Inflation vs Central Bank Digital Currencies
A note before you proceed —
Kindly forgive my ignorance if I paint the picture too simplistically or wrongly, for I am neither an economist nor a cryptocurrency expert. I am a dilettante, dabbling in both. Treat this as a discussion piece, and feel free to comment to continue the discussion. I would love to be illuminated through an engagement with people smarter than I am.
Inflation
Have you ever felt at a loss of not understanding step-1 when others have stepped on to step-2,3,4,5 … ? When you feel you haven’t figured out how to walk when others have started flying? I feel that way about inflation in economic theory. Everyone takes it as a fact that prices should increase with time, year over year. But that has never quite felt intuitive to me.
Aren’t means of production becoming smarter? Isn’t technology improving? Shouldn’t economics of scale make production cheaper? New roads & bridges making distribution easier? Surely, there is more going on here than meets the eye.
For the purposes of this post, I will ignore cost-based inflation. If input costs (oil, raw materials) are increasing because of one reason or another, then it is logical that the product’s price will increase. That doesn’t become an intellectual curiosity. But why should prices increase if costs are not increasing, and technologies for production & distribution are constantly improving? That is the object of intellectual curiosity.
The demand-side economics answer to this is that as wages increase, the purchasing power of people increases and the cost of production also goes up (due to higher human capital cost), requiring firms to jack up prices as well. This causes inflation. While this makes logical sense & gives everyone an intellectual kick since there’s circular thinking involved, one is left to wonder whether this logic is airtight, and the only way things need to be.
After all, technology is evolving at an exponential pace, enhancements in one field seed a myriad others in other fields, on & on, ad Infinium. We should have a world of plenty, not of stretched household budgets.
My interpretation of what causes inflation in this scenario (where production, distribution & raw material costs are stable) is this -
Too much of economic activity is non-value adding i.e. not directly related to production or distribution. It consists of overheads like excessive admin, and marketing departments running rampant, and this causes Inflation.
Some clarifications before we move further -
- While I would receive a lot of flak for calling marketing an overhead, I would point out that I am saying that ‘too much marketing’ is an overhead. After all, it is like an escalating arms race as each company tries to outdo the other, ballooning up this cost center without improving any inherent product value.
- Another example of non-value-adding jobs would be over-investment in initiatives by companies in ‘shiny moonshots’ which were doomed from the start. Example: $10B being funneled into Full-Self-Driving technology over the last decade. Of course, there is a tricky line here as you do want to encourage innovation, creative distruction & moon-shot thinking. Too much of a good thing is the problem. When there’s not enough opportunity for disruption but VC money is cheap, then you see companies taking on random side hustles and every executives trying to be the next visionary.
- Another example of non-value adding economic activity is evidenced by bubbles. Like higher-education costs increasing dramatically without a corresponding increase in teacher salaries or improved infrastructure. The cost basically getting added is management overheads.
All the above scenarios happen blatantly when there is easy money i.e. raising debt capital is very easy. This is what is the ‘overheated’ economy.
Increasing purchasing power alone is necessary but not sufficient for inflation. Inflation would happen when a wage increase is fuelled by an increase in superfluous economic activity, which in turn is encouraged by the availability of easy money.
How do CDBCs help here? For this, we have to understand how a nation’s central bank influences the economy, and how it encourages or discourages debt creation.
Monetary Policy
The essential thing to understand is that the monetary-policy tools available to the central bank are relatively coarse. They can influence interest rates & money supply in the economy as a whole. They don’t differentiate between sectors, rather letting the invisible hand of the market sort that part out. And herein lies the problem.
Imagine if you have to cook a whole lunch of vegetables, lentils, and chapatis but you are only given one large saucepan. You are told to cook everything together and only control the heat knob. How do you think the lunch will turn out? Obviously, certain items will end up burnt and certain others will be undercooked.
The burnt-out pieces, that’s overheating i.e. inflation. The undercooked pieces are market failures (like providing for the environment, the elderly, the disabled — the underserved sections of the economy).
Central Bank Digital Currency
CDBCs would enable Central Bank to have finer control of the economy.
One of the things CBDCs allows is attaching a purpose to digital money. So instead of all money being transmutable and freely exchangeable, there will be money that can be used only for specific uses. Example: Imagine “blue money” which can only be given to institutions providing education services, “red money” which can only be used within this year, and “green money” with no restrictions is equivalent to regular money.
Central Banks will be able to affect money supply & interest rates at a finer sector level. They can detect where the economy is heating up or needs to be heated up. They could evaluate which sector has fierce competition but not much innovation and decide to cool this down so that employees leave this sector and begin more productive pursuits. They can evaluate which sector is underserved and heat this up by making low-interest-credit available which can be used only in this sector.
As a result of this finer control, I posit that unwanted inflation can become highly tamed with a full deployment of CDBCs.
Now, probably the free-market & libertarian soul inside you is alarmed at this prospect of CBDCs, since it allows governments much more control & greater ability to track economic activity. While those concerns are not unfounded, that is a discussion for another time. So tell that soul to calm down for a moment. And think whether the hypothesis laid out above is true. Can this new monetary technology help society tame the inflation?
