Download Historical Experience with Low Inflation

America's Historical Experience with
Low Inflation
J. Bradford DeLong1
U.C. Berkeley and NBER
October 7, 1999
Department of Economics, Evans Hall, #3880
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone
(510) 642-6615 fax
[email protected]
http://econ161.berkeley.edu
Abstract
The inflation of the 1970's was a marked deviation from
America's typical peacetime historical pattern as a hard-money
1
I would like to thank Robert Barsky, Barry Eichengreen, Richard Grossman, Christopher Hanes, Christina
Romer, and Robert Waldmann for helpful discussions, and U.C. Berkeley's Committee on Research for
financial support.
2
country. We should expect America to continue to be a hardmoney--low inflation--country in the future, at least in
peacetime. The low rate of future inflation that we thus forecast
changes the balance of macroeconomic risks and opportunities.
The risk of debt-deflation-mediated recessions is somewhat
higher because a low trend rate of goods-and-services price
index inflation somewhat increases the chances of deflation, but
it does not raise such risks as much as one might think. The
failure of the Fisher effect to hold empirically means that a low
inflation era will in all likelihood be a high real interest rate era.
But such high real interest rates do not appear to significantly
discourage investment or growth.
3
I. Introduction
The burst of inflation that struck the United States in the 1970s still shapes
much American thought about macroeconomic policy. The decade of the
1970s saw GDP-deflator inflation rates peak at nearly ten percent per year,
and saw consumer price inflation peak at rates three or four percent higher.
4
Such a rate of inflation was high enough to potentially induce significant
distortions in investment as a result of the interaction of inflation with our
tax system, which is unable to adequately adjust for the difference between
nominal and real income. Such a rate of inflation transferred substantial
wealth from creditors to debtors. And it rendered accounting statements
constructed according to standard accounting principles thoroughly
untrustworthy.
Moreover, the inflation of the 1970s has cast its shadow upon forecasts of
the likely future of the American economy. Practically everyone's
expectations of what inflation might be in the future are to some degree or
other influenced by the experience of the 1970s. During the 1970s, after all,
the American price level rose by more than eighty percent.
Yet a look back at history reveals that the sustained inflation of the 1970s
was an anomaly in American history.
It is certainly true that there had been previous peaks of inflation higher than
or as high as was reached in the 1970s. But the two biggest peaks had come
during the emergencies of World Wars I and II. One expects considerable
5
inflation while one's country is engaged in a total war. The third peak--the
last one during which inflation peaked at levels higher than reached in the
1970s--took place during the recovery from the mammoth deflation of 19291933. It did not rapidly and substantially raise the price level above marks
that had previously been considered normal. Instead, it restored prices to
levels that had been considered normal before the coming of the Great
Depression.
In addition, these previous spikes of inflation had been very transitory. They
lasted for a couple of years, or at most for half a decade. They did not last
for the decade-plus period during which inflation was a principal economic
policy concern which extended from the late 1960s into the 1980s.
Most of all, however, these episodes of total wartime and deflation-rebound
inflation were clear exceptions to the rule. Aside from these three episodes,
for the entire century between the end of the Civil War and the late 1960s
GDP-deflator inflation in the United States had always been less than five
percent per year, and had usually been less than three percent per year.
Thus the century before 1968 reveals that in peacetime the United States was
typically a hard-money country.
6
There is no strong reason to think that the inflation of the 1970s marks a
structural shift away from this peacetime history as a low-inflation country.
The causes of the inflation of the 1970s were unique, and are unlikely to be
repeated.2 More typical is that William Jennings Bryan lost the election of
1896 when he campaigned on the platform of free coinage of silver at a rate
of 16-to-1.3 Neither the Republican nor the Democratic Party sought at the
end of 1970s to run on a platform of tolerating the "head cold" of ten percent
per year's worth of inflation in order to achieve the benefits of a highpressure economy.4 Both political parties today--save at their fringes--are
eager to praise senior Federal Reserve officials who have pursued monetary
policies that have successfully minimized inflation. It is the inflation of the
1970s that is the significant exception.
