Why Creating Inflation Is The Wrong Policy Choice

Posted on 13/09/2010

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While reading a recent commentary posted on the Guardian Comment Is Free website, I came across the following economic policy suggestion from Dean Baker, co-director of the Centre for Economic and Policy Research:

Assorted international currency notes.

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The Fed should be targeting a higher rate of inflation, in the 3-4% range. This would reduce real interest rates and debt burdens. What is the downside in this picture; inflation accelerates too much and hits 5-6%? How does that compare with years of excessive unemployment, with millions of people unemployed or underemployed needlessly? No reasonable calculation of costs and risks would justify Bernanke’s timidity in the current circumstances.

This suggestion came as part of a wide-ranging critique of the policies of Ben Bernanke and the Federal Reserve, entitled “The wholly fallible Ben Bernanke.” More eminent economists have also advocated this policy approach, amongst them Ken Rogoff of Harvard University (and formerly the IMF Chief Economist) though he was much more cautious in his approach:

Given the massive deleveraging of public- and private-sector debt that lies ahead, and my continuing cynicism about the US political and legal system’s capacity to facilitate workouts, two or three years of slightly elevated inflation strikes me as the best of many very bad options, and far preferable to deflation. While the Fed is still reluctant to compromise its long-term independence, I suspect that before this is over it will use most, if not all, of the tools outlined by Bernanke.

I can think of many downsides with a policy such as this, some of them being quite serious. The first is that inflation is a hidden tax. By printing to money to purchase Treasuries, the Federal Reserve is directly devaluing the currency, which is analogous to a tax on the holders of cash balances. Since the poor and lower-classes tend to hold greater proportions of their income and wealth in cash (or near-cash), they tend to be hurt the hardest by such a policy. Secondly, inflation hurts those on fixed incomes. Such people tend to be retired and have no way of rebuilding their stock of wealth, thus an inflationary monetary policy causes a permanent reduction in their standard of living. Therefore, such an policy can be described as inherently regressive.

Thirdly, due to the devaluation of the currency that occurs, inflation makes individuals with dollar assets and/or dollar incomes, relatively poorer versus those in other countries as the currency will likely depreciate on the foreign exchange markets, making imported goods more expensive (the top imports into the US include oil & its derivatives, pharmaceutical goods, electronics, cars and clothing), reducing the standard of living and contributing to more inflation, potentially beginning a dangerous negative feedback loop. This can then lead into a wage-price spiral, the process by which unionised (and indeed non-unionised) workers demand consecutively higher pay rises to compensate them for the ever-rising rate of inflation, with the potential consequence (when combined by state-sanctioned money-printing) being hyper-inflation.

Official portrait of Federal Reserve Chairman ...

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Fourthly, rising inflation damages the allocative efficiency of the free market economy. Because prices are ever-changing, individuals and firms find it increasingly challenging to make optimal consumption and investment decisions, further damaging GDP growth.

Fifthly, inflation rewards the profligate at the expense of the thrifty. Government/Federal Reserve creation of inflation is an implicit bail-out of debtors as it reduces the real value of their liabilities (the assets of savers). This creates moral-hazard and is likely to reduce the savings rate in the future (perhaps a consequence of the 1970-80’s inflation) as savers realise future saving may well be penalised in the same manner.  To understand the seriousness of the outcome of this effect, let us imagine for a moment that a US Congressman or UK Member of Parliament stood up in the house and made the following proposal: “I believe that we should impose a ‘wealth tax’ on all bank accounts, retirement accounts, stock brokerage accounts and the estimated market value of all real estate, to be levied at the rate of 4-6% per annum on the principal balance of said assets for the next five years. I propose that the revenues from this tax should be used to pay-down the the debts of all individuals and firms in the economy on a pro-rata basis.” This proposal is economically identical to (and just as unfair as) the inflation solution that is being proposed above, yet imagine the public outcry if a government attempted to implement it – I dare say there could be violence on the streets.

Sixthly, there is little evidence at all that the creation of inflation can bring with it an economic recovery and a reduction in unemployment, indeed, the bulk of the empirical evidence suggests quite the opposite. The experience of trying to target the inflation-unemployment trade-off implied by the Phillips Curve quickly led to failure and the stagflation of the 1970’s. Economists understand that economic growth is caused by innovation, technological progress and the accumulation of fixed capital. No economists believe that inflation or money-printing can in itself create economic growth and reduce employment, barring a short-term money-illusion effect.

Finally, while the Great Depression was without doubt very serious and caused much suffering, the US eventually recovered. Recovery from hyperinflation is much less assured without the society in question first suffering a full-scale collapse, as did Weimar Germany in 1923, Salvador Allende’s Chile in 1973, the Chinese Yuan Dynasty in 1368 and the Roman Empire (AD300s). While I am not suggesting that this risk is currently meaningful from the perspective of the US, I do believe that inflation, once created, is very difficult to bring under control given how rising prices become embedded in individuals’ expectations.

While Dean Baker may well respond that “5-6% inflation is not that significant, so what’s the problem?”, I would point out that over a course of five years, this is equivalent to a 25% devaluation of the currency. Surely no-one could describe such a devaluation of the US dollar in these terms? Inflation is dangerous, pernicious and a difficult genie to put back into the bottle. Best not to let it out in the first place.

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Posted in: Economy, My Thoughts