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In a recent piece, Gwyn Morgan argued against loosening EU monetary policy, on the grounds that it would cause high inflation:
"High inflation brings with it a huge moral hazard in that the value of personal savings and pensions collapses, while those who have lived beyond their means are rewarded by the reduced value of their debts."
It is not clear what Mr. Morgan means by "high" inflation. However, in any context this quote is misleading as it confuses expected inflation with unexpected inflation.
When a lender makes a fixed-term loan to a borrower, expected inflation is priced into the contract, which ensures that the lender receives an expected real (inflation adjusted) return. If realized inflation deviates from expected inflation, then one of the parties is "rewarded" by Mr. Morgan's use of the term. If inflation is higher than expected, those who "lived beyond their means" have the real values of their debts reduced. However, if inflation is lower than expected, then lenders realize a higher real return than what they anticipated.
Over the last few years in Europe inflation has been much lower than anyone expected. Government bond yields are proof of this. On November 17, 2006, the government of Germany issued a 10-year bond (series DE0001135317) that pays the holder 3.75 per cent interest every year for 10 years. The price at issue was slightly more than €100. As the rate of inflation fell and expectations for future inflation fell, a bond paying 3.75 per cent per annum became much more attractive to investors, which caused the price of that bond to rise. As of today, the bond is currently selling for €115.68; an appreciation of more than 15 per cent from late 2006.
Mr. Morgan should not be worried about an unjustified wealth transfer from lenders to borrowers. Over the last few years, investors in safe European assets have profited greatly from lower-than-expected inflation. Anyone concerned about unjustified wealth transfers between lenders and borrowers should be calling for higher rates of inflation.
Mike Moffattis an Assistant Professor in the Business, Economics and Public Policy (BEPP) group at the Richard Ivey School of Business – Western University