Thus it is probably best to think of the current relatively low rate of inflation
as a return to a typical American pattern. Anyone forecasting the future from
2
See J. Bradford DeLong (1997), "America's Peacetime Inflation: The 1970s," in Christina Romer and
David Romer. eds., Reducing Inflation: Motivation and Strategy (Chicago: University of Chicago Press);
Herbert Stein (1984), Presidential Economics (New York: Simon and Schuster); Edward Tufte (1978),
Political Control of the Economy (Princeton: Princeton University Press); Donald Kettl (1986), Leadership
at the Fed (New Haven: Yale University Press); Alan Blinder (1982), “The Anatomy of Double-Digit
Inflation,” in Robert Hall, ed., Inflation: Causes and Effects (Chicago: University of Chicago Press).
3
See Lawrence Goodwyn (1978), The Populist Moment (Oxford: Oxford University Press).
4
Although there are some who believe that running on such a platform would have led to overwhelming
political victory. See William Grieder (1987), Secrets of the Temple (New York: Simon and Schuster).
7
today has to be willing to give long odds that the low levels of inflation
America has experienced since the early 1980s will continue.
If it is the case that we are likely to be entering a prolonged era of very low
inflation, what should we expect that era to bring? What potential dangers
does history tell us that low inflation brings to the forefront?
The potential lessons of history are threefold. There are three sets of issues
where America's long-run historical experience with low inflation might be
of help in forecasting the future, or at least in aiding those of us who want to
play the role of Cassandra in pointing out potential dangers.
The first set of issues revolves around low inflation and the credit channel.
The current leading theory of the causes of the Great Depression stresses the
destruction of the web of financial intermediation by deflation between 1929
and 1933: the Great Depression appears from today's perspective to be more
of a credit than a monetary phenomenon. Low inflation raises the chance
that at some point the turning of the wheel of the business cycle will
generate deflation. How great is this danger? How is it to be guarded
against?
8
The answer is: not very great. Low trend inflation does raise the chance that
a contractionary shock might push goods-and-services price indexes down.
But what we fear about deflation can be generated by asset price "deflations"
and foreign-currency debt "deflations" as easily as by goods-and-services
price index "deflations." A period of price stability certainly does not
increase the chances of either of these alternative sources of contractionary
shocks.
The second set of issues revolves around low inflation and real interest rates.
All economists believe deep in their bones in the theory of the Fisher effect:
theory tells us that if one changes the average trend rate of inflation, and if
one then waits long enough, nominal interest rates will adjust point-for-point
(or possibly more than point-for-point given the interaction of inflation and
the tax system) to the change in the rate of inflation, and real interest rates
will return to equilibrium. Is this in fact the case? Or does low inflation pose
a danger in terms of being likely to generate persistently high real interest
rates?
The lessons of history here are double-edged. On the one hand, history
teaches us that we should not expect the Fisher effect to hold. On the other
hand, there are no signs that the failure of the Fisher effect to hold has any
9
bad consequences other than (in a low inflation era) a certain degree of
wealth redistribution from creditors to debtors.
The third set of issues concerns inflation and productivity growth. The idea
behind low inflation is to remove some sand from the wheels of the price
mechanism. In an effectively-zero-inflation climate, people can have more
trust that the real prices they see are likely to persist near their current levels
rather than being always in motion as some (s, S) mechanism recurrently
ratchets real prices of individual commodities to levels that are temporarily
high and then temporarily low. In an effectively zero-inflation climate,
people don't have to worry about inflation. Instead, they can devote their
mental attention to worrying about other things--and we hope that some of
that worry about other things will translate into improvements in
productivity.
But does low inflation in fact produce faster productivity growth? And if it
does not, then what is the rationale behind pursuing policies to guarantee
low inflation--policies that may incur substantial costs in terms of other
objectives sacrificed?5
5
See Olivier J. Blanchard and Lawrence H. Summers (1986), "Hysteresis and the European Unemployment
Problem," NBER Macroeconomics Annual 1, pp. 15-78.
