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David Wessel on low inflation

Ex-Fed chair Ben Bernanke is currently a resident fellow at the Hutchins Center on Fiscal & Monetary Policy at the Brookings Institution. The Center’s director, David Wessel, appeared on NPR’s Morning Edition yesterday to express views on inflation and deflation that are essentially indistinguishable from Bernanke’s.

In particular, like Bernanke, Wessel spoke as though inflation below 2% per annum, and a fortiori deflation, is always bad.

Asked to explain why it should be bad to have less of a bad thing like inflation, Wessel first responded: “I mean it sounds appealing, prices going down, people paying less at the store. But when inflation is low that means wages are going up very slowly too. That's of course not very popular.“ This sort of answer would earn an undergraduate a poor grade from any instructor who emphasizes the distinction between real and nominal variables. Workers should not applaud rising nominal wages per se; what matters for them is their real wages. When inflation is low, so too are nominal wage increases ordinarily. But that says nothing about the path of real wages, which in the long run are not determined by monetary policy.

Wessel continued: "There are a couple of problems with too little inflation. It can be a symptom of a lousy economy, one in which demand for goods and services and workers is anemic."

A key word here is symptom. A condition that can be a symptom of a problem is not the problem itself, and can also appear under healthy conditions. Wessel failed to note that low inflation need not be a symptom of a lousy economy, because he spoke only of variation in the aggregate demand for goods and services. Low inflation (or even deflation) can instead be the benign result of abundant growth in the real supply of goods and services. Under the gold standard, as Atkeson and Kehoe (2004) have reported, periods of lousy economy (recession) were not more common during deflation periods, nor vice-versa.

If the Fed were today targeting the path of nominal income, because the growth rate of nominal income is the sum of the inflation rate and the real income growth rate, low inflation would be a sign of a healthy economy with high real economic growth. Thus Wessel would have provided a more accurate analysis if he had spoken of problems with growth in nominal aggregate demand being weaker than anticipated, not inflation being below its target. (In terms of dynamic AD-SRAS analysis, unexpectedly low growth in AD moves the economy below the natural rate of output.)

Wessel’s second concern is harder to interpret favorably. Low inflation, he said, "can make it hard for the Fed to spur borrowing because it's hard for them to get the interest rate below the inflation rate." Two responses: (a) The Fed should not be trying to “spur borrowing.” Fed efforts to spur borrowing helped to fuel the housing bubble. (b) The Fed is not in fact currently finding it hard to get the interest rate below the inflation rate. The interest rate on 1-year T-bills has been below the CPE inflation rate for more than four years, since 2009’s dip into deflation (in that case due to weak demand for goods following the financial crisis).

Wessel went on the cite the problem of rising real debt burdens in deflation. That can indeed be a problem in an unanticipated deflation (Wessel never distinguished anticipated from unanticipated), but again, only to the extent that the deflation is driven by unexpectedly weak aggregate demand growth and not by robust aggregate supply growth. In the latter case, borrowers have more real income with which to repay.

In his answer to the interviewer’s last question, Wessel declared: “So it used to be that economists believed that a central bank can always create inflation by printing more money. But lately it's been -seems harder to do that than the textbooks had told us.” But what is the evidence that expanding the stock of money does not still generate inflation the way the old textbooks tell us? Surely not the experience of the Fed undershooting its target of 2.0% growth in the PCE by 0.4%, which only implies that the broad money growth rate was 0.4% lower than the rate that would have hit the target. Fortunately or unfortunately, it remains the case that the Fed can always raise the PCE inflation rate by engineering a higher rate of broad money growth, just as the textbooks explain.

By the way, today’s announced number for the May CPI raises year-over-year CPI inflation to 2.1%. The increase of 0.4% over April’s CPI, compounded twelve-fold, implies an annual rate of 4.9%. At this rate the “problem” of an undershooting PCE-deflator inflation rate will be “solved” before long.

(HT to David Boaz)

  • You cannot debunk an idea by debunking a weak defender.

    Inflation forces real price discovery, overcoming price stickiness, especially downward stickiness, especially in wages. Inflation shuffles the deck, requiring economic actors to flex their bargaining muscle. These are all good things for a capitalist system.

    Modest, predictable inflation also aids capital formation. Risk tolerance is a function of whether money appreciates or depreciates under your mattress. History suggests that, for the most part, depreciating money is more likely to be invested than appreciating money. Here, again, we could have too much of a good thing, creating bubbles, but in a demand-starved, liquidity-trapped economy, that's not the problem of the day.

