Download Historical Experience with Low Inflation

America's Historical Experience with
Low Inflation
I. Introduction
The inflation that struck the United States in the 1970s still shapes a large
chunk of our thought about macroeconomic policy. The inflation of the
1970s was high enough to potentially induce significant distortions in
investment as a result of the interaction of inflation with our tax system
(unable as it is to adequately adjust for the difference between nominal and
real income). It transferred substantial wealth from creditors to debtors. It
rendered accounting statements constructed according to standard
accounting principles thoroughly untrustworthy. And the inflation of the
1970s has cast its shadow upon forecasts of the likely future of the American
economy--practically everyone's expectation of what inflation might be is
influenced by the experience of the 1970s.
Yet our inflation rate is now quite low--we seem to think that there is a
greater chance that inflation will average one percent than that it will
average five percent over the next decade. The last experience we had with
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First, a look back at history reveals that the sustained inflation of the 1970s
was an anomaly in American history. There had been previous peaks of
inflation higher than or as high as was reached in the 1970s--during total war
and during the bounce-back from the deflation of the early 1930s. But these
three episodes aside, 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. In peacetime the United States was a hard-money country.
This is the first lesson from history: William Jennings Bryan, after all, lost
the election of 1896 when he campaigned on the platform of free coinage of
silver at a rate of 16-to-1--and the free-silver inflationists framed their issue
not as causing inflation but reversing the deflation caused by the Crime of
1873. Neither the Republican nor the Democratic Party sought at the end of
1970s to run on a platform of tolerating inflation in order to achieve the
benefits of a high-pressure economy. Both political parties today fall over
themselves to praise the current leadership of the Federal Reserve. Thus
anyone forecasting the future from today has to be willing to give long odds
that the low levels of inflation America has experienced since the early
1980s will continue.
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A second lesson from history is that perhaps we have less to fear from
deflation in times of low inflation than we fear--but also that we have more
to fear from deflation in general than we fear.
We today think that deflation was so dangerous in previous eras (and
perhaps in Japan today) because of the principal-agent problem that
confronts investors who commit their funds to enterprises. 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 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 are liquidated and webs of intermediation are torn for no
fundamental purpose.
Monetary policy is the stabilization policy tool of choice. 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. If you assume a symmetrical distribution
of price shocks, and if you take your estimates of the effectiveness of
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monetary policy from recent work by Christiano, Eichenbaum, and Evans,
you can reach the conclusion that there is 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. But the joker in the debt is the assumption
of symmetry. The high variance of the price level about its forecast is driven
in large part by upward spikes in prices during the inflation of the 1970s.
However, credit-channel analyses suggest that large-scale asset price
declines set in motion the same potential contractionary forces as do goods
and services price declines. In the past such large-scale asset price declines
have been more likely--and looking ahead to the future they appear more
likely--than large-scale declines in broad goods and services price indexes.
And the most damaging effects of deflation--at least of asset-price deflation-may well be set up by a previous period of inflation. Inflation leads to an
increasing degree of leverage in the financial system: more debt contracts,
thus a greater chance for declines in asset prices to tear the web of financial
intermediation.
Low trend inflation does raise the chance that a contractionary shock might
push goods-and-services price indexes down. But what we fear about
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deflation is generated more easily by asset price "deflations" than by goodsand-services price index "deflations."
A third lesson deals with the Fisher effect. 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. The end of moderate inflation in the United States in the early
1980s also saw a substantial increase in real interest rates--an increase that
has not yet been reversed: real interest rates are still higher today than they
were in the 1950s or 1960s.
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.
But the increase in economic growth over the following decade that one
would have expected to result from an investment boom driven by an
increase in the return on capital did not happen.
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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. In an
assiduous close reading of Irving Fisher's The Rate of Interest, Robert
Barsky found that Irving Fisher in the end concluded that participants in
financial markets back at the turn of the last century were not competent to
apply his theory: "The inrushing streams of gold [after 1896] caught
merchants napping." Fisher wrote. "They should have stemmed the tide by
putting up [nominal] interest… two or three percent[age] points higher…"
Long-run historical experience gives us no reason to be confident that the
Fisher effect will hold, at least not in any time shorter than a generation.
Yet the lesson of history for the effect of an age of low inflation on the real
interest rate is double-edged. For the failure of the Fisher effect does not
seem to have any of the feared effect on the level of investment: the failure
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of expectations to adjust fully to a changed trend inflation environment
appears to be present on both sides of the market, and to have few
consequences other than to redistribute wealth from creditors to debtors.
The fourth and least lesson 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 one of the (s, S) mechanisms
elegantly modeled by Andrew Caplin and others recurrently ratchets real
prices of individual commodities to levels that are temporarily high and then
temporarily low.
With one fewer 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.
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But does low inflation in fact produce faster productivity growth? Glenn
Rudebusch and David Wilcox, among others, have 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.
In the last analysis, confidence that low inflation is a goal worth pursuing
has to rest on (i) the theoretical prior that removing managers' and workers'
need to focus attention on the problem of forecasting inflation must be
worthwhile, and (ii) the expressed preference--documented in studies by
Robert Shiller and others--that voters' and citizens' appear to have for low
rates of inflation.