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.

More QE Madness (Yes, It Worked)

It's not surprising that QE3 has emerged as a partisan topic. Although the positions against more monetary stimulus are varied, we'll address the comments that previous episodes of Quantitative Easing "did not work." The common complaint is that lending did not increase enough to justify the effort. This is partly true, but mostly misguided.

There's a lot of different places to look if you want to assess the effectiveness of QE, and lending is just one of them. You can look at the change in yields on different assets (like they did at Northwestern), and see a substantial effect.

QE1 bought treasuries and mortgage-backed securities, both saw serious drops in yields. In more layman's terms, the interest paid by the government and mortgage borrowers went down; you can see this in the decline in yields for Mortgage-Back Securities (MBS). No doubt. High-grade corporate debt also went down (since it is a somewhat similar market to treasuries), making it easier for them to borrow too.

QE2 was less effective, because it was more focused. They didn't buy MBS the second time around. Regardless, both of the previous QEs raised inflation expectations, which you could see by tracking TIPS (the inflation-protected version of US government debt). The same inflationary pressure was seen in Britain during the Bank of England's QE operations.

Because of QE efforts, the US government could actually borrow at negative (real) interest rates. In other words, the rate of interest was less than the expected rate of inflation. QE made things much easier for the government to spend some money, if it wasn't so gridlocked.

If you want to get more of the details on the current version of QE, you should check out Scott Sumner's FAQ, which describes nominal GDP targeting, a type of monetary policy that is very similar to what the Fed is currently doing. It's kind of odd, because NGDP targeting is very friendly to libertarians (and Scott is included), even though the Ron Paul variety are probably the last people to embrace this type of monetary activism. The idea is that the government should be ignored, and as least intrusive as possible. The Central Bank can create money-driven economic growth as much as it wants. I know it's a different strain of libertarianism (more Milton Friedman than Von Mises), but it's libertarian nonetheless.

So what makes this round of QE special? Well, it seems like they've been learning their lessons. They're buying the most effective asset classes for the kind of monetary stimulus they're looking for (in particular MBS). But more importantly, they're looking to change the expectations for inflation. While a target hasn't been set yet, Bernanke mentioned that they would be more accommodating of inflation if unemployment remains high. This is why the whole "open-ended" side of this round matters. They will continue to pump money, even after things start to get better. If you're sitting on cash, you're going to start losing money.

(And a quick aside on that theme. The Fed should also stop paying interest on reserves. They're currently considering it. It's just that the Fed moves at about the same speed as a glacier. It took three months of debate to get QE3, so be patient.)

I know I've said this before, but it's worth repeating. If you want unemployment to drop, you need to look to increase the inflation rate. Inflation hurts savers (and the rich in particular), in that it reduces the value of hard assets (like bonds), but it helps workers (and the poor, in particular). It makes debt easier to bear, and it encourages spending directly by creating incentives against holding cash. Both are good for attacking the unemployment.

But there's only so much growth you can get through inflation. Too much inflation (let's say 10 percent a year and higher) will cause all sorts of negative side effects. People will stop saving their money, for example. This is why the Fed has a dual mandate (employment and price stability). You have to strike a balance between the two.

It's also the angle that you'll see attacks on the Fed come from. The rich, and their financial representatives, will bitch and moan about the diminishing values of bond portfolios. They'll moan about the damage to "pensioners," conveniently forgetting that only a small portion of Americans own lots of bonds. Just ignore them. Their stake in all of this is obvious. They don't want a recovery; they just want to sit on their wealth. The Fed is making sure that they can't.

Pomp and Circumstantial Evidence

John H. Richardson over at Esquire reports on the comedy, pageantry and tragedy of Ron Paul's Subcommittee on Domestic Monetary Policy and Technology.

So there you have the national debate a nutshell: The Republicans offer folk wisdom, fringe economics, and a continued obsession, two decades after the collapse of communism, with central planning; the Democrats come with statistics and studies but have become too demoralized and feckless to do much more than invoke Milton Friedman. Then a handful of overworked reporters ask a tiny handful of timid questions and rush off to file superficial stories that everyone ignores, leaving Paul to a line of fans led by a white Rasta with a small pamphlet in his hand: 'Will you sign my Constitution, since you're the only one that follows it?'

The government we deserve...

