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Residents of Weimar, Germany, in the 1920s ran into a similar prob-
lem.9 People who accepted paper money in return for work or goods soon
found that the paper money had no value. The magnitude of the German
inflation is almost impossible to comprehend. In 1920, the cost to send a
letter was under one mark. By 1923, the cost had risen to 50 billion
marks! In this period, prices could double in a day.
Based on stories like these, John Maynard Keynes quipped that in
inflationary times, people ought to take taxis, whereas in noninflationary
times, buses are preferred. His logic? You pay at the end of a taxi ride and
at the beginning with buses. In times of hyperinflation, the later you can
pay a fee, the lower its true economic cost. Similarly, in the inflationary
1970s, my friend Jay™s father taught him to always defer payment by
using credit cards.
My grandmother, who lived through the German hyperinflation,
described some of its effects. As soon as the family earned a paycheck,
she would immediately rush to a store to buy as much as possible before
prices rose. My grandmother™s modest earnings for teaching converted
into so many stacks of bulky bills that she used a baby pram to transport
the cash.
Stores could not change prices on goods fast enough to keep up with
inflation, so some implemented a multiplication factor system.10 A gro-
cery store, for example, might mark a can of soup at 10,000. The actual
cost of the soup at the time of purchase would be the price (10,000) times
a factor posted at the front of the store. So if the factor were 3, the soup
would cost 30,000. This system allowed the store to mark up all prices
immediately by changing the factor. A change from 3 to 4, for example,
immediately increases prices by 33%. My grandmother told of the stress
of waiting in line and fearing that the prices might be increased before
she could pay.
The effect on German savers was dramatic. Imagine someone who
worked his or her whole life to amass a pile of savings. To be concrete,
imagine someone who had stashed away 20 million marks. In 1920, this
would have been a fortune, allowing a life of opulent leisure. Just three
years later this fortune would not even come close to buying a single
Inflation 97



postage stamp. German savers who kept their money in marks were com-
pletely wiped out.
No cloud, it is said, is without a silver lining. While some were wiped
out by the German hyperinflation, others were made much richer. In fact,
hyperinflation works to wipe out all debts. The Bible writes of “jubilee”
years when all debts are forgiven: “Then you shall cause the trumpet of
the Jubilee to sound . . . And you shall consecrate the fiftieth year, and
proclaim liberty throughout all the land to all its inhabitants.” In a Jubi-
lee year, all debts are forgiven.
Hyperinflation is an effective jubilee. For example, during German
hyperinflation the total value of all German mortgages as measured in
U.S. currency declined from $10 billion to under one U.S. penny.11
Debtors were able to pay off their debts with the wheelbarrows full of
nearly worthless marks. Thus, one important effect of inflation is to hurt
savers and help debtors (more on how to profit from this later). This
could be considered good or bad, depending on whether one favors the
savers or the spenders.
While the erasing of debts helps some and hurts others, a second effect
of high inflation is simply bad. Because of the uncertain value of cur-
rency, many people simply stop accepting money. Thus, the economy
returns to barter with all the consequent inefficiencies of simultaneous
exchange.
So an economy like that of 1920s Germany can go in a full circle.
Before the creation of money, all exchanges are done by barter. Then
commodity money replaces barter with gold, and then with paper money.
If the paper money loses value because of high inflation, the economy
returns to barter with its inherent inefficiencies.



Goldilocks and Inflation That Is “Just Right”

Goldilocks entered the house of three bears. In the kitchen, there were
three bowls of porridge. Goldilocks was hungry. She tasted the porridge
from the first bowl. “This porridge is too hot!” she exclaimed. So, she
98 The Old Art of Macroeconomics



