Tuesday, June 23, 2009

Focusing on the Real Economic Problem

Last Thursday, in "Money Out of Thin Air" and in a related column on FindLaw, I tried to debunk some of the recent hand-wringing about how the Federal Reserve (the Fed) has supposedly put us on a path toward hyper-inflation. The complaint that we are now creating money out of thin air is ridiculous, simply because that is how money is always created. If, on the other hand, the concern is that the Fed is creating too much money, then the problem with that argument is that the chain of causes and effects that is supposed to connect the Fed's current actions with inflation simply does not hold up to empirical testing (either in terms of how much money the Fed is actually creating or how such money creation would lead inexorably to increasing rates of inflation).

In this past Sunday's NYT Business section, the economist (and former Fed vice chair) Alan Blinder offered his assessment of the situation, and his conclusions were essentially the same as mine. (He does not directly challenge the idea that money creation is inevitably inflationary, but this is clearly because he was conceding the obvious point that extremely fast money creation must be inflationary: "Under such conditions, Fed expansions of bank reserves lead to expansions of credit and the money supply and, if there is too much of that, to higher inflation." emphasis added) He also points out that the Fed actually adds and subtracts bank reserves (its current policy action) quite regularly, for example during and after Christmas each year.

My agreement with Blinder is hardly surprising, because I have always found him to be among the best of the mainstream centrist liberal economists. Moreover, in this case the only thing that would lead him (or anyone) to a different conclusion would be a deep commitment to denying reality, which Blinder has never been willing to do. Even though his comments were quite consistent with mine, however, he raises a couple of additional points that are worth emphasizing here to complete the picture.

The point that is probably most surprising to those who do not practice the dark art of macroeconomics is that the target rate of inflation is not zero. Is this merely because the Fed is being too weak-kneed? Absolutely not. As Blinder suggests, if the Fed tries to hit any particular inflation rate target, it's aim will inevitably be a bit off. If they miss on the low side of a zero target, we have falling prices, that is, deflation. And it turns out that even mild deflation is a very nasty thing, because once prices start to fall, people stop spending money to wait for it to rise in value even further. This sets up a downward spiral that is very difficult to reverse. Therefore, most monetary economists agree that a low-single-digit target inflation rate (such as 2%) is the best policy.

Can't the spiral happen in the upward direction as well? That is, once we have 2% inflation, is it not possible that people will spend before their dollars lose value, setting in motion a dangerous ascent to much higher rates of inflation? It turns out that this is not a serious risk in the United States, because the Fed does not miss on the high side by much (or, as Blinder puts it, the Fed "might miss and produce, say, inflation of 3 percent or 4 percent at the end of the crisis — but not 8 or 10 percent.") In addition, experience over the last thirty years or so has shown that the Fed can quite readily reduce inflation from rates like 5 and 6 percent to rates like 1 and 2 percent.

The long and short of it is that inflation in the 1-4% range is healthy, and rates above that can be tamed and reversed relatively quickly. There are many things to worry about right now, but inflation is simply and clearly not one of them. Remember, the unemployment rate is setting 25-year records around the country, and it is getting worse. We need the Fed and the Congress to do what is necessary to expand economic activity, which means that they must stop listening to those who would choke the economy before it has even begun to turn around.

-- Posted by Neil H. Buchanan