    Growth has nothing to do with the issue. If growth is high, then inflation will imply a wide distribution of that supply, most likely by virtue of real wages gains. How else does the burgeoning supply get into people's hands?

    Thus, the question is not why too little of bad thing (inflation, allegedly) is a good thing, but why too much of a good thing (inflation, actually) is a bad thing. That question, of course, is easy to answer, but that does not mean that it is not the right way to look at the issue. Indeed, because it is the right way to look at the issue, the issue is not even close to controversial.

    The central bank cannot always engineer inflation, because the central bank can run out of assets it is allowed to buy. The Fed may create money out of thin air, but it can only put it in play in exchange for government debt or bankers' credit. A robust fiscal deficit to monetize is a great help if supply is growing rapidly, as is now the case. Austerity merely shuts down demand and leaves the central bank with nothing to buy.

    Supply is the key. We are living in an age of unprecedented potential output. The output gap is enormous, and the fiscal authorities are the only ones with the firepower to fill it. The infrastructure is a mess. We should spend TRILLIONS to fix it, and the Fed should print the money to pay for it. Our children will thank us for the physical plant, and they won't have to pay back the so-called "borrowings," because they weren't borrowings at all but just the creation of money that has already disappeared into the output gap.

    • Gonzalo R. Moya V.

      Mr. Kramer, if you claim to be a strong defender of the idea that inflation is beneficial, let me tell you that you also fail to be so, although it is because the idea itself that cannot be defended:

      "Inflation forces real price discovery"? On the contrary, real prices are easier to determine when inflation is null, so that variations in relative prices become due only to changes in microeconomic factors, hence becoming true channels of information of their comparative scarcity.

      The main downward stickiness in wages in the minimum legal wage, which -as inflation- is government imposed. Economic actors make use of the concept of inflation to bluff when bargaining a commercial contract, and it is this lack of transparency what indeed "forces" real price discovery, but allocating resources for such activity that otherwise would have been put in a productive use is not (socially) beneficial in any way.

      The keyword in Mr. White´s post is "textbook", as this debate is quite elementary.

    • Brian Simpson

      Mr. Kramer, not only are wages “sticky” due to minimum wage laws, as mentioned by Mr. Moya, they are also “sticky” due to pro-labor union legislation (the National Labor Relations Act and the Norris-La Guardia Act) and welfare for the unemployed (a.k.a., unemployment insurance). The former gives artificial powers to unions to push wages above what the skills of union workers are worth (i.e., what employers would voluntarily pay to hire them) by granting monopoly power to the unions. The latter raises the so-called reservation wage of workers. It effectively reduces the supply of labor by making it so some workers can afford to not work and thus increases wages. Abolish these forms of government interference and wages will adjust very quickly. This was seen during our last recovery with minimal government interference, during the early 1920s depression, when nominal wages fell 19 percent in one year.

      Even if the claim is granted that a depreciating money is more likely to be invested (although that is debatable), that does not necessarily produce more investment in real terms. Because prices are rising, it may be that the greater funds invested create no additional investment in real terms. In fact, because inflation undermines capital formation due to the mal-investment, overconsumption, withdrawal of wealth, negative tax effects, and more that it creates, investment in real terms will tend to be less. This is especially true under an accelerating inflation, which, as history shows, in our statist environment tends to be the case. Here I am speaking of inflation in the form of an undue increase in the money supply or, what is essentially equivalent, an increase in the money supply by the government. Thinking of inflation as mere rising prices makes it more difficult for one to understand all the effects of inflation.

      Moreover, our “demand-starved” economy has come from government interference that Prof. White mentioned: the housing bubble fueled by the Fed. Inflation-fueled booms eventually lead to busts. As a part of the inflationary expansion, people become unduly illiquid as the demand for money declines. As a part of the bust, the demand for money increases as people attempt to restore their liquidity and prepare for the tougher than expected financial conditions. The solution to the lack of demand is not the same recipe that led to the previous boom and current bust, that is, it is not the beginning of another inflation-fueled expansion. That will only create more of the same problems.

      The solution is to reduce taxes, reduce government spending, achieve surpluses, and pay down government debt. This will free up funds for profit seeking businesses to invest. This was done during the early 1920s depression and helped to lead to a quick recovery. Regulations need to be reduced (and, in the best-case scenario, eliminated) as well. This is especially true for the labor markets, so wages are free to adjust downward. During recessions and depressions, businesses often hold off investing as they wait for costs (including wages) to fall. Once costs fall, it makes prospective profits higher and spurs investment. The early 1920s depression provides an example of this as well.