tasted the porridge from the second bowl. “This porridge is too cold,” she
said. So, she tasted the last bowl of porridge. “Ahhh, this porridge is just
right,” she said happily and she ate it all up.
Just as Goldilocks liked porridge that was neither too hot nor too cold,
economists think that the optimal level of inflation is neither too high nor
too low. While high inflation has obvious costs, falling prices also have
their “costs.” During a recent visit to Japan, my wife Barbara and I were
discussing Tokyo rents with a friend. Our host told us that every year she
meets with her landlord to discuss the magnitude of the rent decrease for
the following year. Over recent years, prices of land have fallen dramati-
cally, and consequently landlords have found it necessary to cut rents.
Rent reductions may sound delicious, but the broader consequences
can be quite negative. It turns out that falling prices can cause trouble. In
fact, the Japanese economy has suffered from deflation since the bursting
of its financial bubble in the late 1980s.
An obvious problem with deflation is that it rewards frugality”to an
extent that can harm the economy. My friend Jane, for example, never
wants to buy a computer because she knows that she can buy it for a lot
less next year. In a deflation, all sorts of prices are falling and this can
create a destructive cycle. Falling prices encourage people to wait to buy,
and this in turn reduces demand, which causes prices to fall even further.
This is precisely the opposite of the effects of hyperinflation that encour-
age people to spend money minutes after they are paid.
A second problem with deflation is that people really hate taking pay
cuts. While this seems obvious, the amount of hatred can be surprising,
and the consequences severe. One striking example involves the labor
negotiations between the workers and the management of Hormel Foods
in the early 1980s. Hormel™s products include the meat product Spam,
which inspired the name for junk e-mail. We teach this example in our
negotiations class at the Harvard Business School, and the saga is
recorded in the excellent documentary American Dream.
In the early 1980s, the areas surrounding Hormel™s plant in the mid-
western United States were hit by a severe recession. Accordingly,
Inflation 99



Hormel plant workers agreed to temporary wage cuts. In the next con-
tract negotiation, the workers and management met to reach a more per-
manent labor agreement. After some intense and protracted negotiation,
management offered $10/hour, an offer that was less than a dollar below
that contained in the pre-recession contract. The workers insisted that the
new wage be at least as high as the wage in the previous contract.
With pennies per hour separating the two sides, the union went on
strike. The results were devastating. The strikers were fired. Many of the
fired strikers were forced to move out of the area. The company found
plenty of replacement workers (the prevailing wage for similar jobs in the
area was around half of management™s offer).
The Hormel strikers were unwilling to take a small wage cut even
though the economic conditions were severe. The unwillingness to
accept management™s offer led to severe disruptions in the workers™ lives.
What does this have to do with money and inflation? The relationship
between inflation and the Hormel strike is as follows: Imagine that the
workers were given back their old wages but that inflation has eroded
the value of their wages to the level offered by management. Would the
workers have gone on strike, lost their jobs, and moved out of state to
prevent inflation from reducing their pay by less than a dollar per hour?
No one can know the answer, but evidence suggests that the Hormel
workers would have not gone on strike to prevent a few cents™ worth of
inflation.
If inflation changes a decision, it is labeled “money illusion.” In most
economic theory, workers are expected to react identically to a pay cut by
management, and the same effective pay cut due to inflation. If, however,
workers treat the two situations differently, mainstream economists say
that they are acting irrationally. (Behavioral economists suggest they are
acting like normal people.)
In real world situations, one can never be sure of the causes. So per-
haps there was more to the Hormel story than worker stubbornness. In
laboratory experiments, however, economists can create artificial infla-
tions and deflations. The result from recent experiments by the team of
100 The Old Art of Macroeconomics



