More Inflation Isn't the Answer
It's a sign of desperation that the latest cure being suggested for the ailing economy is higher inflation. In the 1970s and early 1980s, inflation (peaking at 13 percent in 1979 and 1980) was a national curse. Now, it's being advanced as an antidote to high unemployment and meager economic growth. It's bad advice for the Federal Reserve, which holds its annual research retreat at Jackson Hole, Wyo., this week. What seems plausible in the classroom would probably backfire in the real world.
The economy's central problem today is lack of confidence - fear - reflecting enormous uncertainty. Business managers and consumers don't know what to expect. Facing stubborn joblessness, falling home values and volatile stock prices, they have become reflexively defensive. They hoard and hold back. A deliberate policy of higher inflation risks compounding the uncertainty and poisoning psychology even more.
That's what happened in the 1960s and 1970s. Economists argued that modest increases in inflation (say, to 4 percent or 5 percent) would reduce unemployment by allowing more expansionary budget and monetary policies. Slightly higher inflation wouldn't bother most Americans, and lower unemployment would be a clear gain. But inflation wasn't kept under control. Unemployment rose (it averaged 6.2 percent in the 1970s compared to 4.5 percent in the 1950s), and accelerating price increases spooked Americans.
The idea now is that the Fed would pump money into the economy until inflation - a rise in most prices, not just erratic gasoline prices - reached a desired level of perhaps 4 percent to 6 percent. Harvard economist Kenneth Rogoff admits the policy is "radical." He supports it only because he sees the main threat to the U.S. and European recoveries as massive "debt overhangs" of private and governmental debt. "People are retrenching because they realize that high debt makes them vulnerable," he says.
Inflation is one way to reduce debt burdens. As wages and prices rise, the value of existing debt erodes. Consumers, businesses and governments are liberated to spend more freely.
To be sure, higher inflation represents a wealth transfer to debtors (who repay in cheaper dollars) from creditors (who receive cheaper dollars). That's unfair, Rogoff says, but it may be less unfair and disruptive than outright defaults by overborrowed debtors.
Faster inflation might boost the economy in other ways, too. If people think prices of cars, appliances or homes will be higher next month or next year, they may buy now instead of waiting. Higher inflation may also allow the Federal Reserve to lower effective interest rates. If interest rates stay below inflation - though that's hardly assured - the resulting cheaper credit should spur borrowing.
All this explains why higher inflation appeals to economists across ideological lines. While Rogoff is slightly right of center, liberal economist and columnist Paul Krugman also favors it. The trouble is this: Inflation is hard to manipulate in precise and predictable doses. Once people become convinced that government will tolerate or encourage it, they adapt in unforeseen ways. We can't know what would happen now, but we do know what happened in the 1960s and 1970s.
One adaptation was that companies and workers raised wages and prices much faster than expected. Higher interest rates followed. Rates on 10-year Treasury bonds went from 4 percent in 1962 to 8 percent in 1978. The stock market stagnated for nearly two decades. Consumers reacted to greater uncertainty by increasing their savings rates from 8 percent of disposable income in 1962 to 10 percent by 1971. That's exactly the opposite of today's goal - more, not less, consumer spending.
There might be other unpleasant surprises. If retail prices rose faster than wages - a good possibility with unemployment at 9.1 percent - higher inflation could act as a drag on the economy by reducing workers' "real" purchasing power. If investors decided that the Fed had gone soft on inflation, there might be a panicky flight away from the dollar on financial and foreign exchange markets.
Moreover, the power of higher inflation to erode the real value of U.S. government debt is limited, because much of that debt is short-term. About 30 percent matures in less than a year; another 25 percent or so matures in less than three years. All this debt will be refinanced. With higher inflation, it would probably be refinanced at higher interest rates that investors would demand as protection against rising prices.
Inflation is not the answer. Remember: The economy's basic problem is poor confidence spawned by pervasive uncertainties. The Fed shouldn't make the problem worse by embracing policies that, whatever their theoretical attractions, will create more uncertainties in the real world.
In his much-awaited Jackson Hole speech Friday, Chairman Ben Bernanke should make clear that the Fed won't follow this path.