How would you react if a close friend made the following statement:
“Of course, I am firmly opposed to infidelity, but I’ve discovered that it’s not so bad as I had thought. I have a friend who is currently having a passionate affair that is adding spice to his life. He says that he will eventually end the relationship and then go back to being a faithful spouse, refraining from future affairs. His partner will not discover the indiscretion, and hence no harm will be done. Again, I’m firmly opposed to infidelity, but on reflection I have grown to appreciate its silver linings.”
I suspect that you’d have roughly the same reaction as I would.
Tyler Cowen has a new Bloomberg column explaining why conservatives might benefit from a bit of inflation. It begins with a standard criticism of inflation:
I myself am not happy about an inflation rate of 4% to 5%, which seems embedded in the economy right now.
After this statement, Tyler discusses a number of benefits from the recent bout of high inflation. Toward the end, he warns readers not to be entranced by his rosy description of inflation’s effects:
Of course the Fed should put such considerations aside and stick to its mandate for price stability. The rest of us, however, are free to appreciate some of the benefits of higher inflation, at least for a while.
Hmmm. I’m reminded of Marc Anthony’s famous eulogy in Shakespeare’s Julius Caesar. Obviously, Tyler doesn’t have space to list all of the negative effects, but readers may ask themselves if inflation actually has all the pleasant effects described in the column, then why is it “of course” the case that the Fed should stick to price stability?
Inflation is a complex subject, and it’s not always clear what people mean by “the effects of inflation”. Supply side inflation? Demand side inflation? The welfare effects of these two shocks are radically different. In context, it’s pretty clear that Tyler is referring to demand side inflation in the Bloomberg column, as he alludes to effects such as the reduction of the ratio of public debt to GDP (which doesn’t occur unless NGDP growth rises.) In other words, when discussing “inflation”, Tyler is actually considering some benefits from faster NGDP growth. So I’ll focus on demand side inflation.
I don’t want to get into a line-by-line rebuttal of Tyler’s column. The standard model predicts that demand side inflation has important short run non-neutralities and no important long run real effects on the economy. That also seems to be Tyler’s working assumption. But when discussing the welfare effects of inflation, it makes more sense to focus on the long run effects. I worry that many people think in the following terms:
1. The short run effect of inflation on X is positive.
2. The long run effect of inflation on X is zero.
3. Therefore, the combined short and long run effect of inflation on X is positive.
I don’t know if that’s Tyler’s view, but I suspect many readers will draw that conclusion.
In my view, that’s not how things work. Take the example of the public debt. It’s tempting to view inflation as a short run boom to taxpayers, as it reduces the real burden of the debt. Perhaps if the Fed quickly gets inflation under control, there’ll be no long run damage. Here’s Tyler:
To be clear, it is not easy to reap very large gains through this inflationary mechanism. If high inflation continues for too long, interest rates will adjust upwards to the point at which inflation may be increasing the burden of future debt. The past debt may be worth less, but the higher costs of future borrowing may, on net, push government budgets further out of balance. In that scenario, the US might end up with both tax hikes and high inflation.
So the risks are real. But there is a decent chance it will work out, at least if the Federal Reserve can get inflation back under control again fairly soon.
I don’t believe there is a “decent chance” that things will work out in this way. That’s not to say inflation and interest rates won’t decline at some point–I believe they will. But this sort of monetary infidelity will impose a price on future borrowings. If inflation really were painless, the government would do it again and again. More likely, it won’t be painless. Investors will understand that the Fed is less committed to 2% inflation than they had previously imagined, and demand a higher inflation premium when lending to the Treasury. (Recall the 1980s.)
It’s best to view public finance from a “timeless perspective”. Over a period of decades and centuries, policymakers will occasionally enact inflationary policies. Over the long run, investors will rationally adjust their behavior in such a way as to be compensated for the risk of occasional high inflation. During actual bouts of unexpected inflation (such as the 1970s), lenders will not be fully compensated. During other periods (the 1980s), they’ll be over compensated. It’s analogous to the way that insurance companies over charge you during periods when you drive safely and undercharge you during years when you have a major accident. Over the long run, insurance companies figure out a level of premiums that provides an appropriate compensation.
Tyler also looks at the impact of inflation on the wages of different segments of the labor market. Once again, the effects of inflation are neutral in the long run, and thus any distributional effects will reverse after a few years.
Don’t be attracted by the siren song of short run monetary non-neutralities.
READER COMMENTS
nobody.really
Mar 9 2023 at 3:12pm
Thoughtful. But can we know how much investors anticipated the risk of higher inflation when they bought government bonds in the past? And with centuries of experience regarding US debt, how much should the experience of the past few years alter investors’ willingness to buy future debt?
Scott Sumner
Mar 9 2023 at 6:58pm
The safest assumption is that there’s no free lunch, that inflation doesn’t affect the long run real cost of borrowing. That may not be precisely true, but we don’t know if any net effect (non-neutrality) is in one direction or the other.
