Building a Wall Around Inflation

There's a current spat between various left-members of the blog world, like Paul Krugman and Ryan Avent, and the Atlantic's own Mike Kinsley.  Kinsley is worried that the government will start inflating away its debt, to which Krugman and Avent say, essentially, "Pshaw, it won't be so bad!"

I don't believe that the US government will try to inflate the value of our debt away.  Having the world's reserve currency is a valuable asset for a nation's government, and besides, the government has a lot of financing needs.  Inflating away the value of your prior debt only works if you don't need to keep borrowing more money--if you do, the higher interest rates quickly wipe out the value of the inflation.

But I am not convinced that higher inflation is a good idea, even though it has lately become fashionable.  I understand the logic--in a liquidity trap, the government has more room to quickly pump up the money supply.  But liquidity traps are pretty rare events, and there are other mechanisms for doing this.  I mean, apparently, because we're not having GD II:  Trap This!

Meanwhile, a 4% rate of inflation has real costs, even if they are not as high as the costs of hyperinflation.  First of all, there's the simple cost of surrendering the credibility on inflation that our central bank has spent thirty years building up.  Yes, in a theoretical world, we could just all switch the inflation target, and everyone would know that this was just a technical change.  In the real world, people are apt to wonder if the central bank might not switch the target again.  

Inflation is a delicate thing.  Once people expect inflation, you get more of it--and the cost of disrupting those expectations last time around was short term interest rates as high as 20%, and a nasty recession.  Right now, people believe a sort of story about inflation:  we were stupid about it in the 1960s and 1970s, but we learned from that experience, and now we won't go back there--not least, because markets would punish any central banker who tried.  

That narrative may not be really true.  Certainly, the events of the last year should make us skeptical of stories about how much smarter regulators have gotten.  Nonetheless, that story is important, because it holds the market's expectations for inflation in check.  So we should be careful about disrupting it, because we don't know what the new equilibrium would look like.

Moreover, a sudden change to a 4% inflation target would harm many people.  Those with annuities or non-indexed pensions, current holders of bonds, and so forth.  In the past, those problems have been smoothed, at least for the neediest, by increasing government spending in other areas.  But we don't have so much room to do that this time around.  Every government in the world is coming up against fiscal constraints, and we just accelerated the pace at which we're running towards them.

Besides, if we had a 4% inflation target, it might actually undo some of the benefits of the inflation.  Economists like modest inflation because it eases the problem of "sticky wages". People are extremely reluctant to accept nominal wage cuts, so employers often deal with declining demand by laying off workers, rather than cutting their wages.  Inflation eases this problem by eroding the real value of their nominal wages. 

But If we had higher inflation targeting, we'd probably have a lot more people with wage contracts indexed to the CPI.  That means that inflation would be less effective at dealing with the "sticky wage" problem, because wages would increase at the same rate as inflation.

When I took my world religion survey in college, I was fascinated by the concept of "building a wall around the torah".  That's why commandments like "thou shalt not boil the kid in the milk of its mother" have turned into a prohibition against eating meat and dairy together.  It means that there's no chance you can even accidentally cook milk and meat together.  

The "wall" has its ridiculous aspects--you can't have a chicken cheesesteak either, even though chickens don't give milk.  But it means you don't accidentally violate the commandment--and that you aren't tempted to "accidentally" violate it, either.

I think of inflation targeting as sort of like this.  It isn't that 2% is a magic number.  It's that now that we know it's there, we're all agreed that we're not in danger of excess inflation.   If we change that, we will disrupt a now-stable market in unpredictable ways.  Not all of them would be bad, but some would, and I'm not convinced that the putative benefits are worth it.

Update:  A reader thinks that I am creating a "straw man" and that I just made up this crazy 4% number in an attempt to smear Paul Krugman.  Sorry, y'all--I sometimes forget that you're not all following every debate I am.  This has been a really big thing in the deep wonkosphere, but it hasn't attracted much attention outside of it.

Paul Krugman is indeed a fan of Olivier Blanchard's propose to double the target inflation rate.  Contra what some right-wing commenters are probably thinking, this is not a totally crazy idea--it would certainly help in the situation we're now in.  But to me, the history of economic policy is littered with proposals that help whatever situation you're now in, only to create bigger problems later.  I'm not sure that I see the benefits in one specific and fairly rare situation outweighing the costs.

On the other hand, Paul Krugman and Olivier Blanchard are about a hundred times smarter than I am, so take that for what it's worth.

 

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