Moderate inflation is a kind of economic lubricant

Doing what the US did after the second World War – using low interest rates and inflation to erode the debt burden – is often referred to as “financial repression”, which sounds bad. But who wouldn’t prefer modest inflation and a bit of asset erosion to mass unemployment?

Doing what the US did after the second World War – using low interest rates and inflation to erode the debt burden – is often referred to as “financial repression”, which sounds bad. But who wouldn’t prefer modest inflation and a bit of asset erosion to mass unemployment?

Tue, Apr 8, 2014, 01:01

Econonerds eagerly await each edition of the International Monetary Fund’s World Economic Outlook . Never mind the forecasts, what we’re waiting for are the analytical chapters, which are always interesting. This latest report is no exception.

In particular, chapter 3 – although billed as an analysis of trends in real (inflation-adjusted) interest rates – in effect makes a compelling case for raising inflation targets above 2 per cent, the current norm in advanced countries.

This conclusion fits in with other IMF research. Last month the fund’s blog – yes, it has one – discussed the problems created by “lowflation”, which is nearly as destructive as outright deflation.

An earlier World Economic Outlook analysed historical experience with high debt, and found that countries that were willing to let inflation erode their debt – including the US – fared much better than those, like Britain after the first World War, that clung to fiscal orthodoxy.

But the IMF doesn’t feel able to say outright what its analysis clearly implies. Instead the report resorts to euphemisms that preserve deniability: the analysis “could have implications for the appropriate monetary policy framework”.

So what makes the obvious unsayable?

In a direct sense, what we’re seeing is the power of conventional wisdom. But conventional wisdom doesn’t come from nowhere, and I’m increasingly convinced that our failure to deal with high unemployment has a lot to do with class interests.

First, let’s talk about the case for higher inflation.

Many people understand that a falling price level is a bad thing; nobody wants to turn into Japan, which has struggled with deflation since the 1990s. What’s less understood is that there isn’t a red line at zero: an economy with 0.5 per cent inflation is going to have many of the same problems as an economy with 0.5 per cent deflation. That’s why the IMF warned that “lowflation” is putting Europe at risk of Japanese-style stagnation even though literal deflation hasn’t happened (yet).

Moderate inflation turns out to serve several useful purposes.

It’s good for debtors – and therefore good for the economy as a whole when an overhang of debt is holding back growth and job creation.

It encourages people to spend rather than sit on cash – again, a good thing in a depressed economy.

And it can serve as a kind of economic lubricant, making it easier to adjust wages and prices in the face of shifting demand.


Official inflation target
But how much inflation is appropriate?

European inflation is below 1 per cent, which is clearly too low, and US inflation isn’t that much higher. But would it be enough to get back to 2 per cent, the official inflation target in both Europe and the US? Almost certainly not.

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