professors Ernst Fehr and Jean-Robert Tyran indicate that people do
exhibit money illusion.12
A more mundane version of money illusion is the tendency for people
to set watches and clocks a few minutes fast. The clock on my computer
has been six minutes fast for years. If I were completely rational, I would
immediately know the real time. Even after years, however, my lizard
brain is still fooled by my fast clock. While I can rapidly calculate the
correct time, my first glance takes the clock at face value. Consequently,
I get out the door a little sooner than I would with a clock with the right
time.
Money illusion is one reason economists believe that some inflation
is good. Inflation allows the adjustment of prices without triggering
anyone™s emotional stand against getting a worse deal. For example,
increased competition from China might cause the “appropriate” wage
for U.S. textile workers to go down. This real-wage drop can occur either
through an actual pay cut (which is likely to be resisted) or through a
wage increase that is less than the rate of inflation. The true economic
impact is the same in both cases, but one is more palatable.
Wage rigidity appears to hold outside the laboratory as well, and some
believe it was an important source of the extremely high unemployment
rate during the Great Depression.13 Because of money illusion and defla-
tion, some scholars argue that Depression wages did not fall to levels low
enough to induce employers to hire more workers.
This Goldilocks view of inflation has been studied extensively by a
large number of economists.14 In 1996, Larry Summers gave a talk on his
views on the optimal inflation rate. Larry Summers is currently the pres-
ident of Harvard University, and although still quite young, was a tenured
economics professor at Harvard before holding a variety of nonacademic
positions, including Secretary of the Treasury. In his discussion, he sum-
marizes this sticky wage situation as follows: “You can™t get real-wage
reductions without nominal wage cuts, making it harder to get the needed
labor market adjustments.” For this and other reasons, Professor Sum-
mers concludes that an inflation rate of 1 to 3% “looks about right.”15
Inflation 101



Yogi Berra and Milton Friedman Share a Pizza

Where do we stand in our monetary journey? First, we have learned that
money is a financial tool invented to lubricate the economy. Without
money we would be forced to use inefficient and complex simultaneous
exchange as in the kidney transplantation market. Second, we deter-
mined the attributes of ideal forms of money, which helps us understand
the progression of types of money. Third, we have learned the Goldilocks
rule that some inflation, at a low rate, is “just right.”
A mystery remains, however, and it is the one that worried me in the
1970s. All of our knowledge about money and inflation is great, but what
is the use if inflation is an uncontrollable monster capable of toppling
presidents and destroying societies? Knowing the enemy may have some
benefits, but it would be much better if that enemy could be shackled.
The real mystery of inflation is that there is any mystery at all. There
is no magic behind the cause and control of inflation. In The Wizard of
Oz, the magic of the land is revealed when Dorothy pays attention to the
man behind the curtain. Similarly, there are people who determine the
inflation rate. Far from being an uncontrollable beast, inflation is a tame
dog both created and completely controlled by monetary authorities.
Milton Friedman appropriately gets credit for the academic under-
standing of inflation. As in many other areas, however, Yogi Berra cap-
tured its essence without a Ph.D. in economics. When asked how many
pieces he wanted a pizza cut into, Berra replied by saying, “Just four, I™m
on a diet.” (Whether he actually made this joke is subject to dispute.
Berra claims to be misquoted frequently. He coauthored a book titled I
Really Didn™t Say Everything I Said.)
Regardless of its origin, the joke recognizes an obvious truth. A pizza
contains the same number of calories regardless of how it is divided.
Thus, the choice of the number of slices merely determines the size of
each slice, not the size of the overall pizza.
Professor Friedman made the same discovery when it comes to the
value of money. The decision on how much money to create doesn™t have
102 The Old Art of Macroeconomics



much effect on the overall size of the economy, but it does have an enor-
mous effect on the value of money. He wrote, “Inflation is always and
everywhere a monetary phenomenon.”16
When the amount of money is increased, the result is inflation. Inflation
destroyed the value of seashells in Papua New Guinea. When their “money
supply” increased because of the importation of planeloads of seashells,
the value of each seashell decreased. Similarly, the German hyperinflation
was caused by a massive increase in the supply of German marks.
Inflation is simple. When more money is created, the value of each
piece of money declines. That is inflation.
What about the U.S. inflation of the 1970s? I was particularly scared
by news reports that suggested inflation was some mysterious force. As
Figure 5.2 shows, this inflation was not mysterious at all. It was, to quote
Milton Friedman, “a monetary phenomenon.”
The inflation of the 1970s was caused by a rapid growth in the money
supply. Just as there is no mystery (to those in the know) for the cause of
inflation, there is no mystery for its cure.
Growth in U.S. Money Supply (M3)




16%
14%
12%
10%
8%
6%
4%
2%
0%
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970

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