Good deflation/bad deflation, good inflation/bad inflation

I recently attended an economic conference with mostly conservative-leaning economists.  Someone had a paper that mentioned how certain types of deflation can actually be good, as when rapid productivity growth helped reduce prices in the late 1800s.

I agree with this, and mentioned that I rarely hear conservatives talk about “good inflation.”  Well I might as well have thrown a skunk into the middle of the room.  Let’s just say that the idea of “good inflation” didn’t go over too well.

And isn’t that the problem?  Isn’t that why we are where we are?  We have all sorts of models that are basically symmetrical.  You might argue that a stable price level is ideal, and that any inflation or deflation is bad.  But if you argue that some deflation is bad and some is good, then you implicitly have a model that distinguishes between demand and supply shocks.  So supply or productivity-driven deflation is good.  Of course those models imply that inflation caused by a fall in aggregate supply is also good.  The models are completely symmetrical.   This shouldn’t even be controversial.

So why don’t conservatives look at things that way?  And why do you rarely hear liberals talk about “good deflation.”  Maybe it’s just mood affiliation.  Or maybe people just don’t have the right model in their heads.  (I.e. the model I have in my head.)  Some people do understand that the argument is symmetrical.  (I seem to recall both David Beckworth and George Selgin making similar observations.)  But it seems to me that they (and a few others) are the exception.  And maybe that’s why the Fed is having so much trouble creating “good inflation.”

PS.  Notice that NGDP targeting automatically creates deflation when deflation is appropriate and inflation when inflation is appropriate.

We need (low) inflation to prevent (high) inflation

In a recent paper, John Cochrane discusses a scenario where fiscal debts become so burdensome that the central bank is virtually forced to inflate:

At that point, inflation must result, no matter how valiantly the central bank attempts to split government liabilities between money and bonds. Long before that point, the government may choose to inflate rather than further raise distorting taxes or reduce politically important spending. Argentina has found these fiscal limits. So far, the U.S. has not, at least recently.

Argentina is certainly an instructive case, but I’m not sure it shows what Cochrane thinks it shows.  The government of Argentina adopted a highly inflationary policy in 2002, partly in an attempt to dig out from under a big debt burden.  But what sort of policies preceded that decision?

Around 1990 Argentina began some neoliberal reform, which triggered very fast growth in RGDP during 1991-97.  Then it all fell apart.  Argentina had decided to adopt a currency board as a way of tying the hands of the central bank, to prevent a repeat of the previous hyperinflation.  Big mistake, they should have followed Chile’s decision to target inflation.  In 1997-98 many developing countries got into trouble, and devalued sharply.  Argentina lost competitiveness.  Then the high tech boom caused the dollar to strengthen, even against the currencies of other developed economies.  Because Argentina was fixed to the dollar, their peso appreciated even more.  Now they were hopelessly uncompetitive, and tried to restore competitiveness under the only method allowed by a currency board, lower wages and prices, aka internal devaluation.  Argentina entered a 4 year long depression as prices fell and unemployment rose to over 20%.  The GOP made the exact same mistake in the early 1930s.

With NGDP falling so sharply below trend, the debts became politically impossible to manage.  Just as in the US during the 1930s, a new left wing government came in, abandoned the fixed exchange rate and defaulted on debts (via both inflation, and a reneging on the gold/dollar clause in contracts.)

And in both cases RGDP started growing really fast, despite horrible statist polices 10 times worse than anything Obama could imagine in his wildest dreams.  So much for RBC theory.

Conservatives were to blame for both crises.  So if conservatives want to prevent high inflation (and I certainly do) the best way is to make sure NGDP grows at a steady rate.  We stopped doing that in 2008, and we are now paying the price.  A little inflation now may prevent a lot more inflation later.

At the University of Chicago they are skeptical that wages could be sticky for a long enough period to explain the current unemployment rate.  The new classical economists generally do accept that demand shocks can have real effects in the short run, but think wages should adjust within a year or two.  I certainly would agree that not all unemployment is due to deficient AD, there was also the big jump in the minimum wage and the extended UI benefits.  But I think much more of it is AD-related than most people realize.  Paul Krugman has an important recent post that shows just how sticky wages become near zero percent inflation.  There is a shocking discontinuity in the distribution of nominal hourly wage gains at 0%, a pattern that is not consistent with New Classical models.  Those models work well at relatively high inflation rates, when all you need to do is negotiate new contracts with smaller pay increases, but the adjustment process seems to take longer when many workers need nominal pay cuts, at least if we aren’t willing to provide a bit more NGDP.

