Patrick Horan directed me to these tweets:
Luther is right. There are actually three issues that need to be disentangled here:
1. The cost of high trend inflation
2. The cost of high inflation volatility
3. Supply vs. demand-side inflation
High trend inflation increases the real tax rate on saving and investment, which hurts capital formation. This reduces economic growth, lowering living standards. The negative effects are not offset by gains to borrowers, as the Fisher effect implies that nominal interest rates rise to reflect higher inflation expectations.
As Appelbaum suggests, an unexpected surge in inflation can indeed help borrowers. However, in the long run there will be just as many years where inflation is less than expected as there are years where it is higher than expected. The gains to borrowers in the 1970s were offsets by losses in the 1980s, when inflation fell more rapidly than expected. Hence lots of loan defaults and a big S&L crisis during the 1980s, followed by an expensive taxpayer bailout. The 1970s were the party; the 1980s were the hangover. There’s no long run gain to borrowers from a policy of higher inflation. (Not to mention that there’s no plausible reason why we’d want public policy to favor borrowers.)
A high level of inflation volatility (as we saw during 1966-81) tends to create business cycles. (Actually, it is NGDP growth volatility that matters, but that was also very high during the 1970s.) Because of the highly unstable monetary policy, the US experienced four recessions between 1970 and 1981, and two were quite severe. The high inflation did not help workers.
Nonetheless, there is a reasonable case to be made for the argument that the 1970s inflation was not as bad as it seemed. The US was hit by two supply shocks (1973-74 and 1979-80), which resulted in real wages falling during those two spikes in inflation. In both cases, the fall in real wages wasn’t actually caused by the inflation; it was caused by a real shock to the economy, less energy to drive our economy. Those two shocks would have hurt living standards even if the Fed had kept inflation at low levels.
On the other hand, NGDP growth was very higher during the 1970s (roughly 11% from 1971-81) and hence the 8% inflation was not caused by supply side factors. (Real growth was a bit over 3%/year.) Rather the long run inflation was almost 100% demand side. Don’t confuse temporary supply shocks that affect the volatility of inflation with long run demand policy that determines the trend rate of inflation. If NGDP growth had averaged 5% during 1971-81, then inflation would have averaged 2% (or even less if the counterfactual monetary policy had boosted capital formation.) Inflation shocks affect the volatility of real output, without boosting the long run trend rate of growth.
READER COMMENTS
BS
May 27 2021 at 1:48pm
Borrowers such as my relatives who had to renew mortgages when rates were running 16-18% (Canada) may have felt differently. I suppose that someone finishing a mortgage during the period could come out ahead. But would the loaners not have set those rates to basically wash out the renewers’ “gains” in the inflation of the principal amounts? I’ve never seen a set of cases (numbers) showing what happened over, say, a 25-year amortization period from, say, 1970 to 1995.
Jeremy Goodridge
May 27 2021 at 2:03pm
You say : “There’s no long run gain to borrowers from a policy of higher inflation. ”
And you also say : ” High trend inflation increases the real tax rate on saving and investment, which hurts capital formation. ”
Can you explain why, in the long run, borrowers aren’t helped by higher trend inflation while at the same time savers are hurt by higher trend inflation? Are you thinking about things like bracket creep and capital gains taxes that don’t adjust for inflation and thus impose higher marginal taxes on work/savings? Or is there something in the economy itself that is causing this?
Thanks!
Scott Sumner
May 27 2021 at 3:36pm
Here’s an analogy that might help. If you put an excise tax on a specific product, both buyers a sellers of that product are hurt. The tax drives a wedge between the price paid by buyers and the (lower) price received by sellers. Similarly, taxes on capital income drive wedge between what borrowers pay and what lenders receive. Inflation makes that wedge bigger. So both groups are hurt.
Philo
May 27 2021 at 4:05pm
Both inflation and an excise tax give more revenue to the government. Taxpayers are hurt by having to pay the tax, but *maybe* they are helped *even more* by what the government does with the extra revenue, so that overall they are made better off. (Admittedly, this is just a theoretical possibility.)
Scott H.
May 27 2021 at 2:21pm
Yes. There is a lot of “single period game” type thinking in economic thought these days. People think they can start up wealth taxes, suspend patents, inflate away debt, jack up the minimum wage, and because the policy looks nice for the “winners” during the first period of implementation they assume the “losers/victims” will never react.
Scott Sumner
May 27 2021 at 3:38pm
Good comment. That’s always a sign of a “dark ages” in economic analysis. We’ve been though these before, but we always eventually regain our senses.
Brian
May 27 2021 at 3:08pm
How important was the wage and price controls and the ten percent import surcharge that was ordered by President Nixon ? I’m guessing “not important” since you did not mention it but it would be nice to get your opinion.
Scott Sumner
May 27 2021 at 3:39pm
The surcharge didn’t have much impact on inflation. The wage and price controls made the 1974 recession worse than otherwise.
Thomas Lee Hutcheson
May 28 2021 at 7:22am
This ought to be discussed as what is the optimal rate and variability of inflation.
I’d say the ’70 compared to 2008-2020 shows that a policy of too stable and low inflation is MUCH worse than a policy of too high and variable inflation within the observed ranges. [Failure to index capital gains is not a cost of inflation, per se.]
Roger Sparks
May 28 2021 at 9:34am
“High trend inflation increases the real tax rate on saving and investment, which hurts capital formation.”
This quote misses the more important tax effect on embedded capital. I need to explain:
Think of farmers who sell crops once a year. Into that crop, they have invested fertilizer, labor, tax payments and much more. They need to recover this investment in order to have capital for the next crop.
In the 1970’s, inflation acted as a wealth tax. One year’s crop sales were insufficient to recover capital expenses. Therefore, the farmer only had last years capital recovery less inflation deduction(i.e., wealth tax) available to buy this years “fertilizer, labor, tax payments and much more”.
You see, the real problem for farmers was that farm crop prices were lagging the cost of inputs. Had farm crop prices been leading the cost of inputs, inflation would have brought farm smiles.
Comments are closed.