The Erosion

The hundred in the envelope remains a hundred. Nothing has been removed, no entry crossed out, no deduction announced. Yet if the basket it could buy now costs a hundred and ten, the envelope no longer contains the same provision for tomorrow. It contains ten-elevenths of it. In this invented example, a ten-percent increase in prices reduces the purchasing power of unchanged cash by about nine percent. The difference is small enough to overlook and exact enough to matter: inflation changes a ratio, not the printed number. This is the erosion that makes rising prices feel like a charge collected without presenting a bill. But the envelope is only one kind of claim. To discover who bears the charge, we have to follow the terms on which people hold money, receive income and promise payment, rather than place every form of saving inside the same drawer.¹

A lender can anticipate a fall in money's value and try to write compensation into the bargain. Suppose the desired real return is two percent and next year's inflation is known to be ten percent. A nominal return of twelve and one-fifth percent would turn a hundred into a hundred and twelve and one-fifth; divided by the new price level, it buys a hundred and two in today's goods. Fisher's distinction between money interest and real interest gives the comparison its proper form. It also reveals why adding the two percentages is only an approximation. Yet the arithmetic describes a bargain that could preserve the return, not a promise that every account will offer it. The available interest rate, fees, contractual terms and the actual price change still have to be examined. Expected inflation and complete compensation are separate facts.²

The surprise falls differently. Suppose a fixed payment of a thousand was expected to arrive when the price index was one, but arrives when it is one and one-tenth. The creditor receives purchasing power of about nine hundred and nine; the debtor discharges an obligation of that same real size. On this contract, the creditor's loss is the debtor's gain. Neither has to receive newly issued money for the redistribution to occur. Yet a person may stand on both sides of several promises, holding deposits while owing a loan, or receiving a pension while paying a mortgage. The relevant exposure is assembled from the claims, their timing and their terms. A smaller real debt also does not guarantee an easier life: the debtor's income and living costs may have changed adversely. The contractual gain and the household's overall position require different accounts.³

There are ways for a promise to carry protection, though protection is always written against something particular. A payment indexed to the basket in our example could rise from a thousand to eleven hundred and preserve its purchasing power over that basket. A payment that resets periodically may respond only after a delay. A claim on a business or a physical asset has a different exposure again: its value depends on what the asset can earn or command, and need not follow a price index. These distinctions prevent a moral sorting of the economy into thrifty creditors and fortunate debtors. They also prevent the word escape from doing too much. Someone may preserve a financial return while facing higher prices before wages adjust, or hold cash because upcoming payments require it. The ability to change a portfolio does not erase the need to meet tomorrow's obligations.

Even a fully expected inflation can make maintaining purchasing power an occupation. Non-interest-bearing cash carries an opportunity cost when another suitable asset pays interest, and a higher opportunity cost gives its holder reason to manage with less cash. More frequent transfers, closer scheduling and more attention to balances can then become privately worthwhile. Lucas makes this logic explicit in a transactions model: time used to economize on money is time unavailable for producing goods. This is a cost beyond the transfer between a debtor and a creditor. The transfer rearranges claims; the extra effort uses resources. Its size depends on the available payments technology and alternatives, so the old image of shoes worn out on trips to the bank is a mechanism rather than a literal description of every economy. Knowing the price rise in advance permits an adjustment. It does not make every adjustment free.⁴

Calling the erosion a tax raises one more accounting question: who receives the proceeds? An issuer can obtain resources by spending newly created money, which is seigniorage. That flow is distinct from the reduced purchasing power of an outstanding stock. In a deliberately simple example, let the public initially hold a hundred in currency at a price index of one. Let the issuer spend ten newly issued units at a price index of one and one-tenth. The new money buys about nine and one-eleventh in initial units; the old notes have lost the same amount of purchasing power. Total real currency balances remain a hundred. The equality comes from these assumptions, including the unchanged final real balance. It cannot be carried over to every inflation episode or every financial loss. A private debtor's gain, for example, need not place any resources in the government's hands.⁵

Who pays, then, depends on what remains fixed while the unit changes, what was expected when the promise was made, and what it costs to arrange protection. Cash can lose purchasing power openly while a nominal statement stays immaculate. A lender can receive more money and still obtain fewer goods than the bargain anticipated. A debtor can gain on a contract and suffer elsewhere in the same household budget. Behind each apparent winner or loser is a set of dates and terms. The earlier edition's concern was the insecurity that enters promises when their measure will not hold still. That concern survives the distinctions; it becomes more exact. The point of tracing the erosion is to see which loss is a transfer, which adjustment consumes resources, and which apparent gain disappears when the rest of the account is opened. A stable-looking number cannot answer for the life it was meant to provide.