10
In the last analysis, confidence that low inflation is a goal worth pursuing
has to rest on (i) the consequent reduction in tax-system distortions, (ii) a
theoretical belief that removing managers' and workers' attention from the
problem of forecasting inflation must be worthwhile, and (iii) from voters'
and citizens' expressed preference for low rates of inflation.
II. Low Inflation and the Credit Channel6
Deflation and the Credit Channel
Does the absence of significant inflation increase the chance of significant
deflation? The price level no longer has a noticeable upward trend. Does this
absence of inflation mean that the chances of a sharp downward movement
in prices--a deflation--are increased?
Certainly people who write articles for newspapers and magazine believe
that it does. In the first six months of 1999 major newspapers printed 467
articles that fall within the scope of the keyword "deflation." A similar
search records only 36 such articles in the first six months of 1997, and only
6
For a more extended version of the argument of this section, see J. Bradford DeLong (1999), "Should We
Fear Deflation?" Brookings Papers on Economic Activity (Spring).
11
10 in the first half of 1990.7
John Maynard Keynes8 set out what was perhaps the first analysis of the
damaging effects of deflation working through the credit channel. Keynes
argued that deflation was damaging because entrepreneurs were inevitably
short nominal assets:
…the business world as a whole must always be in a position
where it stands to gain by a rise… and to lose by a fall in
prices…. [The] regime of money-contract forces the world
always to carry a big speculative position, and if it is reluctant
to carry this position the productive process must be
slackened…. The fact of falling prices injures entrepreneurs;
consequently the fear of falling prices causes them to protect
themselves by curtailing their operations; yet it is upon the
aggregate of their individual estimations of the risk, and their
willingness to run the risk, that the activity of production and of
employment mainly depends…9
7
Moreover, many of the mentions back in 1990 are ironic: consider the last Financial Times Lex column in
1990. It talks of how in the year just past: "Recession and deflation were hardly on the agenda." See
Financial Times, December 31, 1990, Section I, page 12.
8
John Maynard Keynes (1924), A Tract on Monetary Reform (London: Macmillan).
9
John Maynard Keynes (1924), A Tract on Monetary Reform (London: Macmillan), pp. 40-42.
12
It was Irving Fisher, however, who argued that it was not the fear of falling
prices but the fact that prices had fallen that was the principal source of
danger.10 Fears that past price declines meant that the banks in which you
placed your money were insolvent decreased monetary velocity. Corporate
bankruptcies also disrupted Fisher's equation of exchange. Thus any decline
in prices carried a severe decline in velocity along with it.
Others disagreed. Academics like Joseph Schumpeter and policy makers like
U.S. Treasury Secretary Andrew Mellon argued that periodic deflations were
necessary for economic growth. After all, anyone could make money during
an inflation: only during deflation could the collection of the economy's
entrepreneurs be pruned through bankruptcy which would release factors of
production that could then be re-employed by more skillful entrepreneurs
during the next boom.11
Deflation was so dangerous in previous eras before World War II--or so we
10
See Irving Fisher, "The Debt-Deflation Theory of Great Depressions," Econometrica Vol. 1, No. 4
(October, 1933), pp. 337-57. Irving Fisher (1926), "A Statistical Relationship Between Unemployment and
Price Changes," International Labour Review. Reprinted in the Journal of Political Economy 81:2,1
(March-April 1973), pp. 496-502. Fisher's language provokes occasional culture shock: consider his
statement that "…during the last three years in particular I have had at least one computer in my office
working almost constantly on this problem…" (p. 497).
11
See J. Bradford DeLong (1997), "American Fiscal Policy in the Shadow of the Great Depression", in
Michael Bordo, Claudia Goldin, and Eugene White, eds., The Defining Moment: The Great Depression and
the American Economy in the Twentieth Century (Chicago: University of Chicago Press, 1997).
