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Friday, September 2, 2011

Inflation is Neither as Boring Nor as Simple as it Seems

One nice thing about Dean Baker's new book, The End of Loser Liberalism, is that it puts the Federal Reserve Bank and inflation under the microscope. This is important and valuable, because too many people wrongly take it for granted that inflation is always a bad thing. To give an example, one graduate level textbook in international political economy that I use (Ravenhill, ed., Global Political Economy) has a chapter discussing theories of how different actors form their preferences about free trade (for or against), exchange rates (fixed or floating, high or low), etc. Notably missing is any discussion of why different people might favor higher or lower rates of inflation. The chapter author simply presumes that inflation is bad.

Yet once upon a time, average middle class people understood the significance of international monetary arrangements and inflation on their lives. These were the people to whom William Jennings Bryan's famous 1896 “Cross of Gold” speech was addressed. Farmers understood that the gold standard was harmful to their interests because it forced low inflation and even deflationary policies that made their debt burden worse. They wanted the dollar backed by both gold and silver (“bimetallism”) in order to have a larger money supply and higher inflation.

The first modern work of which I am aware that discusses who wins and who loses from inflation is William Greider's Secrets of the Temple. (For a fairly recent interview with Greider, see here.) The first level of the story is the easiest. It's hard to see how hyperinflation benefits anyone (though the historical memory of Germany's hyperinflation gave us the Bundesbank with its constitutional mandate to control inflation with no reference to unemployment and ultimately gave us a European Central Bank blindly following deflationary policies). Extremely rapid increases in the price level are so destructive that they outweigh the second factor, which holds in normal times: inflation benefits debtors, who get to pay their debts with cheaper dollars; and it conversely harms creditors, who receive those cheaper dollars.

But who are the debtors and creditors? In general, of course, lenders are wealthier than borrowers. Broadly speaking, older people lend to younger people. Thus, moderate levels of inflation transfer wealth from richer to poorer and older to younger. They make it easier for the middle class to build up assets like home ownership, and more generally for the economy to expand to full employment.

As Greider argued and Baker agrees, the decision to target a particular inflation rate is a highly political one with Fed decisions making it generally more difficult to reach full employment or the bargaining power full employment would give to workers. While the Federal Reserve Board officially has a dual mandate to promote both employment and price stability (in contrast with most central banks which, Baker points out, are responsible for price stability alone), in practice it has done little to promote employment even in the current jobs crisis, whereas it has frequently moved to raise interest rates when unemployment rates were quite high. Baker, as did Greider before him, argues that it is crucial to bring the Fed under more democratic control. Baker concedes that institutional reform of the Fed is a long way off, but argues that in the meantime progressives need to step up public pressure on the Fed to do something about unemployment, comparable in volume to the non-reality-based screams from the Right that what little the Fed was doing would set off massive inflation.

What was news to me, though, is that the Fed refunds to the U.S. Treasury the interest it earns on its assets (primarily “government bonds and mortgage-backed securities”), to the tune of $80 billion in fiscal year 2010. Baker suggests that if, instead of selling these assets off as planned over the next 10 years, the Fed holds on to them, the Treasury will save about $600 billion in interest payments over the period. This is almost equal to the revenue that will be gained by letting the Bush tax cuts for the wealthiest 2% of Americans expire.

Baker's main point is quite sound: progressives need to pay a lot more attention to the Fed than they have, and they have to amplify the voices of the few economists who have called for the Fed to announce that it wants a higher rate of inflation than 2%. The stakes are too high, and the general lack of knowledge means that there is quite a bit of room for organizing to make progress if the information gap is closed.

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