Low inflation and government prudence may be harmful for .

[T]o reduce the rate of inflation in an economy from something like 10 per cent. to any figure which we would dare to regard as tolerable, cannot but be accompanied by severe stresses, one of which will be an increase in unemployment. That does not derive from the method by which it is done. It derives from the fact that it is done.

Even a relatively mild inflation distorts the structure of production. It leads to the overexpansion of some industries at the expense of others. This involves a misapplication and waste of capital. When the inflation collapses, or is brought to a halt, the misdirected capital investment — whether in the form of machines, factories or office buildings — cannot yield an adequate return and loses the greater part of its value.

Economists’ instincts are that uncertainty about current prices, future prices, and the real meaning of nominal trade-offs between the present and the future; distortions introduced by the failure of government finance to be inflation-neutral; windfall redistributions; and the focusing of attention not on preferences, factors of production, and technologies but on predicting the future evolution of nominal magnitudes must degrade the functioning of the price system and reduce the effectiveness of the market economy at providing consumer utility. The cumulative jump in the price level as a result of the inflation of the 1970s may have been very expensive to the United States in terms of the associated reduction in human welfare.

There is the guilty knowledge that a fall in the rate of inflation must be accompanied by a rise in the rate of unemployment and that a sharp fall from a high rate of inflation must have severe consequences, which are inescapable. This is because an economy geared to inflation at 25 per cent per annum has to undergo a terrific readjustment to change to expectation of only 15 per cent or 10 per cent per annum inflation. Since inflation cannot go on up for ever, this prospect is inescapable.

Ray then revealed the most simple and important distinction of all. There are only four things that move the price of assets: 1. inflation, 2. deflation, 3. rising economic growth, and 4. declining economic growth.

Regulation and more orthodox economic knowledge are not what protect the individual and the financial institution when euphoria returns, leading on as it does to wonder at the increase in values and wealth, to the rush to participate that drives up prices, and to the eventual crash and its sullen and painful aftermath. There is protection only in a clear perception of the characteristics common to these flights into what must conservatively be described as mass insanity. Only then is the investor warned and saved.

Risk arises as investor behaviour alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.

An alternative “rational expectations” view denies that there is any inherent momentum in the present process of inflation. This view maintains that firms and workers have now come to expect high rates of inflation in the future and that they strike inflationary bargains in light of these expectations.

Indeed, there has long been a strand of thought that says that moderate inflation may be necessary if monetary policy is to be able to fight recessions. Still, advocates of inflation have had to contend with a deep-seated sense that stable prices are always desirable, that to promote inflation is to create perverse and dangerous incentives. This belief in the importance of price stability is not based on standard economic models—on the contrary, the usual textbook theory, when applied to Japan’s unusual circumstances, points directly to inflation as the natural solution. But conventional economic theory and conventional economic wisdom are not always the same thing—a conflict that would become increasingly apparent as one country after another found itself having to make hard choices in the face of financial crisis.

During any period of inflation expectations, calculations, plans are bound to be based upon an extrapolation of that degree of inflation. After all, we all extrapolate—we have to form notions of what is to come from what has just gone. Then, if inflation in fact tails off or is eliminated, a certain proportion of those expectations are defeated, in some cases disastrously; and until resources have rearranged themselves and expectations have re-formed themselves upon the basis either of reduced inflation or of stable money values, there will be transitional unemployment of resources, including labour. Anyone who purports to reduce or end inflation without causing transitional unemployment is either deceiving himself or deceiving others; and those who object to a method which undeniably holds the key to inflation that it would cause unemployment...are really saying, though they do not dare to do so openly, that they would rather inflation continued than that additional, transitional unemployment should be incurred; for if inflation is slowed down or eliminated by whatever means—by prayer, by magic, by prices and incomes policy, or by control of the money supply—that is the result which will follow.

There is a big logical jump between acknowledging the destructive nature of and arguing that the lower the rate of inflation, the better.

By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily. . . . As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

The paradoxical result of this analysis is that overall portfolio risk is reduced by the addition of a small amount of riskier foreign securities. Good returns from Japanese automakers balanced out poor returns from domestic ones when the Japanese share of the U.S. market increased. On the other hand, good returns from U.S. manufacturers offset poor returns from foreign manufacturers when the dollar became more competitive and Japan and Europe remained in a recession as the U.S. economy boomed. It is precisely these offsetting movements that reduced the overall volatility of the portfolio.