13
now think--because of the side effects of the principal-agent problem that
confronts investors who commit their funds to enterprises. The investor has
very limited ability to monitor and assess what is going on at the level of the
operating business. Thus investors need to structure their relationships with
entrepreneurs so that they are forced to monitor the progress of the business
as little as possible, and a good way to do that is through debt. In such a debt
contract the investor receives a fixed sum negotiated ex ante in all states of
the world in which the entrepreneur can pay, and in those states of the world
in which the entrepreneur cannot pay his or her rights are extinguished in
bankruptcy.12
In economic theory there is no reason that a debt contract has to be a
nominal debt contract, unconditioned on macroeconomic signals of
production, price levels, and unemployment. But in practice the economy
has and has long had a lot of nominal debt contracts.
Deflation destroys the ability of entrepreneurs to service their nominal debt
obligations. The existence of nominal debt contracts means that to the
12
See Robert Townsend (1979), "Optimal Contracts and Competitive Markets with Costly State
Verification," Journal of Economic Theory 21:5 (October), pp. 265-93; Douglas Gale and Martin Hellwig
(1985), "Incentive-Compatible Debt Contracts I: The One-period Problem," Review of Economic Studies
52:5 (October), pp. 647-63.
14
financial system deflation appears to be a signal that entrepreneurs have
failed, and that their enterprises need to be liquidated. This makes deflation
destructive: valuable organizations and webs of intermediation are
eliminated for no fundamental purpose. And there is significant evidence
that deflation has been at work, both before and since World War II.13
The Role of Monetary Policy
How fast can monetary policy act to influence the price level? The answer
since Milton Friedman stated that monetary policy works with "long and
variable lags" has been "not very."14 Monetary policy is powerful, but power
and speed of action are two different things.
Recent econometric estimates continue to bear out this assessment.
Christiano, Eichenbaum, and Evans (1998) are pleased that there is
substantial agreement on the qualitative impact of changes in monetary
policy "in the sense that inference is robust across a large subset of the
13
See Ben Bernanke, "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great
Depression," American Economic Review Vol. 73, No. 2 (June 1983), pp. 257-76; Ben Bernanke and Mark
Gertler, "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review Vo. 79, No. 1
(March 1989), pp. 14-31; and Ben Bernanke and Mark Gertler, "Financial Fragility and Economic
Performance," Quarterly Journal of Economics Vol. 105, No. 1 (February, 1990), pp. 87-114.
14
See Robert J. Gordon, ed. (1975), Milton Friedman's Monetary Framework: A Debate with His Critics
(Chicago: University of Chicago Press).
15
identification schemes that have been considered in the literature." 15 But the
time delay in the effect of a change in monetary policy is large: not until
some eight quarters after the initial interest rate shock has the impact of a
change in interest rates had anything near its long-run effect on the rate of
inflation (or deflation). According to Christiano, Eichenbaum, and Evans, a
one percentage point upward shift in the federal funds rate is associated with
a less than one-tenth of one percent decrease in the annual rate of inflation
even ten quarters out.
Monetary policy is the stabilization policy tool of choice: other discretionary
policy lags are longer and more variable. But the ability of the Federal
Reserve to offset shocks to the price level at any horizon of less than three or
four years is limited. And DeLong (1999) reports calculations assuming a
symmetrical distribution of price shocks that suggest at least a one-in-twenty
chance that the price level two-and-a-half years hence will be eight
percentage points or more below today's best forecast.
.
15
Lawrence Christiano, Martin Eichenbaum, and Charles Evans (1998), "Monetary Policy Shocks: What
Have We Learned and to What End?" (NBER Working Paper No. 6400).
16
30 -Mont h- Ahead
Change in Price Level
30%
Out come
20%
10%
Forec ast
0%
1950 .01
1960 .01
1970 . 01
1980 . 01
1990 .01
The biggest potential source of error in this calculation is, of course, the
assumption of symmetry. The high variance of the price level about its
forecast is driven in large part by the high upward spikes in prices during the
inflation of the 1970s. Akerlof, Dickens, and Perry (1996) have documented
substantial downward nominal wage rigidity in today's economy that would
imply a substantial asymmetry in price shocks, and would reduce the
dangers of a deflationary spiral to a very low level indeed.
