Authored by Brigitte Granville, originally posted at Project Syndicate,
With all of the problems afflicting the world economy nowadays, inflation seems to be the least of our worries. In addressing the post-2008 economic malaise, which stems from over-indebtedness, policymakers are correct to focus on the threat of debt deflation, which can lead to depression.
But dismissing inflation as “yesterday’s problem” could undermine central banks’ efforts to address today’s most pressing issues – and, ultimately, facilitate inflation’s resurgence. Understanding how the Great Inflation from the late 1960’s to the early 1980’s was tamed offers important lessons for addressing far-reaching economic problems, however different ours may be, and provides insight into the dangers that may lie ahead.
The first useful lesson concerns expectations. In the decades following World War II, the doctrine that inflation needed to be traded off against employment – based on the relationship that William Phillips described in 1958 – dominated economic thinking. But the Phillips curve fared poorly in the 1970’s, when many countries experienced “stagflation” (high levels of both inflation and unemployment).
This vindicated criticism by Milton Friedman and Edmund Phelps, among others, who had already begun to argue that the Phillips curve represented merely a short-term relationship. If people do not expect inflation, the illusion of increased purchasing power can boost employment and output for a relatively short period. But once workers realize that real wages have not increased, unemployment will return to its “natural” level consistent with stable inflation.
Later, “new classical” economists like Robert Lucas and Thomas Sargent demonstrated that once people understand that inflation is being manipulated to generate market optimism, the monetary authorities’ actions lose their impact. The result is higher prices and no job creation.
These ideas, combined with effective policy practice like that of the US Federal Reserve under Paul Volcker’s chairmanship, led many countries worldwide toward more explicit inflation targeting, in which central banks stabilize inflation expectations by making a credible commitment to a predetermined rate of price growth. By the 1990’s, inflation was old news in the advanced economies, with much of the developing world soon to follow.
Today, the Fed is again playing the expectations game. But, in order to stave off the threat of deflation and depression, it is targeting a lower unemployment rate, below 6.5%. As progress toward that target is made, Fed Chairman Ben Bernanke announced in late May, the Fed will begin to “taper” its program of long-term asset purchases known as quantitative-easing (QE).
That prospect has already sparked renewed financial-market volatility. In July, Bernanke attempted to calm investors with remarks signaling that, amid inadequate employment gains and persistently low inflation, the Fed would not abandon monetary stimulus anytime soon.
This stance reflects the Fed’s dual mandate, according to which monetary policy targets maximum employment consistent with price stability. But the credibility needed to anchor expectations is difficult – sometimes even impossible – to achieve when two targets are being pursued simultaneously. The resulting uncertainty could trigger more volatility, especially in bond markets, potentially impeding economic recovery (for example, by pushing up long-term mortgage rates) or augmenting future inflation risk.
By contrast, the credibility associated with pursuing only an inflation target builds on itself. Given this, it would be safer and more effective for the Fed and other central banks to pursue a single inflation target, and then use the gain in credibility to aid economic recovery.
For example, a central bank might announce that circumstances during, say, the next two years warrant a doubling of the inflation target from the usual – that is, almost never varied – annual rate of 2%. Such an approach would reduce the risk of debt deflation, while capping inflation expectations to prevent a damaging surge in prices as recovery takes hold.
Such preventive measures are all the more important in view of the Great Inflation’s second relevant lesson: fiscal discipline is essential to price stability. Sustaining a high budget deficit over many years will lead to an unmanageable debt buildup, unless that debt is inflated away or restructured.
As it stands, the United States – and presumably the United Kingdom – plans to begin tapering QE when the economy is growing faster, unemployment is lower, and government and household revenues are rising. But will tax revenues rise fast enough to offset the escalating cost of servicing the government’s mountain of debt?
Even if public debt is not growing as fast as before, the huge volume of existing debt must be repaid. The best cure would be controlled higher inflation – that is, the aforementioned temporary increase in the inflation target – to erode the real value of public debt and forestall the risk of a much more damaging inflationary shock later, one in which expectations become unhinged.
But, while this approach could work in the US, the European Central Bank is institutionally constrained from raising the inflation target. Although its pledge last August to purchase unlimited quantities of short-term government debt has calmed markets, activation of the ECB’s “outright monetary transactions” program is conditional on continued fiscal retrenchment. So the eurozone’s crisis-stricken economies cannot grow.
In this context, the eurozone’s most heavily indebted countries will have to force their creditors to accept a restructuring of public debt. The preferable alternative would be growth-boosting devaluations – that is, a eurozone breakup. But if, as seems likely, such devaluations are left too late, debt restructuring might still be needed.
In the coming years, Europe appears set to lurch from the frying pan of depression to the fire of high inflation. When it does, the lessons of the Great Inflation will suddenly be all too pertinent.