Our Friend, Inflation

HyperInflation - By Paolo CameraWith the economy still sputtering, politicians of every stripe are wondering how to jumpstart growth.  One promising method will make it cheaper to hire the unemployed, create advantages for American exports and reduce the burden of accumulated debts: inflation.  Curiously, some politicians have confused the medicine with poison.  In particular, Conservatives have abandoned their Milton Friedman heritage; once advocates for flexible money, now Republicans long for the gold standard.  It is a bizarre spectacle to see Ron Paul, the Chairman of the House Subcommittee on Monetary Policy, advocating the abolition of the Federal Reserve.  How have extreme positions gained credence at precisely the moment when the economy needs expansive monetary policy?

A fundamental misunderstanding of money underlies the hysterical fear of nonexistent inflation. The end of the gold standard did not result in the creation of a worthless paper currency.  In fact, every dollar is backed by the most valuable thing in the world: the U.S. economy.  Goods and services in the economy are traded for currency that was created in exchange for U.S. Treasury debt, which is considered risk free because the U.S. government has a monopoly on the right to levy taxes on the U.S. economy.  The removal of gold from the exchange actually makes it more explicit that money is a means of exchange to reduce the transaction costs of barter – goods and services are sold for a currency backed by the value of other goods and services in the economy.  This is not a defense of high levels of government debt; if anything this underscores the importance of responsible management of national finances.  Nonetheless, as the economy grows, so should the money supply and the price level.

Inflation is borne in prosperity. When lots of people have incomes – usually that means jobs – they buy more goods and services.  Their increased demand bids up prices and the result is inflation.  The benefits of healthy inflation were undermined by the “stagflation” of the 1970s, where high unemployment and inflation existed simultaneously.  The economic literature establishes that stagflation resulted from the combination of bad monetary policy and the growing pains of moving to a freer market system of prices and currency.  The oil shocks that are the popular explanation for high inflation in the 70s were just a smoke screen over a decade that saw wild swings in monetary policy, Nixon’s shocking abandonment of the gold standard and the phase out of price controls.  Paul Vockler’s triumph over inflation in the 80s, and the double-digit unemployment that accompanied it, was just the bitter medicine necessary to reestablish central bank credibility after a lost decade. 

The subsequent “Great Moderation” of the past three decades is marked by generally sound monetary policy, with some notable exceptions.  In retrospect, money was too loose during the recent housing bubble.  More importantly, money has been too tight in response to the last three recessions, marked by “jobless recoveries.”  The Fed has over-learned the lessons of stagflation and dampened the return to economic growth as the economy began to bounce back.

Some economists have begun to advocate for expansive monetary policy to create inflation and spark economic growth.  Scott Sumner, an economist at Bentley University, thinks that our whole conception of the Fed’s “price stability” mandate is flawed.  The Fed has taken price stability to mean minimizing inflation, but inflation is only the derivative of prices, not the level of prices.  We should be concerned with where prices are, not where they are going.  Imagine if everything you owned declined in value by 10% last year, but now leadership was panicking that everything was increasing in value by 5% this year.  You’d think: “but my stuff isn’t even worth what it was two years ago!”  Yet, that’s how inflation targeting works.  Rather than digging out of the hole in prices caused by a recession, the Fed strangles the inflation necessary to regrow the economy.  Targeting the price level, rather than inflation, allows for temporarily high inflation to make up for lackluster price growth in the past.  

If inflation was really so bad, then inflation hawks should welcome recessions; nothing steps on the neck of inflation like a stiff recession.  Our current recession, for example, has seen historically low levels of inflation (2009 boasted negative inflation).  The return of inflation will mean the economy is again flush with growth.  America did not wake up less productive in September of 2008; robust growth should be easy now because we have lots of people we can put back to work.  Yet, instead of bouncing back we are trudging along.  Three decades of stagnant wages and jobless recoveries should be enough to convince us that inflation is not the root of all evil.  At this point, inflation is more like an old friend we haven’t called in far too long.