17
Kinds of Deflation
Moreover, this credit-channel analysis of the macroeconomic dangers of
deflation leads immediately to the conclusion that declining goods and
services price indexes are not the only potential source of macroeconomic
danger from the credit channel, and should not be placed at the center of the
focus. A large-scale asset price decline can have similar destructive
consequences for the credit channel and the web of financial intermediation.
This is one theory of the source of Japan's macroeconomic difficulties over
the past decade.
Another source of potential deflationary effects is harder-currency
borrowing by banks, companies, and governments with transactions are
denominated in currencies that lose value. When demand for a private
business's products falls, it is natural for the business to cut its price. When
demand for a country's products--either its exports or its properties--falls, it
is natural for the country to cut its price by letting its exchange rate
depreciate.
But if its banks and corporations have borrowed abroad in harder currencies,
18
then depreciation looks like deflation: it writes up the home-currency value
of their debts, erodes entrepreneurial net worth, and sets the destructive
credit channel in motion. The credit channel effects we fear from deflation
have more potential sources than simply a fall in broad goods-and-services
price indexes alone.
Thus there is a case to be made that the most damaging effects of deflation,
at least of asset-price deflation, are likely to be set up by a previous period of
inflation. Inflation leads to an increasing degree of leverage in the financial
system: more debt contracts, and a greater chance for falls in asset prices to
set off contractions in the web of financial intermediation.16 Whether this
increased degree of leverage springs from inflation alone or from the
powerful interaction of inflation with a tax system that assess tax liability
based on nominal income is not clear.17 But it is reasonably clear that even if
a period of inflation lowers the danger of debt-deflation from a downward
spiral in goods-and-services price indexes, it does not reduce--and may
increase the potential danger from these other sources of pressure.
Thus the conclusion has to be that any effect that a low trend rate of inflation
16
See William English (1996), "Inflation and Financial Sector Size" (Washington DC: Federal Reserve
Fiannce and Economics Discussion Series 96/16).
17
Martin S. Feldstein (1983), Inflation, Tax Rules, and Capital Formation (Chicago: University of Chicago
Press).
19
has in increasing the risks of a debt-deflation credit-channel downward
spiral is presumably not a very large increase.
III. Low Inflation and Real Interest Rates
The end of moderate inflation in the United States in the early 1980s also
saw a substantial increase in real interest rates.
20
The figure shows estimated real interest rates on three-month and ten-year
U.S. Treasury securities since 1960. The real interest rate is estimated by
subtracting the rate of inflation over the previous twelve months from the
21
nominal interest rate. It is thus a very imperfect measure of changes in real
interest rates in the short term. To the extent, however, that investors believe
that changes in inflation are persistent and are unforecastable, it will provide
a reasonable guide to changes in real interest rates across decades.
The three most striking features of the figure are (i) the downward trend in
real interest rates from the 1960s into the inflationary 1970s, (ii) the upward
jump in real interest rates to what were (for the United States) extraordinary
levels during the Volcker disinflation, and (iii) the continued high level of
real interest rates since. Real interest rates today are some one hundred basis
points higher at the short end and at least one hundred fifty basis points
higher at the long end than in the early 1960s.
The Fisher Effect
Back in 1984 when economists first noted this rise in interest rates, Olivier
Blanchard and Lawrence Summers attributed it to an increase in the return
on capital springing from deregulation and reductions in marginal tax rates.18
But the increase in economic growth over the following decade that one
18
See Olivier J. Blanchard and Lawrence H. Summers (1984), "Perspectives on High World Interest
Rates," Brookings Papers on Economic Activity (Fall), pp. 323-74.
22
would have expected to result from an investment boom driven by an
increase in the return on capital did not happen. Thus today it seems much
more likely that relatively high real interest rates in financial markets are a
result of some failure of the Fisher effect: investors appear to believe that
there is a significant chance of a renewal of inflation like that of the 1970s.
Historical experience tells us that such failures of the Fisher effect for
prolonged periods of time--generations--are not at all uncommon. Lawrence
Summers (1983) argued that there was essentially no evidence for the
existence of a response of nominal interest rates to changes in long-term
trend rates of inflation back before World War II, and only a partial response
to changes in long-term trend rates of inflation since World War II.