So How Can We Fix This Mess?

We continue our talk about debt. Reinhart and Rogoff's book spends a lot of time focusing on the different components of national debt. You can have, for example, public debt owed to foreigners, public debt owed domestically, private debt owed domestically, and so on.

I covered public debt in the previous post, but the other components deserve a little attention too. Despite popular opinion about things like China, the US doesn't have much of an external debt problem. It's only 4 trillion of our 15 trillion dollar public debt, and maybe a third of all debt. On the other hand, it definitely has a private debt problem, which is currently 230 percent of GDP. Don't forget, it was default on private debt, subprime mortgages, that got us into this mess into the first place. So even while we fixate on public debt, the thing killing our economy is the process of paying off the huge debt burden we built up over the last decade.

The Economist argues that this is the key to actual recovery, and I tend to agree. People will not start spending money again until they get free of all their debt. Unfortunately, this can't happen all at once, since my spending is your income and my saving is your loss. Some agent in the economy - consumers, businesses or government - always has to be spending something. Which brings back the earlier question about timing. If you cut government spending now, it means you're putting off private debt reduction until later. If you tackle private debt right away, government is going to have to spend extra.

So how do you do this?

To answer this question, you have to take an overview of basic macroeconomic policy. My previous comments might seem too Keynesian and too forgiving of high debts. I don't want to give either impression. Keynes is a big deal, but the vast majority of economists are not Keynesians. Most are a lot more typical of the free-market ideas that dominate the right.

So to recap, here is what I believe to be the general consensus on deficits among economists. First of all, debt is a big deal, whether it is accrued privately or publicly. The inability to repay debts is the heart of every financial crisis. That's why it's important that governments live within their means, and countries create strong financial institutions (rules and regulations) that prevent people and companies from getting hopelessly indebted.

Unfortunately, in a global depression, which is what we face today (since most countries have still not recovered the output lost during the 2007 financial crisis), austerity measures can be counterproductive. They reduce the overall size of the economy, making it more difficult for people, businesses and government to repay the debts they took on during the boom.

But this is where mainstream macroeconomists begin to diverge. The question is about government's role in promoting the recovery. Those (usually) on the left talk a lot about fiscal stimulus, like building bridges and digging ditches, to compensate for the reduced spending in the private sector. Since my spending is your income, and vice versa, we cannot all reduce spending at once and expect an economy to grow. This fundamental truth is the heart of Keynesian economics.

The more conservative argument, called the monetarist approach, is slightly more technical. Developed originally by Milton Friedman and Anna Schwartz, it focuses on the real interest rate in the economy, which in turn determines the money supply. Here's how it works, and I apologize in advance for the tangent:

I'm pretty sure you understand the dynamics of aggregate supply and demand. Along the demand curve, increasing prices will lower the amount of product demanded. The opposite is true for supply, as an increasing price will increase the amount supplied. In any economy, there exists a point where the total amount of goods supplied and total amount of goods demanded are equal, which is known as equilibrium price level.

The supply and demand for savings, borrowing and investment function the same way, with one additional caveat. If I have a certain amount of money, and you don't, there is an "equilibrium" interest rate that encourages me to lend to you and you to borrow from me. As the interest rate goes up, I want to lend more, and you want to borrow less. Now, your desire to borrow is not only determined by the interest rate on the loan. It also depends on the rate of return that you can earn on available projects. Even if the interest rate on my loan is not particularly attractive, you'll be happy to take it if you know you can invest it to earn a little more.

A recession always leads to a significant drop in the real interest rate. The cause-and-effect is a little murky, since investment is a part of GDP, but the logic is clear. If the economy is contracting, you won't see very many good places to invest your money. You'll demand a much lower interest rate before you borrow. Moreover, at any time within an economy, people have different levels of indebtedness. Some private actors might have borrowed too much, encouraging them to spend less and leading to the decline. But it's always safe to say that not everyone is in debt.

So here's where monetary theory comes in. By lowering interest rates, you encourage those people not in debt to borrow now and pick up the slack. At the same time, you make it easier for everyone else in debt to pay back what they owe. If you owe a loan with a 10 percent interest rate, but you can go to a bank to refinance at 2 percent, you'd be a fool not to take that opportunity. A lower interest rate means you have more money to spend while you pay down that loan. Since your spending can increase, and those people that were avoiding borrowing can now borrow at attractively low interest rates, the economy will increase total spending and start to grow again.

