinery which will next year be worth 101 dollars (that's the 1%), and used them to earn 0.1 dollars in addition - ok, I see it now, you have to think in terms of how much the machinery is worth. Yeah, fair enough.
Posts: 10645 | Registered: Jul 2004
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posted
No, that wouldn't go a long way to keeping a lid on inflation. Quite the opposite, in many situations.
Australia's inflation improvements have been due to increasing deregulation and liberalization, not the presence of mandatory superannuation. Mandatory superannuation created an artificial spike in the savings rate which has been declining ever since as households use debt instruments to consume closer and closer to the level they would prefer to consume at if the government were not forcing them to save.
Superannuation would only have an effect on inflation through a change in the savings rate. Despite a clear decrease over time in the real savings rate in Australia after the initial spike, inflation has behaved consistently in correlation with other factors, not that decrease.
Posts: 15770 | Registered: Dec 2001
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posted
Makes sense to me. But what about the part of it that isn't mandatory? Savings there are clearly being improved with encouragement of lower tax rates on superannuation and the co-contribution scheme. I can't see how those improvements can be called artificial.
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