What's so Scary about a Little Inflation?

Forbes contributor Charles Kadlec sees only one thing in QE3: a good ol' fashioned dollar devaluation. As he writes:

The Fed’s zero interest rate policy accentuates the negative consequences of this steady erosion in the dollar’s buying power by imposing a negative return on short-term bonds and bank deposits. In effect, the Fed has announced a course of action that will steal — there is no better word for it — nearly 10 percent of the value of American’s hard earned savings over the next 4 years.

Now, obviously, I'm not one to agree with Kadlec's conclusions. Even though the critique of the Fed's tracking methods is a little interesting, there is not a single explanation of why a slowly devaluing dollar is a bad thing. He just assumes it outright and instead throws around a silly little thought experiment about changes in prices over 20 years. Even stranger, he doesn't seem to mind proving that a little inflation is good. He quotes the FOMC's statement on why a little inflation is much more benign than deflation, and does nothing to try and prove it false.

The FOMC's argument falls in line with the monetarist discussion of inflation, which comes from the work of Milton Friedman and from A Monetary History of the United States in particular.

For the economy to grow, the amount of money available has to increase. We have inflation because we play it safe; we allow money to grow faster than the economy, because the alternative is disastrous. Deflation, when the supply of money not keeping pace with the economy (or more usually declining faster than the economy), is very punishing to anyone with debt; your ability to pay your debt decreases while the required payments stay the same. Since the relationship is basically fixed, its not surprising that deflation almost always leads to a collapse in economic activity. This is the heart of the room to grow argument that most contemporary economists support.

Moreover, inflation allows for wage flexibility. It encourages hiring. It provides the central bank the opportunity to cut rates when needed. It encourages more people to be involved in financial markets, instead of hoarding hard currency. And most importantly, it encourages businesses to spend saved cash on machinery and other fixed assets. It's hard to argue that inflation is too high when American companies are holding more than a trillion dollars in cash.

Of course, as is often the case in economic policy, higher inflation rates do have a real cost. Most economic explanations of inflation, especially those that remain hawkish, talk about how inflation is a secret "tax" on savers. This is only partially true. Inflation moves money from savers to debtors. It benefits government when it is a debtor, but it benefits most people as well, since most working people are debtors too. If the government is a saver (like Spain and Ireland before the crisis), then inflation hurts them too.

Going back to the much more important issue, there is no reason to assume that wages wouldn't increase at the same rate as inflation. Wages are entirely independent from any understanding of inflation. They can increase faster than inflation or they can increase slower than inflation. Inflation has everything to do with the relationship between money and national growth (GDP).

Which is why it is possible to have real wage growth (wages growing after inflation) and it is possible to have negative wage growth. Nonetheless, growth was almost always higher during periods of higher (moderate) inflation.

Now, during these situations, rich people suffered. And Republican governments tended to address this suffering by reducing this inflation. But reductions in inflation tended to be recessionary too, reducing job growth and wages. Which is why, since WWII, Democratic presidents have been in charge of higher employment and higher wage growth. Maybe not everything is connected, but these things are.

This is another stimulus just waiting to happen. Unfortunately, at 2 percent inflation, there just isn't any incentive to get started on this. The real return on fixed assets just isn't high enough, but it would be if inflation was higher.  Yes, higher inflation would be bad for bankers, and that's obvious since you site another person from the financial community as your hard currency expert (aren't you at least a little surprised that they all share the same background?). But I would rather have an economic recovery than a bunch of rich bankers.

Scott Sumner, the guy chiefly responsible for moving inflation back to the center of the discussion on monetary policy, is a libertarian. In fact, nearly every economist advocating NGDP targeting (raising inflation to compensate for a slowdown in spending) are libertarians. They are intellectual descendants of Milton Friedman, also a libertarian.

I'm not advocating some radical leftist theory, and you haven't heard me mention anything about forced full employment, or increased government transfers (at least not right now). I'm advocating ideas started by a libertarian (uncle Milty) supported by other libertarians (uncle Freddy) and to this day still advocated by libertarians (the Market Monetarists). Hell, I'm starting to get worried about the accusations that I'm a traitor to my own side.

If you base NGDP targeting on the rates of return from GDP futures, which would be a market-driven target, you would get an entirely market-driven monetary policy. The supply of currency would expand during downturns (not being a hard currency), but this is exactly what Friedman said was necessary.

To get there, you have to learn to love (a little) inflation (sometimes). These spurious arguments about war and peace are stopping you from realizing that this could easily be a strong, stable and entirely pro-market monetary policy. People like Kadlec just need to come out of the Austrian woods to see that there are other market-based monetary regimes. I promise, it won't hurt a bit.