So that's basically the two approaches. The fiscal side says "have government pick up the slack;" the monetarist side says "make it easier for the private sector to pick up the slack." You can obviously combine them as well. You can have a central bank lower interest rates while the government lowers taxes and conducts safety net spending to revive the economy. They counteract each other too. If a government sharply reduces spending, lowering the interest rate won't do much. If the central bank keeps interest prohibitively high, fiscal stimulus will fail.

Both approaches have their limits. A heavily indebted government can't spend more without creating a debt crisis. And interest rates can only be dropped to zero, even though they might need to go even further. The second problem, zero percent interest rates, is known as the zero bound. It's also where we are today. The central bank has set interest rates to zero, the return on federal borrowing is actually negative, and yet we still lack the spending to encourage economic growth.

Solving depressions, moments where the interest rate is essentially zero but spending still is too weak, demands some unconventional policies. But there is a consensus forming that the general goal is to target a specific nominal GDP level (real growth plus inflation) and hold it there for an extended period of time. This concept comes from Scott Sumner, the new face of Modern Monetary Theory, i.e. the new Friedman-ites.

To hit a nominal GDP target, either inflation or real spending needs to increase. If the target is comprised mostly of inflation, no big deal. Since debt contracts describe a specific, dollar-amount of debt that needs to be repaid, inflation makes this debt burden smaller in real terms. Inflation also discourages companies from holding cash and lower interest-bearing assets, which ultimately gets them to spend more.

How long should the NGDP target be held? Monetarists argue that it could essentially last forever, if you had the proper market tools to judge future rates of NGDP. More leftist economists would say that the central bank should raise its inflation rate for a period of time, until its slated NGDP target is fulfilled. Paul Krugman's argument is that we should say we'll tolerate higher inflation in order to get 8 consecutive quarters of 5-7 percent nominal GDP growth, and then we'll start lowering it again.

The government can obviously play a role in supporting that extended target. It can increase its spending to raise real growth and limit the more pernicious effects of inflation on the economy (like when wages are stagnant but prices rise). Once the target is met, both the central bank and the government should begin backing off. The government would need to start paying down its debts; the central bank would start raising interest rates to push inflation back down.

Many monetarists argue that the government should always maintain an essentially fiscal-neutral budget, i.e. deficits should always be less than GDP growth (except for those times when they interfere with the actions of the central). They add that a nominal GDP focus will actually reduce debt without any action from the government, since inflation and growth will reduce the actual debt burden even if much of it isn't repaid.

Keynesians say that we should be paying down budgets during the good times in order to give us the budget flexibility to aggressively increase spending during bad times. The irony of that, of course, is that Keynesians are commonly thought of as "borrower and spenders," when in fact they're pretty aggressive budget hawks during good times. People just don't listen to them in good times.

To be a Keynesian, you need to have a bit of faith in people and institutions. Governments have little incentive to reduce deficits during economic booms, but this is the most important thing they can be doing when the economy is growing. That's not to say this never happens; Clinton and Congressional Republicans were able to get a budgetary surplus during the tech explosion. It's exactly what they should have been doing.

To be a monetarist, you need to kind of believe in magic. A scary large part of monetary policy is based around expectations. This basically boils down to saying that if the Fed says something is going to happen, it's going to happen. That's a pretty bold claim, and it doesn't necessarily always become true. The Fed can lose control over inflation, which happened in the late 70s, and central banks throughout the world fail at their mandate.

Regardless, either approach to macroeconomic policy depends on having strong economic and political institutions (i.e. the rules and practices that we follow when developing policy). A country can pay down very high debts, but it is less likely to do so if it is run by a corrupt elite. At the same time, a central bank can control expectations, but it needs to be seen as independent and transparent to do so. More than any particular policy, I'm starting to strongly believe that this is the real secret ingredient of sustained economic growth. When the rules are fair, when the system treats people equally, and when the organizations within a society live up to the standard set for them, either approach to taming the business cycle is reasonable (hell, do both). Without properly functioning institutions, neither will work.

