Ride of the Volckery
I’ve returned from my hike across the beautiful Crawford Path. Sunday night, slightly sore and groggy, I read Paul Volcker’s warning in the New York Times to not pursue an inflationary monetary policy to solve our employment crisis.
My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.
What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost.
Reading his op-ed left me slightly more sore and groggy. It is important to notice that Volcker implies that inflation would be stimulating in the short-run. I can’t for the life of me understand why he doesn’t consider 9% unemployment a “real problem,” but let’s move on. Volcker never explains why keeping inflation at 1 or 2 percent is optimal policy – he only worries that 3 or 4 percent will lead policymakers to try higher and higher rates. I guess once the Fed gets a little hit of that inflation soon they’ll be desperate for more only to keep up with those expectations. It’s only a matter of time, I suppose, that the abuser will be stagflating on the treasury room floor.
But is this gateway drug theory of inflation accurate?
I can’t be the only one that notices that inflation goes up and down. Every time we hit 3% inflation, we didn’t get hooked and ruin our longterm economy, right? Every person that takes a painkiller doesn’t become an oxycontin addict. Even though Volcker knows some junkie from the ’70s we shouldn’t conclude that sick people shouldn’t take medicine.
Here’s some other commentary on Volcker’s column:
I have frequently discussed a bizarre schizophrenia in the way many pundits approach demand stimulus. Monetary stimulus is “bad” because it leads to higher inflation. Fiscal stimulus is good because it leads to more growth.
Volcker: “President Obama has now set out new proposals to support economic growth. I hope he will be able to work with a responsible Congress to find the common ground that is urgently needed to deal with the economic challenges before us, restoring a healthy economy ‘in a context of price stability.'”
I can’t make any sense out of that statement. Isn’t Obama proposing fiscal stimulus? And doesn’t fiscal stimulus work (if at all) by boosting AD and hence inflation?
My case is that 2% inflation is a fundamentally bad idea. I argue that 4% inflation is not merely “OK” it is preferable. It is preferable because in even in normal times it produces higher nominal interest rates. Higher nominal interest rates in turn give the Fed more leverage under traditional monetary policy.
When you consider the long run costs of inflation you have to consider that there will be unanticipated events. Some of those events will be deflationary. If you don’t have an adequate buffer the Federal Funds rate will bump up against zero.
The big rise in prices during and after WWII arguably did a lot to eliminate the debt overhang, making it possible for the economy to enter a sustained, non-inflationary boom.
And this is the relevant history we should be looking at: this isn’t your father’s slump, it’s your grandfather’s slump. Volcker, I’m sorry to say, is worrying about refighting the 1970s when we’re actually refighting the 1930s. And fighting the wrong war is a good way to lose the one we’re in.
I would turn the slippery slope point around. In the ’70s, inflation was clearly too high. So Volcker and his colleagues brought it down by producing a brutal recession. Then around 1990, Volcker’s successors nipped a new inflationary cycle in the bud with another recession. But this time, they brought inflation down to a lower level than it had been before the eighties. Why? What goal did this “opportunistic disinflation” serve? To me it looks precisely like mindless slope-slipping. Having been roundly congratulated for whipping inflation, policymakers decided to gain even more kudos by driving it even lower. But this hasn’t helped anyone, and, indeed, the best economic times of the past 30 years were the years in the late-1990s when Alan Greenspan let inflation hover around 3 percent before raising interest rates and inaugurating the ensuing 10 thin years.
I think it’s worth keeping in mind that the inflation of the 70s wasn’t inevitable. It was the result of oil shocks and uniquely poor Fed policy. Arthur Burns could have kept the inflationary genie in the bottle if he’d had the spine to do it, but he didn’t. He was too much of a political hack. And a deliberately chosen one, too: Richard Nixon blamed his defeat in 1960 on tight money engineered by the Fed, so when he had an opportunity to appoint a Fed chairman of his own he made sure to appoint one who would provide him with the easy money policies that would keep the economy roaring.