Why the System Needs Rising Prices

Nearly every major central bank targets 2% inflation, forever.¹ They publish their reasons for the number. The system is also rescued with new money whenever house prices, and the other prices that borrowing pushed up, threaten to fall suddenly. What breaks in that fall and who collects from the everyday 2% tell you exactly what’s being kept alive.

Why 2%, and why forever

Two facts about our money explain what the target has to live with. In our system, money is loaned into existence.² When a bank writes you a mortgage, it isn’t passing on someone else’s savings. It creates a new deposit in your account.³ That deposit is new money. When loans are repaid, that money disappears again.⁴ When they go bad, the loss eats the bank’s own capital instead, and the bank stops lending, which does the same thing to the money supply. So the money in the economy is the total of all the loans not yet repaid, plus whatever the central bank creates directly when it buys bonds.⁵ If all the loans were somehow repaid at once, there’d be almost no money left.

The second fact is that nearly all debt is fixed in pounds. The amount you owe stays the same whatever prices do. If prices and wages fall, your £1,200 monthly mortgage payment doesn’t fall with them. It just takes a bigger bite of a smaller income. The rate might be cut. The £180,000 you owe won’t be.

A system built out of those two facts can take a slow fall that comes with better tools. In that fall it’s the cost of making things that drops, and pay drifts down slowly behind it, so the money to meet a fixed payment is still there. What it can’t take is a sudden fall in the prices credit pushed up, houses first, because then the losses spread through the banks. In that fall it’s the lending that has stopped, so incomes and the house fall together and at once, and the fixed payment is hit from both sides in the same year. Houses come first because people buy them with borrowed money. And where the loan was written against a house, the house is worth less too, so the bank stands to lose more on that loan. So every time a sudden fall in those prices threatens, the system is rescued with new money, and the rescues keep getting bigger. In between, the aim is for prices to rise a little every year, forever. Two is the number the major central banks set their target against, as a point, as a ceiling, or as the edge of a band, and it’s a number the debt structure can live with.⁶ Small enough to feel like weather. Compound 2% a year and it halves the purchasing power of savings roughly every 35 years. Across a full working life it takes about 60%. Almost nobody notices it happening.

Technology explains the “forever”. It makes the job harder every year. Under a money nobody can add to, the natural direction of prices is down, because people keep getting better at making things and competition passes the saving on. Better tools mean the same goods take fewer inputs to make. That holds for everything technology has changed the making of. It doesn’t hold for housing, care, teaching, or building. How far prices would fall on their own is about the rate at which output per hour of work grows, which is what the productivity figures measure. In Britain that was near 2% a year before 2008, and between 0.7% and 1.3% a year from 2009 to 2019, depending on which of the statisticians’ two measures you take.⁷ The push behind that fall keeps getting stronger, because the tools are improving faster than they did, as software and AI spread into industry after industry. You won’t see that in the official productivity figures yet.⁸ So the true baseline isn’t zero. If prices would have fallen 2% on their own, as they would have at Britain’s rate before 2008, holding them flat already takes two points of push, and hitting the 2% target takes four. So in a world where technology keeps pushing prices down, a 2% target is a standing commitment to create enough new money and credit to cancel the whole of the price fall, and then push prices two points beyond that. And because technology compounds, what it takes to cancel the fall keeps growing. That’s why the target can never be hit once and then put away. Central banks publish why they aim there. They want room to cut interest rates in a downturn, they know wages resist falling, and they say the official measure of prices overstates the rise. Those are the reasons they give, and the debts aren’t among them. Missing it low is treated as an emergency. Missing it high is called “transitory”.

Why do they nearly all land on the same number? Every major economy runs the same design, money loaned into existence against debts fixed in pounds or the local equivalent, so every one of them has the same weak spot, a sudden fall in the prices credit pushed up. How hard that fall hurts depends on how much debt the economy carries and how that debt is written. But two is a number every one of those debt structures can live with. Nobody defects alone for free, either. If your neighbours inflate at two and you hold at zero, your currency strengthens, your exporters complain, and your politicians hear about it. It’s a race to debase, to cut what the currency buys before your neighbour does, and the club of major central banks moves together. Switzerland comes closest. It targets below two, and it spent more than a decade creating francs to stop its currency rising.⁹ Defecting cost it a central bank balance sheet bigger than the country’s economy. And the target makes itself look normal. Once 2% is officially defined as “price stability”, money losing value every year becomes health by definition, and the question of who collects the difference almost never gets asked out loud.¹⁰

One footnote, and I’m stepping outside the argument’s own ground here, so hold it loosely. The 2% number has a famously thin pedigree. It surfaced in New Zealand’s policy reforms in the late 1980s and spread through the 1990s by imitation.¹¹ Nobody derived it from first principles, and the arguments for it came later. The strongest of them is that 2% buys room to cut rates before they hit zero.¹² It was a number the debt structure could live with, and then the measure became the goal.

