Sunday, February 14, 2010

Inflation targets: How much is enough?

Seen on multiple econoblogs today, the IMF's chief economist suggests that a 2% inflation target is too low, and instead it should be a 4% inflation target, because otherwise central banks have insufficient headroom to lower interest rates in the event of an unexpected collapse in asset values.

This is an interesting observation. Ian Welsh made it on my own blog on my post where I pointed out why we want inflation in any economy that has fractional reserve lending. Inflation buffers the action of the business cycle by making it unprofitable to turn money into mattress stuffing. Down cycles are already somewhat deflationary because banks increase their reserves in preparation for borrowers not being able to repay loans, which in turn decreases the effective fractional reserve money multiplier and thus the money supply. Without inflation, the normal action of the business cycle is amplified by money fleeing the system during down cycles (because bank fees and charges exceed the real increase in value caused by inflation) to become "mattress money" and thereby causing even further effective deflation than is explainable by banks increasing reserves during down cycles, since money under mattresses -- AND ITS MULTIPLIERS -- effectively ceases to exist as far as the monetary system is concerned. But inflation keeps money from disappearing under mattresses, and also keeps banks from stashing ridiculous amounts of money into reserves, since money in reserves would be decreasing in value too. I suggested inflation targeting of 2-4%, pointing out that the ECB had a 2% inflation target, and Ian pointed out that at 2% there were still parts of the economy in real deflation, and proposed 4% as a more reasonable inflation target.

Glad to see that there are now some "real" economists who are following up on this observation made by us "mere bloggers". (Note that this observation was *not* original to either of us but has been floating around the econo-blogs for quite some time, it's just now apparently managed to bubble into the open). Now all we have to do is somehow convinced Ben Bernanke that this is a great idea...

Oh yeah, for some critics: First of all, I already explained why we want fractional reserve banking, so let's not go there right now. Let's talk inflation instead. The problem isn't inflation, but, rather, predictability. In a system where inflation is at a known predictable targeted rate, banks and other financial institutions can build it into the rates they pay you for your savings (e.g. if it is targetted at 4%, they can pay you something over 4%) so that savings are not lost to inflation, and they can set the spread on their loans to cover the interest they're paying you. In short, it's not the scale of inflation which is the most important thing here, at least at the levels we're talking about (2-4%). The S&L's failed in the late 70's because inflation became unpredictable and future inflation did not match the inflation rate predicted at the time they issued loans, not because of inflation itself -- if inflation had stayed at the level predicted when they issued the loans, it wouldn't have mattered whether that level was 2% or 4% or 6%.

Now, how do things change between a 2% target and a 4% target? Well, anybody holding mortgages suffers... but not by much. Most of these mortgages were already issued at a greater than 4% target rate -- e.g., I check my bank and mortgages are at 5.5% there -- so while it would cut the spread down drastically, they're still okay. Indeed, history during the 1970's backs that up -- it wasn't until we got past 6% inflation that things started slowly crumbling for the S&L industry.

In short, there's no real reason why not to raise our inflation targets to 4%. Well, other than ideology and stupidity, both of which have been the predominant cause of the current financial crisis, and which I expect will continue to impair any attempts to resolve this situation -- or to prevent it from occurring again in the event that it is resolved. Because if reality contradicts their ideology too blatently, how could they ever get converts to their ideology? Hmm? So they're going to fight anything that doesn't agree with their ideology tooth and nail... and take the rest of us down with them, if they can.

-- Badtux the Economics Penguin


  1. There's a theory that the Fed is powerless to fight deflation. We're against the 0 interest rate boundary, so spending stimulus is all that's left.

    I think Krugman pointed out a couple of weeks ago that if the government printed an extra trillion dollars next week, the net inflationary effect would be nil.

    That's the magnitude of the hole we're in.

    Over at CR they point out that 5 million workers will exhaust unemployment benefits by July. Companies are sitting on record levels of cash, but will neither hire or make capital investments.