PS.  Some people wonder about the title of my blog.  Krugman’s post contains the single most perfect illustration of money illusion that I have ever seen—the distribution of nominal wage rate changes.

PPS.  Krugman has another post on Italy, which suggests why Cochrane’s theory should not be dismissed.  I don’t think his model tells us much about the US.  But it might eventually prove to say a lot about the European periphery.

Do the “rentiers” actually gain from deflation?

I don’t know the precise definition of this (French?) term, but I’d like to use Paul Krugman’s definition, as I’ll be commenting on his post:

Financial securities are overwhelmingly held by the rich “” more than 60 percent by just one percent of the population, more than 98 percent by the top 10 percent. It’s true that middle-class Americans own significant shares of deposits, and that some part of their pension accounts would be in bonds. On the other hand, middle-class Americans owe the lion’s share of debt; relatively speaking, the wealthy have hardly any.

So if you think about the distributional consequences of the choice between a Japan-style lost decade of very low or negative inflation and a Mankiw-Rogoff strategy of higher inflation for a while, it’s very much about benefits to the wealthy versus benefits to the middle class. Since I’ve been arguing that some inflation would help the economy recover, what we’re seeing in practice is that defending the interests of a small wealthy slice of the population takes priority over a possible recovery strategy.

If ‘rentiers’ means government bond holders, then rentiers obviously benefit from deflation in the US (although perhaps not in Greece or Argentina, where default is possible.)  But Krugman is clearly looking at a broader class, those that hold financial assets.  Unless I’m mistaken the Fed policy that reduced NGDP in 2009 at the fastest pace since 1938 also tended to sharply reduce the value of most financial assets.  Stocks fell dramatically, as did many riskier forms of debt.  Commercial real estate also plummeted in value.

Monetary policy is not a zero sum game.  I favor monetary stimulus because I think it’s good for the country, not because I’ll benefit.  But as a matter of fact I do think I would benefit, despite that fact that I am a bit of a rentier myself (not that my income is what the NYT would consider “lucrative,” but I’m a very high saver.)  Indeed I think poor, middle class, and rich Americans would all benefits from monetary stimulus, just as all three classes were hurt by the crashes of 2008-09 and 1929-33.

PS.  I just noticed that Matt Yglesias made the same mistake.  Remember that stocks rallied in both 1933 and 2010 on news of monetary stimulus.  Corporate America wants monetary stimulus.

Playing with fire

There has been a recent upswing in conservative articles discussing the idea of going back to some sort of gold standard.  I don’t think people realize how dangerous this idea is.  You can’t just “give it a shot” and see how it works out.  It’s like marrying the daughter of a Mafia chieftain–you need to be very sure you are willing to commit.

A true gold standard (not Bretton Woods) allows Americans to buy or sell gold.  If you are not 100% committed to staying on gold, but instead hint you might devalue the dollar at some point, people will dump dollars and buy gold.  The increase in demand for gold will raise its value, or purchasing power.  This is deflationary under a gold standard, where the nominal price of gold is fixed.

Nor is this merely a theoretical problem.  There were large bouts of private gold hoarding during four periods of the Great Depression, all associated with devaluation fears; the last half of 1931, spring 1932, February 1933, and late 1937.  All four were associated with economic distress, falling stock and commodity prices, etc.  And there is event studies-type evidence showing causation going from gold hoarding to deflation.

It’s not easy to know which price of gold would be appropriate.  Perhaps market gold prices would go to the right level after an “announcement” of a return to gold, but even that depends on the announcement being 100% credible.  But after you re-peg, the real value of gold can change due to industrial demand shifts, even if there is no monetary hoarding of gold.  Furthermore, all countries are not likely to follow the US back on gold, so you might have monetary gold hoarding in Europe, as people feared for the euro.  Booming Asia might increase the industrial demand for gold, just as it has raised the demand for many other metals.

