Inflation has, historically, been seen as a destructive force, something to be generally resisted, and with good reason. Eras of high inflation - whether we're talking about the 11.3% rate this country experienced in 1980, or the hyperinflation seen in Weimar Germany - have been periods of serious economic pain. As a result, we've come to see inflation as a destructive force.
However, the circumstances the United States is facing at this point in history are the exception to the rule. Higher inflation - not merely economic growth, which can produce higher inflation as a side effect - but higher inflation itself is necessary to address the weaknesses holding back our economic recovery.
First off, let me be clear about what I mean by "higher inflation." I'm not talking about the roughly 10% level we saw at the end of the 1970s. I'm' not even talking about half of that. In 2009, the annual inflation rate was negative 0.34%. Thus far in 2010, the rate is 1.71%. For the past five months, it has averaged 1.15%. By "higher inflation," I'm talking about something in the area of a 3-4.5% annual rate. By way of comparison, we had a 4.30% inflation rate in 1984, 3.66% inflation rate in 1987, a 4.08% rate in 1988 - hardly a period known for its economic misery.
But if the harm from slightly-higher inflation is negligible, what the benefits? I see three major concerns:
- The housing market. The number of underwater homes - people whose homes are worth less than the amount owned on their mortgages - is approximately one quarter of all residential mortgages. This situation has stalled the recovery by stalling the housing and construction sectors. Higher inflation will increase the value of those homes, without a corresponding increase in the amount owed on them, thus bringing them above water and spurring more activity in these essential sectors. In addition, reducing the number of underwater mortgages will decrease foreclosures, avoiding the tremendous human suffering associated with them, but also producing an interesting side benefit - making those toxic assets held by the financial sector less toxic. Which brings us to point #2.
- The credit market. Lenders are sitting on their capital, instead of investing it in useful, stimulatory efforts, for two main reasons. One is their need to keep cash on hand to maintain their financial position, due to their ownership of negative-value toxic assets. As these assets gain in value through fewer foreclosures, they will free up lenders to actually lend for a change - to businesses, to builders, and to homebuyers. The second reason for this hoarding is the low rate of inflation. Those with cash on hand are willing to park it in low-yield investments like government bonds, because that low yield is still higher than the inflation rate. With higher inflation, those same holders of capital will actually be losing money, in real terms, if they keep their assets in those low-yield vehicles. Higher inflation will lead them to invest that capital more productively, and thus stimulate higher growth.
- The national debt. This country has well over $13.5 trillion in existing debt, most of it created under Presidents Reagan, Bush, and Bush. Last year, the US government paid $414 billion in interest on that debt. Higher inflation is a way to reduce that debt load, in real dollar terms. By raising inflation by two points for a period of ten years, we can reduce the size of that existing debt, in real dollars, by almost a quarter, without having to raise taxes or reducing spending. Who wouldn't want that?
The best tool at our disposal for influencing inflation rates is the Federal Reserve. Under current policy, the Fed has set a target of 2% annual inflation. Under normal economic conditions, this would be an appropriate goal; however, these are not normal economic conditions. The Fed should raise its target rate to something above 3.5%, act more aggressively to expand the money supply, and indicate quite clearly that it will continue to pursue this goal over a number of years. Our economy can easily accommodate 2-3% higher inflation than we're seeing right now, and we'd be better off for it.
Note: one common objection to an inflationary monetary policy is the slightly-higher food inflation we're seeing now. It is true that food prices are running ahead of general inflation, and that this cost will hurt those who've lost jobs or had their pay cut due to the recession. I have two observations about this. First, food prices, like energy prices, are extremely idiosyncratic, rising and falling for reasons unique to those industries, and not reflective of overall inflation at all. Food price inflation should not be treated as indicating that the overall economic situation is more inflationary than the Consumer Price Index indicates. Second, the best way to salve the economic pain of those of us who've lost jobs in this recession is not cheap bread; it's JOBS. If food prices don't budge over the next year, but neither do job numbers, then the needy will still be hurting. If the recovery heats up and we add millions of jobs, then the newly employed will be better off, regardless of food prices. Keeping inflation low, at the cost of job growth, is a bad deal for everyone.