Jose Pablo
Mar 12 2023 at 12:52pm
“Investors”(as a herd, and that is what they are) never really “learn” anything.
They keep lending to the Argentinian government, investing in “thin air assets” like crypto (or gold), buying long term government bonds with interest rates close to zero .. and so on …
Assuming that they “learn” how to price long term expectations on inflation, reminds me of Yogi Berra: “In theory, theory and practice are the same. In practice they are not”.
vince
Mar 12 2023 at 2:25pm
Are you doubting efficient markets?
Jose Pablo
Mar 12 2023 at 6:29pm
I am totally sure that markets are not “efficient”.
But to the point here. If they were efficient it would not be because the “actual” marginal investors have any capacity to adequately take into account the long term effects Scott is referring to, when pricing assets.
I am well aware of the theoretical benefits of so believing, but I have met too many of them to entertain this totally baseless hope.
vince
Mar 12 2023 at 7:20pm
The latest, no doubt, being Silicon Valley Bank.
Jose Pablo
Mar 12 2023 at 8:36pm
For instance.
If investors can be repeatedly fooled by “entrepreneurs” pitching nonsensical investments (from Dutch tulip bulbs to East India Company shares to bitcoin) or repeatedly fooled by bankers with no regard whatsoever for matching the duration of both sides of the balance sheet, them why are this very same investors not going to be repeatedly fooled by governments inflacting out their debts?
When you met actual money managers in the flesh, those are not misteries anymore and you realize that this would keep happening again and again.
Kevin
Mar 9 2023 at 3:38pm
Just today, 538 posted an article suggesting, based on research from Laurence Ball and others, that a 4% inflation target might be better, because liquidity traps would be less likely to occur. In Ball’s paper, he couldn’t help but mention in the conclusion that it might not be so bad to allow for 6% inflation for awhile in order to shrink the government debt it real terms. https://www.imf.org/external/pubs/ft/wp/2014/wp1492.pdf
I’m just stunned. Do people really believe that it’s beneficial to get fleeced by quasi-governmental agencies? Am I missing something? It just seems like gaslighting. Admittedly, I’m no expert, but is it wrong and overoptimistic to expect and hope for 2% inflation going forward, or can we expect those who serve our ever-expanding government to shift the goalposts as our nation racks up more and more debt?
Capt. J Parker
Mar 10 2023 at 1:13pm
Missing from the 538 piece was the fact that the US and may other developed countries were running budget deficits of around 2% so, SUPRISE! a 2% inflation target just happened to keep government debt from piling up. But now, SUPRISE! something closer to 4% is needed to have the same effect.
The Ball paper was good. Thanks for the link! It was Ken Rogoff advocating a temporary 6% inflation to ease government debt and he was writing in 2008. Also in 2008 there was a big increase in government debt in the wake of the great recession. Rogoff was arguing that once the debt level was 100% of GDP, economic growth stagnated and hence he was arguing that the level of debt was the biggest problem. I don’t doubt Rogoff was serious and I don’t think Rogoff is anyone’s idea of a doctrinaire progressive. If you read the Rogoff article Ball references, you realize Rogoff was well aware of the downsides to his proposal. Nonetheless, I’m sure Powell is, nudge, nudge, really committed to, wink, wink, bringing down inflation as fast as possible without causing a recession, say no more!
The question of who get’s fleeced by such a temporary boost in inflation has been well studied. The short answer is debtors win and creditors lose. The very poor get hosed because they have only expenses. The middle class makes out because they have mortgages, car loans and student debt which gets paid back with cheaper dollars. Stockholders also make out because corporations usually carry a bunch of debt. It’s bond holders and banks who lose. Bondholders have traditionally been fat-cats. So the distributional effects are positive for a big slice of the country who could use a break.
But there are a few exceptions. Retirees who have been adjusting their portfolios to more stable bonds or annuities before the inflation and those with defined benefit retirement plans get whacked. On the bright side, there may be opportunities to lock in today’s higher bond rates for a while.
Kevin
Mar 11 2023 at 4:37am
Thanks so much for the response. It enhances my understanding of the situation.
vince
Mar 10 2023 at 1:54pm
Tinker away. Industrial policy is bad, except when it’s monetary policy.
vince
Mar 9 2023 at 4:16pm
Keeping it simple, inflation helps borrowers and hurts savers. It’s a distortion and I’m not sure why anyone would say it’s desirable.
Andrew
Mar 9 2023 at 4:51pm
I was surprised you said “But this sort of monetary infidelity will impose a price on future borrowings.” I would have thought the primary impact of monetary infidelity would be the loss of trust in the Fed leading to an increase in the number and magnitude of required interventions based on your previous posts / writing. That is loss of trust in the fed would increase the variance of inflation, and hence the frequency of both high inflation and recession / possible deflation. The increase in lending premium would seem to be of secondary importance in terms of utility lost / misery caused.