And there is little room for error.  A 10% increase or decrease in the real value of gold seems very small when it is just a commodity.  But under a gold standard that sort of shift can be accommodated only by changing the overall price level by 10%.  A sudden 10% rise or fall in the price level is very destabilizing to the economy.

Even if the government is committed to gold, investors may fear the next government won’t be (remember FDR?)  In that case the promise to stay on gold may not be credible.  In the old days there was a powerful emotional attachment to gold, as paper money was feared as inevitably leading to hyperinflation.  Only then will voters be willing to suffer austerity to stay on gold.  A modern analogy is the long painful struggle of Argentina to stay on its currency board during the 1998-2001 deflation, attributable to a fear they would return to hyperinflation.  But we now know that fiat money can produce modest inflation rates, so our voters won’t undergo the pain of the mid-1890s, or early 1930s, just to stay on gold.  And if you aren’t willing to undergo that pain, the system won’t work.

Some supporters point to Bretton Woods, but that “worked” in direct proportion to the extent that the gold constraints were ignored.  Gold was highly overvalued after the 1933 devaluation, and then the US grabbed a huge share of the world’s gold in the run-up to WWII.  After the war those two factors gave us an unprecedented amount of slack, where we could mildly inflate until gold was no longer overvalued.  Once we reached that point in the late 1960s, the system immediately fell apart.  It would have collapsed even sooner if Americans had been allowed to own gold.  And if LBJ had tried to deflate to stay on gold, Americans (if allowed to) would have hoarded gold in the (correct) expectation that the next president would devalue the dollar, putting expediency ahead of principle.  That hoarding would have had the same effect as the hoarding of the early 1930s–deflation and depression.

HT:  Bruce Bartlett

PS:  Today’s NYT said:

Economists are now engaged in a spirited debate, much of it conducted on popular blogs like Marginal Revolution, about the causes of the American jobs slump. Lawrence Katz, a Harvard labor economist, calls the full picture “genuinely puzzling.”

If you check the four links you won’t find me, but the link to MR (Alex Tabarrok) starts as follows:

I find myself in the unusual position of being closer to Paul Krugman (and Scott Sumner, less surprising) than Tyler on the question of Zero Marginal Product workers.

Close, but no cigar.  Still I guess it’s progress being just “one degree of separation” away from the Times.

Three very good monetary posts

Matt Yglesias on Kocherlakota’s strange logic

Paul Krugman does a very good post that is slightly different, but analogous, to something I wrote yesterday and will post shortly.

Nick Rowe does a very good post on rules vs. discretion.  He zeros in on a key quotation from a recent Bullard interview:

[Update: This interview (H/T Mark Thoma) with James Bullard, President of the St Louis Fed, is an example of what I mean. I used to think that the Fed had an implicit inflation target of around 2%-2.5%. Now I learn that one man who votes on Fed decisions has a lower bound of somewhere just below 1% on his personal inflation target.

He also suggested a renewed vigilance on a threshold that, if crossed, would cause the Fed to act. Referring to the annualized gains in core consumer prices of around 1%, Bullard said, “That’s not extremely low. But if it would start to go down from there, to 50 basis points or down to zero, then I would start to get concerned we’d be in a Japanese style scenario, so I think we want to defend our inflation target on the low side, and take aggressive action if necessary.”

Though the analogy is imperfect (and the fact that it is imperfect says a lot), we do not interview deputy governors of the Bank of Canada to find out their personal inflation targets. They would all give exactly the same 2% answer, and think you were silly for asking. Which is not to say that some of them don’t think the target should be changed; but until it is changed, and the new target is announced, it’s 2% for all of them. Period. Rule of law vs rule of men.]

Exactly.  And I can’t resist quoting the first two lines from my review of Bernanke’s Jackson Hole speech, which raised a few eyebrows in the blogosphere:

Pretty disappointing, but with one silver lining.  We pretty much know where the “Bernanke put” is, he drew a line at roughly 1% core inflation.

It’s unlikely we”ll get deflation, but 1% inflation won’t produce a robust recovery.