May 07, 2012
Robert Samuelson had a serious discussion of Paul Krugman’s idea (and in his professor days, Ben Bernanke‘s) that the Fed could boost demand by deliberately targeting a higher rate of inflation. The idea is that this would lead to a lower real interest rate.
If businesses expected inflation to be 4.0 percent over the next five years, rather than 2.0 percent, it would give them more incentive to invest. They would be able to sell everything for 20 percent more money in five years. Higher inflation would also erode the debt burden of homeowners and others with large debts. This could free up additional money for consumption.
While Samuelson acknowledges the potential benefits from higher inflation in boosting growth he still opposes the policy. He cites Bernanke’s own objection as Fed chair, that it could undermine the inflation-fighting credibility of the Fed in the future. He also adds his own objections:
1) wages might not keep pace with inflation, dampening purchasing power;
2) higher inflation may lead consumers to become fearful and therefore save rather than consume;
3) financial markets might over-react and demand higher real interest rates.
There is some validity to each of these, but it is likely that the negative effects would be dwarfed by the potential gains in a context of continued high unemployment. In the case of the Fed’s inflation fighting credibility, that might be nice, but we are losing over $1 trillion in output a year because of the continuing downturn. Millions of unemployed workers and their families are seeing their lives ruined. It is hard to imagine a loss of Fed credibility that can be remotely equal in cost.
As far as wages keeping up with inflation, we have a long history on this. In general they do, there is not a negative relationship between real wages and inflation. Of course, everyone’s wages will not keep pace with inflation. They will be losers in this story. But anyone who thinks they have a policy that will lead to large gains without hurting anyone has not studied their policy closely enough. (Many of the workers who would see real wage cuts with higher inflation would have lost their jobs if inflation had remained lower.)
Samuelson’s argument that consumers will become fearful seems unlikely in an environment of 4-5 percent inflation. This could happen if we see the sort of double-digit inflation that we saw in the 70s. Although even then consumers were not that fearful — economists like Martin Feldstein were still complaining about insufficient savings.
The same argument applies to the point about the interest rates demanded by investors, with the additional provision that the Fed can insure a supply of low interest loans to potential investors through its zero interest federal funds rate and its quantitative easing policies. While this may imply some greater risk premium associated with loans at some point in the future, that would again seem a minor concern in the current context.
Anyhow, it is refreshing to see Samuelson trying to engage seriously on this topic and to put his concerns on the table. I think he is mistaken, but this is the debate that we should be having.
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