Now and Then

Without a doubt, recent government efforts meant to reduce the effects of the financial crisis often seem inaccessible and arcane. Much of the recent debate has focused on things like "bailouts," "backdoor loans" and "quantitative easing. While we deal with the efforts of an interventionist Fed today, we can take a lot about previous efforts during financial panics.

Liaquat Ahamed's Lords of Finance, the story of the key central bankers during the interwar period, obviously deals with these issues extensively. Two stand out: efforts to stem the banking panic (today's TARP and bailouts) and the decision to abandon the gold standard (similar to today's lax monetary policy at the Fed). The latter was the most important pieces of monetary policy in the first half of the Twentieth Century. There were many efforts to mitigate the effects of the depression in the US, but none were as effective. As Ahmad writes, monetary easing was "one step that succeeded beyond anyone's wildest expectations in getting the economy moving again."

Efforts to stem the banking crisis were also eerily similar to the Fed's response to the collapse of Bear, Lehman and the rest of the American financial system. How did it happen back then? Roosevelt had four brilliant young economic advisers during his first term: Dean Acheson, undersecretary of the Treasury, James Warburg, Roosevelt's direct adviser on economics, Lewis Douglas, the budget director, and George L. Harrison, the head of the New York Fed. These men were instrumental in the first maneuvers that Roosevelt conducted to save America's banking system, which was on the verge of collapse. Something like 7000 banks failed between 1931 and 1933, the New York Fed ran out of gold reserves supporting the system (it lost $350 million dollars on March 3, 1932), and almost half of the currency in circulation was withdrawn from banks. In a span of eight days, they stopped this cascading disaster right in its tracks. Hoover had been trying to do it for three years already.

I'll let Ahamed take it from here:

Every one of Roosevelt's advisers, including Harrison, believed that having stabilized the banking system, they could rely on the traditional levers - expanding credit, undertaking open market operations - to get the economy moving again. Most important, none of them could see any reason for breaking with gold.

note: This means abandoning the gold standard and devaluing America's currency. This would create inflationary pressure in the US, as foreigners could buy American goods at a lower price - in their currency - and Americans would have a harder time importing goods. This increase in demand for American currency leads to inflation, which is a good thing when a country has high unemployment and depressed aggregate demand.

Pitted against this array of economic expertise was one man - the president himself. Roosevelt did not even pretend to grasp fully the subtleties of international finance; but unlike Churchill, he refused to allow himself to be in the let bit intimidated by the subject's technicalities - when told by one of his advisers that something was impossible, his response was "Poppycock!" Instead, he approached the subject with a sort of casual insouciance that his economic advisers found unnerving but which nevertheless allowed him to cut through the complications and go to the heart of the matter.

His simplistic view was that since the Depression had been associated with falling prices, recovery could only come about when prices began going the other way. His advisers patiently tried to explain to him that he had the causality backward – that rising prices would be the result of recovery, not its cause. They were themselves only half right. For in an economy where everything is connected, there is often no clear distinction between cause and effect. True, in the initial stages of the Depression the collapse in economic activity had driven prices downward. But once in motion, falling prices created their own dynamic. By raising the real cost of borrowing, they had discouraged investment and thus caused economic activity to weaken further. Effect became cause and cause became effect. Roosevelt would have been unable to articulate all the linkages very clearly. But he had an intuitive understanding that the key was to reverse the process of deflation and kept insisting that the solution to the Depression was to get prices moving upward.

Roosevelt ended up adopting a policy on gold similar to the research of George Warren, a Cornell economics professor who was an expert on farming. And the actual mechanism for accomplishing this was through a farming bill, with an amendment that most people overlooked. It was a reckless and foolish decision that appalled most of the people working for him and caused outrage among the world’s financial experts. But, as Russell Leffingwell, a Morgan partner, wrote to Roosevelt, “your action in going off gold saved the country from complete collapse.”

Days after Roosevelt's decision, the Dow jumped 15 percent, one of the highest increases in its history. During the following three months, wholesale prices jumped by 45 percent and stock prices doubled. With prices rising, the real cost of borrowing money plummeted. New orders for heavy machinery soared by 100 percent, auto sales doubled, and overall industrial production shot up 50 percent.

This is exactly what should have happened if the stimulus had any real teeth. We are where we are because of a true lack of guts. Roosevelt may have been insane for doing what he did, but his hard-headedness and iron cajones prove why he is a true American hero.