In praise of (a little) inflation

By Megan McArdle

At a conference this weekend, talking (once again) about the gold standard, I was struck by the fact that the things economics writers take for granted often sound horrifying to ordinary people.

In this case, the trouble came when I said that it's a good thing that the Federal Reserve errs on the side of having a little bit of inflation, and that in fact inflation in small amounts is probably good for the economy. The reaction of the assorted nice, normal people I said this to was about what you'd expect: they looked as if I'd suggested recreationally vivisecting their cat.

And yet, this isn't really all that controversial. A little bit of inflation lubricates the problem of sticky wages and prices: which is to say, that prices and wages are quicker to adjust upward than downwards.

To liberals, this generally sounds great: once you get a wage gain, it's yours to keep! The problem is, in an economic downturn, or a sectoral slump, the cost of your keeping that wage gain is that oftentimes, someone else gets the lovely parting gift of a layoff. The principle is less controversially illustrated using office leases, which also tend to be sticky. If your industry is in a slump, you might need to renegotiate the lease on your office or factory downwards. That keeps the space occupied, benefitting the owner, and allows you to operate profitably. The problem is, landlords hate negotiating leases downwards; perhaps they can't (because they have a mortgage), or they can't bear the thought of accepting less than they got before, or they may not want to cause trouble with other tenants of similar properties. There's also, as with labor contracts, fear of bad faith; if landlords show a tendency to believe hard-luck stories, everyone will be along with one. Also, even if you are in trouble, they'd rather you wrung a concession from someone else, such as workers or suppliers.

The problem is, if you genuinely are in trouble, inability to renegotiate could result in your going out of business, making everyone worse off. A month or two's vacancy generally costs more than the downward renegotiation would have.

Inflation eases these problems; landlords, suppliers, and workers take real wage cuts without the psychological barriers of lowering their prices. So decreases in demand produce much less severe contractions in output; this is one of the explanations for the relative mildness of postwar, and particularly post-1980, recessions.

Nor is anyone made particularly worse off by this, unless they've a habit of stashing large wads of cash under the mattress; interest rates and cost-of-living adjustments largely mitigate the effect on the most vulnerable groups, pensioners and those on disability. Consistent, but low, inflation is one of the great economic success stories of the 20th century. But somehow, every time you try to explain this, you end up with an audience holding fast to their cats.

This article available online at:

http://www.theatlantic.com/business/archive/2007/09/in-praise-of-a-little-inflation/1934/