What breaks when prices fall

Take a café owner with a £150,000 business loan and a librarian with a mortgage, both customers of the same bank. Now let prices, incomes, and house prices fall broadly and suddenly, with nothing done to stop it.

1.Takings fall

The café’s menu prices are its income. When prices fall, its takings fall with them, unless it sells enough extra to make up the difference. Its ingredients get cheaper too, and eventually its wage bill. One thing doesn’t move. The loan payment.

2.Wages follow

The owner can’t pay yesterday’s wages out of today’s smaller takings, so hours get cut, then jobs, then pay. Wages are sticky, meaning they’re slow to move.¹³ They fall more slowly than prices, but in an economy this loaded with debt they follow. The librarian’s pay gets frozen while her mortgage payment stays fixed. Her frozen pay buys more, so on everything except the mortgage she’s better off. The falling prices were never her problem. The fixed payment is. Everything else in her life shrinks around it, its real weight climbing while the number on it stands still, and when her pay finally follows prices down, it’s the payment that breaks her.

3.The first missed payment

The fixed payment now takes a bigger share of a shrinking income. Say the café’s takings drop 8% in a year while the loan payment doesn’t budge. The owner did nothing reckless. The arithmetic stopped working. The debt got heavier without anyone borrowing another pound. That’s the first missed payment, and the same arithmetic is hitting millions of borrowers at once, because the price fall is economy-wide.¹⁴ How many of them are pushed into a missed payment depends on the size of the fall and on what happens to the price of the things the loans are secured on. In this fall those prices are dropping too, the librarian’s house among them. The historical record ties mass defaults to falling property prices. It ties them to falling shop prices only at the scale of the Great Depression.

4.The bank eats the loss

A loan is something the bank owns. What a bank owns is mostly promises of repayment, and what it owes is mostly deposits. Between the two is a thin cushion of the bank’s own capital. Measured against everything the bank holds, that’s a few pounds for every hundred.¹⁵ Measured the way regulators usually quote it, against everything it holds with each part weighted by how risky it is, it’s more than twice that.¹⁶ So the bank doesn’t need everyone to default. If losses on its loans reach the size of that cushion, the bank is insolvent, meaning it owes more than it can pay. That takes more than five pounds in every hundred going bad, because a bad loan isn’t a total loss. The bank sells what the loan was secured on and gets part of its money back. When the price of what the loan was secured on is falling, it gets back less, and then a smaller share of bad loans is enough.

5.Credit gets pulled

The wounded bank defends itself the fastest way it can. It stops making new loans, and when a loan reaches the date it has to be repaid or renewed, it won’t renew. Where it can cancel a borrowing limit without the borrower’s agreement, it cancels it, and a business with nothing wrong with it loses its funding. Where it has promised the limit in a contract, it can’t cancel, so in the first weeks of the pull-back, businesses borrow everything they were promised while they still can, and the bank finds money going out rather than doors closing. A builder who depends on short-term borrowing finds the limit cancelled once property prices start slipping. Sound firms start failing with their customers still there, because their funding isn’t.

6.The money supply itself shrinks

Money is created by lending, so when new lending stops while old loans keep being repaid, deposits are destroyed with nothing replacing them, and the total amount of money in the economy contracts.¹⁷ With less money around, prices fall further. That makes the remaining debts heavier still, which means more defaults, more bank losses, less lending, and less money. The loop feeds itself. Economists call it a deflationary spiral, but it’s the same arithmetic going round and round, each turn tighter.

7.Banks stop trusting banks

The same freeze runs at the top of the chain. Each bank knows the others are carrying the same kind of losses, so they stop lending to each other. In late 2008 some fully backed letters of credit, the bank guarantees that stand behind payments in trade, froze for days.¹⁸ Containers sat on docks because banks had stopped trusting each other’s promises. That’s what the cascade looks like at the top of the chain.

8.The state steps in

Faced with that sequence, authorities step in, crisis after crisis. They rescue banks, create money, and change rules, because the alternative is the whole debt pyramid being written down all at once. The debts show up in the rescues, not in the everyday 2%. Central bankers can read the sequence as well as anyone. They’re standing between an economy loaded with debt fixed in pounds and the arithmetic above.

Everything above is the debt structure’s reaction to a sudden broad fall in prices, not a property of falling prices themselves. Prices falling because things got cheaper to make is simply your money buying more each year, and this system can take that. The catastrophe needs the borrowing, and it needs the prices the borrowing pushed up to fall suddenly. People can live with falling prices. A system built out of debt fixed in pounds can’t live with a sudden fall in the prices credit pushed up.

What “a little inflation is good for growth” is keeping alive

The official story says that without inflation, people put off buying, spending dries up, and the economy stalls. Yet you buy a phone, a winter coat, tonight’s dinner, even though next year’s version will be better or cheaper, because you need or want them now. Electronics have fallen in price for decades and people queue overnight for them.¹⁹ What does get put off is the purchase that can wait, and sometimes that’s a big one, like a car. What falls when people wait is the borrowing that would have paid for it, and life carries on. No saver’s life gets worse because the money they put aside buys more later.