In response to the criticism that pre-World War I rates of inflation were
essentially unforecastable--and hence that there was no predictable
component to shifts in pre-World War I inflation--Barsky and DeLong
(1991) pointed out that the link under the gold standard between mining and
prices did provide a way to forecast pre-World War I inflation.
23
Although the log of the pre-World War I price level is almost a random
walk), there is a component of future price changes that is forecast by
changes in the world stock of gold. The smooth gold production series picks
up an important and forecastable low-frequency component of inflation
which is masked in univariate analyses.
24
Worldwide gold production was a well-known and closely-followed quantity
at the time. The correlation between pre-World War I rates of inflation and
rates of increase in the world gold stock was significant. Financial markets
back before World War I could have used the information implicit in gold
mining to forecast in the years immediately after 1896 that the world
economy was shifting from a regime of slow deflation to one of slow
inflation. Yet they do not appear to have done so.
25
Instead of a Fisher Effect, we have a pre-World War I Gibson Paradox.
Interest rates respond to the turnaround of the direction of movement of the
price level around 1896 so slowly and hesitantly that the nominal interest
rate is correlated not with the inflation rate but with the integral of the
inflation rate, the price level.19
Irving Fisher himself attempted to reconcile his point-for-point adjustment
of nominal interest rates to inflation, and concluded that the failure of the
nominal interest rate to rise after 1896: "…must, in all probability, have been
due to inadvertence. The inrushing streams of gold caught merchants
napping. They should have stemmed the tide by putting up [nominal]
interest… two or three percent[age] points higher…"20
It is clear that long-run historical experience gives us no reason to be
confident that the Fisher effect would hold. So why should we be surprised
19
See Shiller and Siegel (1977).
20
See Barsky and DeLong (1991), who note that this assessment by Fisher fits awkwardly with his
(earlier) arguments in The Rate of In terest for the Fisher effect:
"Foresight is clearer and more prevalent to-day than ever before. Multiples of trade
journals and investors’ reviews have their chief reason for existence in supplying data on
which to base prediction. Every chance for gain is eagerly watched for. An active and
keen speculation is constantly going on which, so far as it does not consist of fictitious
and gambling transactions, performs a well-known and provident function for society. Is
it reasonable to believe that foresight, which is the general rule, has an exception as
applied to falling or rising prices?"
26
when the Volcker disinflation of the early 1980s turns out to have had a
significant and long-lasting effect on the level of real interest rates?
Implications for Investment
Yet has the persistent rise in real interest had significant economic effects?
Has it led to a reduction in real investment below its counterfactual path? It
is not at all clear that it has had any such effect. Untangling the causes of
secular changes in savings and investment rates is next to impossible
because the changing composition of the capital stock has been shortening
its average lifetime. Gross investment as a share of GDP has certainly not
fallen since 1980. Net investment as a share of GDP may have fallen. And it
is not even clear which way we would expect a rise in the ex ante real
interest rate to shift the savings rate.
Thus the lesson of history for the effect of an age of low inflation on the real
interest rate is double-edged. First, do not expect the Fisher effect to hold:
expect the real rate of interest in low-inflation times to be relatively high.
Second, do not expect this failure of the Fisher effect to have any significant
effect on the level of investment: the failure of expectations to adjust fully to
27
the low-inflation environment is, presumably, present on both sides of the
market. (There are, of course, substantial effects on the relative wealth of
debtors and creditors).
IV. Low Inflation, Productivity Growth, and Utility
Economists' faith that low inflation is a goal worth pursuing rests in the end
on a belief that low inflation is a source of higher real productivity and real
material standards of living. Yet this association appears to be surprisingly
hard to document empirically.
