Nov 13 JDN 2459897
A lot of people seem really upset about inflation. I’ve previously discussed why this is a bit weird; inflation really just isn’t that bad. In fact, I am increasingly concerned that the usual methods for fixing inflation are considerably worse than inflation itself.
To be clear, I’m not talking about hyperinflation—if you are getting triple-digit inflation or more, you are clearly printing too much money and you need to stop. And there are places in the world where this happens.
But what about just regular, ordinary inflation, even when it’s fairly high? Prices rising at 8% or 9% or even 11% per year? What catastrophe befalls our society when this happens?
Okay, sure, if we could snap our fingers and make prices all stable without cost, that would be worth doing. But we can’t. All of our mechanisms for reducing inflation come with costs—and often very high costs.
The chief mechanism by which inflation is currently controlled is open-market operations by central banks such as the Federal Reserve, the Bank of England, and the European Central Bank. These central banks try to reduce inflation by selling bonds, which lowers the price of bonds and reduces capital available to banks, and thereby increases interest rates. This also effectively removes money from the economy, as banks are using that money to buy bonds instead of lending it out. (It is chiefly in this odd indirect sense that the central bank manages the “money supply”.)
But how does this actually reduce inflation? It’s remarkably indirect. It’s actually the higher interest rates which prevent people from buying houses and prevent companies from hiring workers which result in reduced economic growth—or even economic recession—which then is supposed to bring down prices. There’s actually a lot we still don’t know about how this works or how long it should be expected to take. What we do know is that the pain hits quickly and the benefits arise only months or even years later.
As Krugman has rightfully pointed out, the worst pain of the 1970s was not the double-digit inflation; it was the recessions that Paul Volcker’s economic policy triggered in response to that inflation. The inflation wasn’t exactly a good thing; but for most people, the cure was much worse than the disease.
Most laypeople seem to think that prices somehow go up without wages going up, but that simply isn’t how it works. Prices and wages rise at close to the same rate in most countries most of the time. In fact, inflation is often driven chiefly by rising wages rather than the other way around. There are often lags between when the inflation hits and when people see their wages rise; but these lags can actually be in either direction—inflation first or wages first—and for moderate amounts of inflation they are clearly less harmful than the high rates of unemployment that we would get if we fought inflation more aggressively with monetary policy.
Economists are also notoriously vague about exactly how they expect the central bank to reduce inflation. They use complex jargon or broad euphemisms. But when they do actually come out and say they want to reduce wages, it tends to outrage people. Well, that’s one of three main ways that interest rates actually reduce inflation: They reduce wages, they cause unemployment, or they stop people from buying houses. That’s pretty much all that central banks can do.
There may be other ways to reduce inflation, like windfall profits taxes, antitrust action, or even price controls. The first two are basically no-brainers; we should always be taxing windfall profits (if they really are due to a windfall outside a corporation’s control, there’s no incentive to distort), and we should absolutely be increasing antitrust action (why did we reduce it in the first place?). Price controls are riskier—they really do create shortages—but then again, is that really worse than lower wages or unemployment? Because the usual strategy involves lower wages and unemployment.
It’s a little ironic: The people who are usually all about laissez-faire are the ones who panic about inflation and want the government to take drastic action; meanwhile, I’m usually in favor of government intervention, but when it comes to moderate inflation, I think maybe we should just let it be.