      We do need to improve our infrastructure; however, this should not be done under the guise of “stimulating” the economy. Ultimately, the poor maintenance of our infrastructure is due to its provision by the government. Profit seeking business owners could do a much better job. An indication of this was provided in the railroad industry in the 19th century. Those railroads with less assistance and protection from the government tended to do a much better job building railroads and be more profitable in the long-term. Unfortunately, the privatization of roads and bridges will not occur in the foreseeable future, but the spending necessary for the government to improve our infrastructure should come from shifts from inappropriate forms of government spending, not from greater deficit spending.

      Unfortunately, because in today’s political (and, more fundamentally, philosophical) climate none of the remedies I discuss above will be implemented, we are doomed to repeat the boom-bust cycles. I discuss all of this in my new book Money, Banking, and the Business Cycle.

    • "Inflation forces real price discovery"

      Discovery? Or do you think it might produce conditions that change the actual distribution of relative prices? Is more spending always more enriching than less spending? Can you imagine any unmanipulated market signals that might indicate when that is the case?

      "Modest, predictable inflation also aids capital formation."

      When in history has inflation had the greatest long term predictability–during government fiat money, or during metal-based money?

      "History suggests that, for the most part, depreciating money is more likely to be invested than appreciating money. Here, again, we could have too much of a good thing, creating bubbles, but in a demand-starved, liquidity-trapped economy, that's not the problem of the day."

      Is it wise to disregard investment quality over quantity? Can you imagine the possibility that increasing a historically low level of investment in certain endeavors might produce a worse situation than not doing so?

      "How else does the burgeoning supply get into people's hands?"

      Through price reductions maybe?

      "the issue is not even close to controversial."

      Well, I those who think an issue is uncontroversial must be right.

      "the central bank can run out of assets it is allowed to buy. The Fed may create money out of thin air, but it can only put it in play in exchange for government debt or bankers' credit"

      That's a strange conception of price, even for bonds. Typically assets as voluminous and fungible as government debt don't "run out" unless there is an conflicting price signal, such as imposed by a government price ceiling. Instead, the price changes to reflect scarcity. Sure, in a private market it would be hard to imagine many circumstances in which there would be a market for nonpositive nominal interest rates. But first, the central bank isn't limited by such concerns, since it can conjure up however much money it needs to outbid competitors that use already existent money and to accept any interest rate offered. Second, even in the unlikely situation that government budget deficits cease to exist, there will still be massive bond issuances in the form of rollover for the outstanding debt.

      "Austerity merely shuts down demand and leaves the central bank with nothing to buy."

      Do you seriously think that is even a remote possibility in our lifetimes? No deficits AND no rollovers of outstanding debt? Obviously "austerity" to you is a relative term, much like calling a 10 drink/day guzzler a "t-totaller" because he isn't consuming 20 drinks/day. But as most English speakers use the word, calling tiny declines in massive deficit spending growth rates "austerity" is ridiculous.

      "The output gap is enormous, and the fiscal authorities are the only ones with the firepower to fill it."

      So, output is output is output is output. Got it. I guess that's why Americans lived so luxuriously during WWII.

  • Gonzalo R. Moya V.

    Mr. Simpson, "Vikingvista", thank you both for debunking the rest of Mr. Kramer´s post so thoroughly.

    Regarding the phrase "depreciating money is more likely to be invested than appreciating money", your responses were that inflation "does not necessarily produce more investment in real terms" and that pro-inflationists "disregard investment quality over quantity".

    However, economic agents indeed look for financial assets whose nominal return is larger than the rate of inflation so that their yield is non-negative in real terms. Given the strict positive relationship between risk and return, the only assets that satisfy the above requirement are those considered investments rather than savings (e.g. corporate stocks instead of a bank´s certificate of deposit).

    Austrians have correctly pointed out how this inflation-hedging leads to speculative purchases that over-value such assets. Thinking in terms of "Tobin´s q" though, whenever the market-value severely surpasses the book-value of a firm, this should estimulate entrepeneurship, as investors would prefer establishing a competitive firm in a particular industry rather than getting ownership of the established ones.

    Hence, Mr. Kramer, instead of calling for the fiscal authorities to fill the output gap, they should look for the market solution that is lowering the obstacles for entrepeneurship.

    • Brian Simpson

      Thank you for the comment, Gonzalo. I think we are in basic agreement. The question is whether the real returns will remain "non-negative" as prices rise (especially if they do so in an accelerating manner) and once we account for all the negative effects of an inflation of the money supply. These are the things I was trying to bring attention to.