Alesina and Summers (1993) showed that there is no evidence at all that
independent central banks that pursue low-inflation policies are sacrificing
any other worthwhile macroeconomic objective in the long run. But that is
only half of what needs to be demonstrated. Rudebusch and Wilcox (1994)
found striking correlations between productivity growth and inflation, but
could not convincingly show causation. After all, if total nominal demand is
predetermined then a strong correlation between high productivity and low
inflation is guaranteed by the identity that quantity times price equals
expenditure.
28
Here economic history is of no help. As long as inflation remains moderate,
there is no chance of teasing out of the data any convincing causal chain at
the macroeconomic level running from lower inflation to faster productivity
growth.
Nevertheless, economists' confidence that it is there remains strong. Rates of
inflation low and stable enough that nobody has to worry about confusing
overall changes in the nominal price level with real changes in relative
prices reduce the magnitude of the problem economic agents have in
interpreting the price signals they see. With one less thing to worry about,
the organizational time and effort that had gone into forecasting inflation and
interpreting news in an inflationary environment can be devoted to analyzing
other things instead--and at least some of those other things should raise
economic productivity. In the absence of convincing evidence to the
contrary, economists' priors will remain centered on the belief that low
inflation is a source of stronger economic growth.
But the case for pursuing and welcoming low enough inflation to be called
"price stability" does not have to rest there. Politicians welcome low
inflation for a reason: they believe that to come out against low inflation is
29
electoral death.21 It was Arthur Okun in the mid-1970s who popularized the
"misery index"--the sum of the annual inflation and unemployment rates. It
proved an effective rhetorical weapon in the presidential campaign of 1976
against Gerald Ford, and in the presidential campaign of 1980 against Jimmy
Carter.
Robert Shiller (1997) explored the reasons for people's distaste for inflation,
and came up with two broad conclusions. First, that the public believes that
inflation is a sign that all is not right with economic policy--it is a signal of a
degree of incompetence on the part of economic policy makers. Second, that
the public finds inflation to be one additional source of risk in an already
risky world--moreover, a source of risk that they cannot easily assess or
understand without learning more about macroeconomics. Thus a distaste
for inflation appears to be in the utility function.
And if a distaste for inflation is indeed in the utility function, economists
should recognize that low inflation is an appropriate policy goal for that
reason alone.
21
Whether they are correct to believe that "soft money" political positions are vote losers is not clear. See,
among many others, Fair (1978) and Tufte (1978). Grieder (1987) adopts the position that voters' distaste
for inflation is a form of "false consciousness" that should be fought.
30
V. Conclusion
A look back at America's historical experience with low inflation carries at
least five potential lessons for the future.
The first is that we should recognize that the inflation of the 1970's was a
marked deviation from America's typical peacetime historical pattern as a
hard-money country. Thus we should expect that there is a good chance that
America will continue to be a hard-money--low inflation--country in the
future, at least in peacetime.
The second is that the increased risk of deflation and depression in a lowinflation environment can be oversold. A low level of trend inflation does
make a downward spiral in the goods-and-services price index slightly more
likely. Such a spiral could be the source of a severe recession. But such risks
are lower than one might think: starting a deflationary spiral in today's
economic environment would be very difficult, and there is probably more
to fear from asset price "deflations" which are effectively unlinked to the
trend of overall consumer or producer prices.
31
The third lesson is that we should not expect the Fisher effect to hold. A low
inflation era will in all likelihood be a high real interest rate era. But we
should also expect that such high real interest rates will probably not
significantly discourage investment or growth--even though they will
transfer wealth from debtors to creditors.
The fourth lesson is that it is hard to tease out of the historical record any
significant macro causal link running from low inflation to faster growth.
Economists' belief that low inflation is good for growth continues to rest on
our common theoretical priors.
And the fifth and last lesson is that history teaches us that voters dislike
inflation. Political parties that preside over episodes of significant inflation
in industrial countries have a good chance of getting bounced. The "misery
index"--the sum of inflation and unemployment--resonates at the political
level. Whether voters and citizens dislike inflation for what we economists
would consider to be good reason may not be fully relevant. A taste for low
inflation appears to be in the utility function. To the extent that low inflation
reduces this potential for anxiety, it is a policy goal that is worth pursuing
for that single reason alone.
32
33
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