Some days I want to just shoot myself, like when I read the one millionth comment that easy money will hurt consumers by raising prices. Yes, there are some types of inflation that hurt consumers. And yes, there are some types of inflation created by Fed policy. But in a Venn diagram those two types of inflation have no overlap.
So here’s my plan. Beginning tomorrow, November 1st, I will ban all discussion of inflation from the comment section. I won’t respond to questions on inflation. (God knows how Bob Murphy will react to this—something tells me it won’t make me look good.)
Before everyone starts whining, I am about to provide a substitute language for you to use, and tell you when to use it:
1. Let’s start with the easiest type of inflation to consider, and the only one people really care much about—supply side inflation. Suppose the AS curve shifts to the left because of a cutoff in oil production, crop failures, bad government tax and regulation policies, etc, etc. Real GDP will fall, if we do nothing to aggregate demand. And prices will rise. People think it is the price rise that is making them worse off, but that’s an illusion; it’s really the drop in RGDP. How do we know? Because consider the case where the Fed responds with tight money, which shifts AD far enough to the left to prevent any inflation from the adverse supply shock. In that case there are two possibilities; the drop in real GDP and real living standards would be just as bad (if money is neutral) or it would be even worse, if money isn’t neutral. It is the fall in RGDP that is the key problem, and any price change is incidental to what’s really going on. So if you ever envision an inflation problem that makes consumers worse off, please don’t call it “inflation,” call it “falling real incomes.”
2. Now let’s turn to demand-side inflation, which either makes people better off in the short run (via higher RGDP, higher real incomes), or has no effect (if money is neutral.) Here there are many cases to consider:
2.a. Some argue that low inflation makes a liquidity trap more likely. But as we can see by comparing Japan, China, and Hong Kong, mild deflation creates liquidity traps only when real growth is persistently low. The problem isn’t low inflation, it’s low expected NGDP growth. That’s because real interest rates are strongly correlated with real GDP growth, and of course expected inflation in nominal rates is perfectly correlated with the expected inflation component of NGDP growth. So from now on please talk about the danger of low NGDP growth leading to a liquidity trap, not low inflation. China had deflation in the late 1990s, but fast RGDP growth—hence no LT.
2.b. This also applies to the phony tears people shed for the savers hurt by inflation. Let’s assume savers buy long term nominal bonds. Those bonds promise a fixed amount of money, at specified futures dates. The standard argument is that inflation hurts savers by reducing their real return on bonds. But savers don’t care about the nominal interest rate minus the inflation rate, they care about the nominal interest rate minus the per capita NGDP growth rate. I’ll give you an example. Years ago the British government indexed the initial starting point for retirement pensions to the cost of living, not average wages (as we do.) The Thatcher reforms led to real increases in living standards iGn reat Britain, and so over time the living standards of retirees fell further and further behind living standards of the employed (who received nominal wages increases that exceeded inflation.) Eventually the old-timers looked at the flashy lifestyles of their younger neighbors, and revolted. The UK government was forced to change the indexing scheme. People don’t care about real incomes they care about how they’re doing relative to their neighbors. If NGDP rises faster than expected, then a bondholder is paid back a smaller share of national income than he anticipated when he bought the bond. And that hurts.
2.c. The Fisher effect applies to nominal interest rates minus NGDP growth, not minus inflation. Some Keynesians fear that the Fed can’t stimulate the economy, because it finds it politically difficult to increase the expected rate of inflation. But they don’t need to increase the expected rate of inflation, just the expected rate of NGDP growth (and the SRAS is pretty flat right now.) When expected NGDP rises you get more investment whether firms expect more inflation, or more RGDP growth. So just shoot for more nominal growth.
2.d. Some people say inflation and deflation are bad because wages are sticky. A sudden bout of deflation will raise real wages, and lead firms to lay off workers. But that’s only true if the deflation comes from falling NGDP growth expectations. Suppose it is the “good deflation,” produced by rising productivity. Then if wages are sticky the deflation raises living standards. This occurred during the 1927-29 boom, when the price level fell in America. Of course that was followed by a “bad deflation,” sharply falling NGDP during 1929-33. So rather than talk about good and bad deflation, let’s just talk about what we really mean, rising and falling NGDP.
2.e. Some people think the Fed should target inflation. When you mention oil shocks they say “well that’s an exception, I favor a flexible inflation target that allows prices to rise during supply shocks.” OK, but then why not just target NGDP, so you don’t have to make exceptions? Why totally confuse the public?
2.f. One of the supposed costs of inflation is the excess tax on capital caused by the fact that capital gains taxes and taxes on interest are not indexed. But that’s really a problem of high nominal returns on capital, not high inflation. You say the two are correlated? I say they’re even more correlated with NGDP growth. So let’s talk about how rapid NGDP growth imposes inefficient tax burdens on capital.
2.g. Menu costs? Maybe, but it’s ambiguous, which is not enough to overcome my presumption for NGDP growth. After all, many economists think the biggest menu costs apply to wages, which seem very hard to adjust. Costly strikes result from attempts to adjust wages. Or workers occupy the capital building in my hometown of Madison. And wages are arguably more closely linked to per capita NGDP than inflation. In early 2008 inflation rose rapidly while NGDP did not. Wages remained well contained.
2.h. The inflation tax from printing money? It comes from the opportunity cost of holding cash, which is the nominal interest rate. And the nominal interest rate depends on NGDP growth. (I should add that it also depends on lots of other things, like economic slack and budget deficits. But those other things are also “not inflation.”)
2.i. Inflation can reduce the burden of the national debt? No, NGDP growth reduces the burden of the national debt. Does unexpected disinflation trigger debt crises? No, it’s unexpected falls in NGDP that trigger debt crises.
To conclude: If you are about to type the word “inflation,” please stop. If you have in mind something that implies lower living standards, please type “falling real incomes.” If it is a demand-side inflation (all the items in category 2 above) then type “NGDP growth” or “nominal income growth.”
So you have 12 hours to convince me to rescind this ban, before it goes into effect. If you cannot come up with a scenario where I need the word “inflation,” then it will be banned.