    It's one thing to have an inflation target; quite another to be able to reach it.


  2. You are correct that normal monetary policy ceases to work the moment you hit the zero boundary. Just ask the Japanese -- they've literally printed 3 times their national GDP in money over the past 20 years, and it's all disappeared under mattresses, doing nothing to create inflation. Indeed, the whole point of this exercise is so that if things ever return to normal, we don't hit the zero boundary again. Because once you hit the zero boundary, monetary policy becomes useless -- just watch Krugman scratch his head muttering "how do we get out of this?" if you don't believe me.

    Regarding the question of, "how do we return to normal again?" -- clearly something has to be done about consumption. I've pointed out that we need a *real* unemployment insurance system -- one that covers your normal house and car payments and health insurance coverage while you're looking for a job so loss of a job doesn't throw you into homelessness -- because without that, consumption during down cycles goes to the shitter. Businesses won't invest or hire unless there is consumption or demand which calls for them to invest or hire -- as I pointed out on the posting about job tax credits, businesses are not charities, they hire only when there is demand that justifies hiring, not because labor is cheap or expensive. We have to get that money out from under mattresses and back into circulation again, and the only way to get that is consumption -- we need to target consumers with things that will have them stop putting money under mattresses and start spending again, or we're stuck.

    And of course there's direct investment in America's crumbling infrastructure. It's been estimated that America's infrastructure needs a $2.2 trillion dollar investment over the next five years to prevent it from crumbling into uselessness. President Obama has proposed nothing on the scale needed. And there's things like high-speed rail and such which are obvious investment opportunities, as well as light rail, converting mass transit bus fleets to electrified / hybrid systems, etc., all of which could put a lot of Americans back to work in good-paying jobs and get them consuming again.

    Yet none of this is being done. 1/3rd of America hates the thought of progress and is the Party of No, actually *wanting* civilization to fail. 1/3rd of America is dumbasses who believe any plausible shit that agrees with whatever prejudices they've been taught to believe by mass media. And the other 1/3rd of us... well. We don't seem to be doing such a good job of bringing the dumbasses around, are we? I suppose it's a lot easier for liars to invent soothing lies that exploit human nature than for us to communicate reality... sigh. We are so, so fucked.

    - Badtux the Economics Penguin

  3. I've been thinking a lot in recent months about the content of that last paragraph. Frex: Who is a conservative? It's been known for centuries that stupid people are conservative. Ignorant people - the "low information voter" - lends to conservatism, because reality is hard, and regressive conservatism packages their talking points in easily digestible sound bites - and it doesn't matter if they're true or false. The 20% of any population that are authoritarian followers will naturally be conservative. (In contemperary America, I think this is the religious right.) Then there are the rich, and their lap dogs - conservatism logically serves their interests - at last in the short run.

    There is another, more mysterious group of intelligent, educated, non-wealthy people who mainline the reactionary koolaide. For them, I think conservatism is a personality defect.

    The rest of us are bogged down in trying to make ends meet, and working through all the difficulties of modern life. Politics, economics and reality are hard - they take time, thought and dedication. Most potentially progressive people are too busy, too tired, or too distracted to realize that the America they thought they had is slowly being drained away by the dedicated regressives.

    Yup - WASF

  4. Well, when you pump trillions into the banks, who use it to shore up their balance sheets...

  5. The problem wasn't trillions pumped into banks, the problem was trillions pumped into banks during a period when major parts of the economy were in real deflation. If we'd still had significant inflation along the lines of 3-4% per year, the banks couldn't leave that money sitting in the bank because it'd be losing value, they'd have to loan it out and put it back to work fostering commerce. So now the money is sitting in the Fed's electronic vaults doing nothing. Which, BTW, Ben Bernanke is still encouraging by paying interest on those reserves. INTEREST! As if you needed to pay interest on reserves to encourage banks to keep reserves during real deflation!


    - Badtux the Sore-cloaca Penguin


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