So if household spending isn’t what’s being kept alive, what is, and who collects?

The debts themselves. Inflation quietly shrinks the real weight of debt already fixed in pounds, and of new debt whenever the interest rate on it is lower than the rate prices are rising. The biggest borrowers, governments and anyone who borrowed to buy houses and shares, then repay in pounds that buy less than the pounds they borrowed. It’s a default that never needs announcing.

The banks. Rising prices and incomes, counted in pounds, keep the loans getting repaid on time wherever the payment doesn’t rise with them. On a loan with a fixed rate, the payment stands still while incomes rise. On a loan whose rate moves, that protection holds only while the rate rises more slowly than incomes do. Rising money and credit also lift the price of the things loans are secured on, and that lift holds while borrowing stays cheap. The cascade runs in reverse. Gentle inflation is the weather the bank’s loans live in.

The state’s funding. The clearest figures are American, and they come from a rescue year, when the same lever runs at full size. The gap between what the United States government spent and what it took in tax was larger in a single Covid year than the whole profit of corporate America, so taxing profits at 100% couldn’t have closed it.²⁰ What money creation gave the state was funding on a scale tax could not reach. The central bank bought the government’s debt with new money, and its buying kept the interest the government had to pay low. That’s most of how the gap was bridged. Then the inflation that followed made the debt the government already owed lighter, because it would be repaid in dollars that bought less. Inflation is the tax that never needs a vote.

Asset owners, first in line. New money usually enters through loans and financial markets, and reaches asset prices before it reaches wages.²¹ Whoever owns houses and shares gets the gain early, and whoever earns a salary pays the higher prices later. That ordering, repeated for decades, widens the gap between people who own things and people who don’t, whatever the two sides blame each other for.

And last, the weakest claims on anything real. Businesses that cheap credit helps keep trading, the ones called zombie firms, and the jobs that exist to run the redistribution and price-control schemes that manage the harm an inflating money does.²²

The growth story comes with an invoice. Between 2000 and early 2018, the world added roughly 185 trillion dollars of new debt to get about 46 trillion of measured growth.²³ Four borrowed for each one gained, and each new unit of debt buys less growth than the ones before it. That’s the look of growth, rented at a cost that compounds.

And the real price is the one that never appears on the invoice. Counted from zero, 2% looks tiny. Counted from the fall that should have happened, it’s the whole gap. Technology should have been cutting your cost of living by about as much as productivity grew, a point or two a year. Instead prices rose two.²⁴ The fall you never received is the productivity gain that technology handed the system, year after year, and the rise you paid sits on top of it. No statistic records that fall, because it never happened. Under a money nobody can add to, that gain would have reached you as lower prices. Instead, governments and banks created enough new money to stop prices falling. The rising money supply swallowed that gain, and what didn’t reach you later as pay went to the borrowers and asset owners above. You worked just as hard. Machines made the things in your basket cheaper to make. Your weekly shop never got cheaper. That’s the theft. And it’s why inflation is wage deflation read from the other side of the ledger.

“Deflation caused the 1930s, look at Japan.” Those were debt deflations, that same cascade, the collapse of systems built on too much borrowed money. They show what happens when the prices credit pushed up fall suddenly in a system carrying that much debt. They say nothing against prices falling because things got cheaper to make. Using them to argue for the 2% target is citing the disease as the case for the medicine that builds it.

“Wages fall in deflation too, so workers gain nothing.” They do fall, but more slowly than prices, because wages are sticky. When prices fall because things got cheaper to make, that stickiness works for the typical worker, whose pay drifts down slowly while the cost of living falls faster, so what their pay buys rises without constant renegotiation. Under inflation the same stickiness works against them. We’ve watched wages lose to house prices for forty years.²⁵

The rescues keep the debt structure standing. Growth is the story told for a little inflation. Solvency, the whole debt pyramid not being written down at once, is the function of the rescues, not of the everyday 2%, whose reasons are the published ones. Whatever the reasons, the everyday 2% still takes from savers and wage earners, year after year, and hands the difference to borrowers and asset owners. The system can take prices drifting down as things get cheaper to make. What it can’t survive is a sudden broad fall in the prices credit pushed up.

The arithmetic needs no villains. A central banker who let the bad debts be cleared out, who raised rates and let the defaults run, would cause mass unemployment, be blamed for a depression, and wouldn’t be allowed to finish. Volcker came closest in 1980. Even he only raised rates, and most of the debt he was crushing was owed by households and firms, not by the state. Nobody gets to run that experiment from here. The system chooses the behaviour, whoever holds the job. Indict the design, not the people operating inside it. They can’t step outside it. You can.