Not Yet an Inflation Nation

The unprecedented and aggressive moves by the Federal Reserve to stem the slide of the US economy have raised concerns about the eventual inflationary consequences of sustained monetary easing.  Most recently, Alan Meltzer has addressed this in his op-ed “Inflation Nation” in the New York Times on Monday, May 4, 2009. Meltzer’s views, and those of other inflation hawks, merit consideration.  At some point, monetary policy must confront the longer-run effects of current policy.  But, like St. Augustine, we hope that policy become virtuous, but not just yet.

Meltzer raises the specter of the runaway inflation of the 1970s, and the painful recession engineered by the Fed, and other nations’ central banks, to wring inflation out of their economies.  But the 1970s does not provide the relevant proof text for the present.  History does not repeat, of course, but it suggests.  And the shadow of history that we should be concerned with today is the 1930s and its depression rather than the Great Inflation of the 1970s.

There were many problems in the 1970s; disco music, leisure suits, and, of course, an insufficient appreciation of the costs of inflation.  We’ve learned a lot since then, at least as far as inflation inertia and monetary policy are concerned.  Monetary policy cannot fine-tune an economy, and there is an inertia to inflation, not least through its effects on people’s expectations.  But it is also worth remembering that the inflation of the late 1970s was built on a foundation that went back to at least the mid-1960s.  Consequently, the taming of inflation by the Fed under Paul Volker required the deepest recession that the country had seen since the Great Depression – or, at least the deepest recession up until today, when worldwide economic weakness arose due to financial distress and, importantly, against a backdrop of low inflation.

Meltzer and others concerned about the aggressive policies of the Fed and other central banks cite Friedman’s famous dictum that inflation is always and everywhere be a monetary phenomenon.  It does not follow, however, that monetary easing always and everywhere leads inexorably to inflation, not least because the easing itself need not be inexorable.

A more apt lesson from Friedman for the present day comes from his work with Anna Schwartz, the monumental Monetary History of the United States. A central finding of this book is that the contractionary policy by the Federal Reserve (a consequence of a misreading of monetary aggregates), coupled with financial distress, contributed to the severity and duration of the Great Depression.  This is the lesson that is most relevant today.

Michael W. Klein

William L. Clayton Professor of International Economic Affairs

Fletcher School, Tufts University

May 4, 2009

6 Responses to "Not Yet an Inflation Nation"

  1. Irini Fountoulaki   May 7, 2009 at 2:35 am

    I think that you miss the point. The US is not the creditor nation and center of world production as it was in the 1930’s. What the US policy makers are doing is essentially debt inflation. They are socializing the losses of lame-duck industry for political reasons and financing this by massive public debt. How will this debt be monetized in the future?The US has to compete with low tax, low debt countries. How will it remain competitive with high debt and taxes?Is not this the reason why everyone is concerned about inflation? Have you considered this side of things? I would appreciate an answer.

    • Guest   May 7, 2009 at 10:11 am

      Irini, thanks for your commment.It’s important to consider fiscal and monetary policy separately. Policy in the US at this point is one where debt is increasing – which is reasonable at a time of economic distress. The two questions are (1) will fiscal policy turn towards reducing the debt as a proportion of national income as the economy recovers and (2) will the real debt burden be reduced through taxes and reductions in spending, or by inflating it away. Thus my comment that monetary policy should, eventually, be “virtuous” but, given the adverse circumstances at present, not just yet. Long-run competitiveness is due to lots of things beyond the debt to income ratio and the tax rates of the US.

      • Guest   June 18, 2009 at 8:31 am

        Experience in the EU shows that these policies based on the hope of growing out the crisis generally fail. The Goverment programs keeping lame duck companies on life support take on a life of their own with the expanded political patronage. It creates a permanent drag on the economy that results in sluggish growth. What often happens is the reverse of your target. The public debt grows faster than the general economy. How have places like Italy and Greece succeeded to have public debt in excess of 100% GDP.The US by adopting a crony corporatist system and short circuiting Schumpeter ‘creative destruction’ is going down the road to hell.Apart from the rhetoric, I do not see anything in the Obama administration that will make the US more competitive in global markets. This is just not in the mindset of a person like Obama, who has always been a dependent of government rather than a creator of value.Indicatively Europeans, who have burned their fingers, are not following Geither’s invitation.