Scott Sumner
Mar 9 2023 at 6:56pm
That’s also true, but in this post I was focusing on the factors discussed in Tyler Cowen’s column.
Spencer
Mar 10 2023 at 9:11am
Inflation is related to morals. It causes higher crime rates. It results in a higher Gini index.
bb
Mar 10 2023 at 1:36pm
Scott,
I’m not totally sold on this argument. It seems to me that much of the WW2 debt was successfully inflated away. While I do not agree with the Feds actions over that last 2 years, I do think it’s possible reducing the debt to gdp ratio could be a silver lining. I think we understand that the demand side recessions happen because wages and credit are sticky in one direction. I think tight monetary policy made it very difficult for countries like Spain to address their public debt issues. It’s not clear to me that erring on the side of loose monetary policy for a few years wouldn’t have short run of positive and long term of zero for similar sticky in one direction reasons. Are there real-world examples that support your view. I also don’t think framing it as a moral question is helpful- although I don’t think you make a habit of that. Thanks.
Scott Sumner
Mar 10 2023 at 2:01pm
This is one of those cases where the benefits are easy to see and the costs are harder to see. (A phenomenon that is quite common in economics, and leads to lots of bad policies.)
I agree that much of the WWII debt was inflated away, but I don’t agree that this was costless. Investors then demand a premium for lending to the government, to account for the risk of higher inflation. (Not needed under the gold standard.) If you then shift to a lower inflation policy (as in the 1980s) you end up paying extra interest to bondholders to compensate for the risk of inflation. In the very long run, the over and under payments net out to roughly zero if investors are rational.
Never adopt policies that only work if you assume the public is being fooled—they always backfire in the long run.
vince
Mar 11 2023 at 11:35am
“Never adopt policies that only work if you assume the public is being fooled—they always backfire in the long run.”
But isn’t that a main justification for inflation? The Fed, for example, has admitted that inflation helps employers reduce wages without it being apparent to most employees.
Don Geddis
Mar 11 2023 at 11:58am
It’s much more complicated than that. The goal is not to reduce all wages. In fact, stable inflation has no particular long-run effect on real wages. Instead, the particular barrier is downward nominal sticky wages, which show a huge cliff at 0% raises. This leads the labor market to be less efficient than it could be (thus resulting in less real wealth for everyone). Low, stable inflation allows for small real wage cuts for a few jobs, without requiring nominal wage cuts.
But the goal is not to reduce everyone’s (real) wages. Instead the goal is to overcome the observed barrier at 0% nominal raises. E.g. Krugman’s graph.
vince
Mar 11 2023 at 12:50pm
Were wages sticky before the Fed started inflating in 1913?
Scott Sumner
Mar 11 2023 at 1:38pm
“Were wages sticky before the Fed started inflating in 1913?”
Yes.
vince
Mar 11 2023 at 2:00pm
I’m not doubting you, but how about prices?
seer of things
Mar 11 2023 at 4:22am
Your logic wins, IMHO, and it’s lucid, and it needed to be said in a public forum. Wow.
Philo
Mar 12 2023 at 1:49am
“If inflation really were painless, the government would do it again and again.” Well, the government does do it again and again.
Of course, it’s not painless, and is, in fact, politically unpopular. But governments often find the short-run effects congenial on the whole, and many voters do not understand that it is the government that is doing it.
Jose Pablo
Mar 12 2023 at 6:49pm
is, in fact, politically unpopular
is it?
It should not be for the people that has bought real assets with fixed interest long term debt (of which there are a lot).
Or for workers with enough bargaining power to maintain (or even increase) their real salaries.
It should not be that good to people lending money. But since, very likely, the people lending money is less numerous than the people borrowing it, inflation should be more popular that it actually is
[As a reminder, inflation at 4 or 6% should not have most of the negative consequences of hyperinflation and, as Don Geddis points out, allows for a more frequent and efficient repricing of “assets”, including “human capital”. Asset prices certainly are “nominally sticky”, particularly in the minds of such assets owners]
BS
Mar 12 2023 at 10:05pm
An interesting experiment. There is some fraction of people – no idea how large it is – that retires on personal savings (including defined contribution pensions and non- or only partially-indexed defined benefit pensions). Some people are retiring with perhaps 30 years of life remaining, plus end-of-life costs. This is not the same situation as status quo 1925 or 1955 or whatnot. I doubt many calculators include the cost of a couple of good whacks of inflation over that time period.
Michael
Mar 13 2023 at 9:32am
Agree that temporary high inflation will cause more expensive borrowing in the future.
But inflation also works as a Wealth Redistribution tax. The wealthy pay more here, and can’t avoid this tax.
Yes, the poor person with $500 cash to their name also pays this tax. Bit their payment amount will be extremally small, compared to the wealthy who have $200,000 in cash assets, plus stocks and real estate.
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