The Merits of Inflation
In a series of speeches designed to defend his record, Alan Greenspan, until recently a symbol of both the new economy and stock market exuberance, repeated the orthodoxy of central banking wherever he went. His job, he insisted disingenuously, was limited to taming prices and guaranteeing financial stability.
That fixation with price stability led to policy excesses, and disinflation gave way to deflation, probably an economic ill far more damaging than inflation itself. In the crusade waged internationally against monetary and fiscal expansion, the benefits of inflation have often been overlooked.
As economists are fond of pointing out, inflation is not the inevitable result of growth. As long as the output gap stays negative, meaning the economy is drowning in spare capacity, inflation lies dormant.
It is debatable whether inflation was tamed, in America as elsewhere, by the farsighted policies of central bankers. A better explanation may be overcapacity, both global and domestic, produced by years of inflation that distorted investment decisions. Excess capacity, combined with rising competition, privatization, globalization, and deregulation, triggered relentless price wars and steadily falling prices.
The implicit price deflator of the non-financial business sector came in at -0.6 percent in the year to the end of the second quarter of 2002. As oil prices rise, their inflationary shock will give way to a recessionary and deflationary aftershock.
Depending on one’s perspective, this is a self-reinforcing virtuous, or vicious, circle. Consumers learn to expect lower prices, meaning inflationary expectations fall and, with them, inflation itself. The intervention of central banks only accelerated the process, and it now threatens to turn benign structural disinflation malignantly deflationary.
Should the United States reflate its way out of either an approaching double-dip recession or deflationary anemic growth?
It is widely accepted that inflation leads to the misallocation of economic resources by distorting the price signal. Businesses are not sure whether to attribute rising prices to a genuine surge in demand, to speculation, to inflation, or to something else entirely.
They delay investments, or over-invest and launch preemptive buying sprees. As Erica Groshen and Mark Schweitzer showed in an NBER working paper entitled “Identifying inflation’s grease and sand results in the labour market,” companies unable to predict tomorrow’s earnings hire less.
What rate of inflation is desirable? Other central banks, the Bank of England for instance, favor an “inflation band” of between 1.5 and 2.5 percent. The Fed has been known to tolerate inflation rates of 3-4 percent.
These variations among broadly comparable economies reveal widespread disagreement over what the rate of inflation actually measures, and over when and how it should be managed.
They express visceral hostility to inflation but ignore the danger of deflation entirely. As inflation subsides, disinflation quietly fades into deflation. People, accustomed to the deflationary bias of central banks, come to expect prices to keep falling.
Inflation rates, as measured by price indices, fail to capture crucial economic realities. The consumer price index in the United States may be overstated by a full percentage point year after year, according to the startling conclusion of the commission’s report.
Current inflation measures fail to account for entire classes of prices, tradable securities among them. Even if these were included, the way inflation is defined and measured today would still leave them badly misrepresented.
Consider a deflationary environment in which stagnant wages and zero interest rates can still carry a positive or negative inflationary effect. In real terms, during deflation, both wages and interest rates keep rising even while they sit still. It is difficult to capture this “downward stickiness” in modern inflation measures.
The method used to calculate inflation obscures much of the “quantum effect” at the border between inflation and deflation. As George Akerloff, William Dickens, and George Perry explained in “The Macroeconomics of Low Inflation” (Brookings Papers on Economic Activity, 1996), inflation lets companies cut real wages.
Workers might agree to a 2 percent pay increase in an economy running 3 percent inflation. They are unlikely to accept a pay cut even when inflation is at zero or below.
Economists at a November 2000 conference organized by the ECB argued that a continent-wide inflation rate of 0-2 percent would push structural unemployment in Europe’s rigid labor markets up by an incredible 2-4 percentage points. At zero inflation, unemployment in America would rise, over the long run, by 2.6 percentage points.
The new consensus holds that the price of a substantial reduction in unemployment need not be a substantial rise in inflation. The level of employment at which inflation does not accelerate, the non-accelerating inflation rate of unemployment or NAIRU, is sensitive to government policy.
What matters are real, inflation-adjusted, interest rates. If inflation is at zero or below, authorities cannot stimulate the economy by cutting interest rates below the level of inflation.
This has held true in Japan for the past several years and is now becoming a concern in the United States. The Fed, having cut rates 11 times in the previous 14 months, may be nearing the end of its monetary tether unless it is willing to expand the money supply aggressively. The Bank of Japan has recently turned to assertive, unvarnished monetary expansion in line with what Paul Krugman calls a “trustworthy guarantee to be reckless.”
Inflation is exported through the domestic currency’s devaluation and the lower prices of export goods and services that follow. Inflation thus indirectly boosts exports and helps close yawning gaps in the current account.
The effects of inflation are fiscal, not merely monetary. In countries without inflation accounting, nominal gains are taxed in full, even though they reflect the rise in the general price level rather than any actual growth in earnings. Even where inflation accounting exists, inflationary gains still get taxed.
Inflation therefore increases the state’s revenues while eroding the real value of its debts, obligations, and expenditures denominated in the domestic currency. Inflation is a tax, fiscally corrective, but without the deflationary and recessionary effects of a “real” tax.
The effects of inflation, paradoxically, resemble the economic recipe of the “Washington consensus” advocated by the likes of the rabidly anti-inflationary IMF. As a long-term policy, inflation is unsustainable and would cause catastrophic effects. In the short run, as a “shock absorber” and “automatic stabilizer,” low inflation can be a valuable counter-cyclical tool.
Inflation also benefits the great many businesses, and individual debtors, by increasing their earnings and partially eroding the value of their debts and savings. It amounts to a disincentive to save and an incentive to borrow, to spend, and, alas, to speculate. “The Economist” called it “a superb method to move wealth from savers to debtors.”
On the other hand, runaway inflation forces people to resort to hedges such as gold and real estate, inflating their prices in the process. Inflation, paired with negative or low interest rates, also tends to worsen risky imbalances by encouraging excess borrowing.
Still, the absolute level of inflation may matter less than its volatility. Inflation targeting, the latest trend among central bankers, aims to curb inflationary expectations by running a credible and consistent anti-inflationary as well as anti-deflationary policy administered by a trusted and neutral institution, the central bank.
That fixation with price stability led to policy excesses, and disinflation gave way to deflation, perhaps an economic ill far more damaging than inflation. It is widely accepted that inflation leads to the misallocation of economic resources by distorting the price signal. Inflation rates, as measured by price indices, fail to capture essential economic realities. If inflation is at zero or below, authorities cannot stimulate the economy by cutting interest rates below the level of inflation.
In countries without inflation accounting, nominal gains are taxed in full, even though they reflect the rise in the general price level rather than any actual growth in earnings. Also worth a read is our article Technique of Forex trading, and for a related look at how policy plays out closer to home, our piece on state and local election outcomes.