Planet Money: Inflation Saviors

Planet Money is probably the best economics show on radio; consistently interesting and usually economically sophisticated in a way most other finance related shows aren’t.  This episode from several years ago, rebroadcast last December, is one of their most intriguing, but flawed in one serious and frustratingly unnecessary way.  

It tells a story, which I had never heard, of an episode in Brazilian inflation history in which the Brazilian government managed to bring down a large inflation without the normal dislocations (i.e., a big recession) associated with bringing down inflation.

In short, they introduced a new unit of measure…not a currency yet, but just a unit of measure...which was defined to be X units of currency, with X increasing at the current rate of inflation.  The government published the official value of this unit of measure in currency every day, and started doing their everyday business in the new unit of measure.  Eventually the rest of the country became accustomed to performing their everyday transactions in this new unit of measure, consulting that day’s conversion tables to determine what amount of currency to pay.

Once the rest of the country because so accustomed, they eliminated to old currency and introduced a new currency denominated in the new unit of measure.  

Clever, if you can pull it off, and a truly fascinating story.

The problem is that the story omitted the most important part of the economics, which is that while this was going on the Brazilian central bank went through the mundane, boring, but incredibly difficult task of fixing the dysfunctional monetary policies that caused the inflation in the first place. 

Inflation can be seen to have two parts:  a piece caused by inflationary expectations and a piece caused by underlying monetary policy.  High inflationary expectations can be self-fulfilling as people try to spend money to turn it into assets that aren’t rapidly depreciating in value, causing something of a vicious cycle.  Monetary policy can cause inflation by continually pumping more liquidity into the monetary system than is necessary to support current activity at current prices, which causes prices to increase.  The second is by far the most important of the two.  If the central bank does that, the country will experience inflation.  Period, full stop.  If the central bank stops doing that, inflation will subside.  Period, full stop.  

The Brazilian trick outlined in the story deals with the transitionary period between irresponsible and responsible central bank management, which typically causes an economic downturn as people misread lower inflation for reduced demand for their products and services, and reduce output.  But it doesn’t do anything to make the central bank behave responsibly.  The story only mentions changes in central bank behavior in a tiny codicil at the end.  It would not be surprising, even expected, if listeners came away from the story thinking that the way to “solve” inflation was to ease the populace into using a new unit of measure, when, in fact, it is still thecae that the only way to stop inflation is to adopt a responsible monetary policy.