Monetary Policy 201
This from Paul Volcker strikes me as substantially wrong:
[My] first economics course… at Harvard… Arthur Smithies…. Session after session he would drill into our head that a little inflation was a good thing. And I could never figure out why. But I know he kept saying it, so already at the time I for some reason had an allergy to what he was saying. But it’s interesting, his lectures, it’s the same thing that central banks are saying today….
I would never interpret it as you have to have [inflation] exactly zero. Prices tend to go up or down a little bit depending upon whether the economy’s booming or not booming. And I can’t understand making a fetish of a particular number, frankly. What you do want to create is a situation where people don’t worry about prices going up and they don’t make judgments based upon fears of inflation instead of straightforward analysis of what the real economy is doing.
And I must confess, I think it’s something of a moral issue…. You shouldn’t be kind of fooling people all the time by having inflation they didn’t expect. Now, they answer, well, if they expect it, it’s okay. But if they expect it, it’s not doing you any good anyway. Those arguments you set forward don’t hold water if you’re expecting it…
There are three major considerations:
- In any economy with debt contracts that fix principal in nominal terms, it is easier to fall into a destructive Fisherian debt-deflation chain of bankruptcies when you have a zero rate of inflation than when you have positive inflation and so some normal-time upward drift in the price level.
- Sometimes the Wicksellian “neutral” or “natural” short-term safe real interest rate will be less than zero. That’s the rate consistent with full employment and no price-level surprises. That’s the rate at which the economy wants to be, and the rate that a central bank properly performing its stabilization policy mission will aim for. But whenever the Wicksellian “neutral” rate is, say, -x%, no central bank can get the economy there unless the inflation rate is +x%.
- People really, really hate having their nominal wages cut. Firms would thus rather reduce costs by firing people than reduce costs by cutting nominal wages: in the first case, at least the people who hate you are no longer around to cause trouble and disrupt operations. Getting your nominal wages cut is a psychological diss with substantial sociological consequences. In an environment of moderate inflation firms thus have an extra degree of effective freedom at their disposal in reacting to changing circumstances: they can raise their prices by the amount of ongoing inflation, but not give the the corresponding inflation-compensating nominal wage increases. That extra degree of freedom is worth a considerable amount to employers. And it is worth a considerable amount to workers as well–for workers hate getting fired, especially in a slack economy, much, much more than they hate having their real wages eroded by inflation.
Paul Volcker, although he would not put it this way, seems to be working with a Lucas aggregate supply curve: that the unemployment rate is equal to the natural rate of unemployment minus or plus a slope parameter times how much people have been positively or negatively surprised by inflation, and that workers’ utility is highest when unemployment is at its natural rate, and lower when unemployment is either more or less than the natural rate.
Volcker, however, would not call it a Lucas aggregate supply curve. He would call it a Smithies aggregate supply curve, or a Viner (1936) aggregate supply curve:
In a world organized in accordance with Keynes’ specifications, there would be a constant race between the printing press and the business agents of the trade unions, with the problem of unemployment largely solved if the printing press could maintain a constant lead…
It has never been clear to me why this Viner aggregate supply function has such a hold on the economics profession as a benchmark model from which you start–and, in this case, stop–thinking.
I do not think it is clear to Cardiff Garcia either. In his conversation with Volcker, he raised these points:
Cardiff Garcia: If you have zero percent inflation, then you’re closer to having a [destructive] deflationary spiral…. If you have a little bit of positive inflation, then interest rates will be correspondingly a bit higher, so if there’s a downturn, you have room to lower them. And… if you have a little bit of inflation, then it’s easier for companies to give real wage cuts to their employees without laying them off, if they just freeze their wages and then they go down because of inflation…
But Volcker does not pick up on any of these–sea-room to avoid deflationary spirals, more freedom to move the Wicksellian “neutral” rate to where it wants to be, more labor-market flexibility. He simply takes immediate refuge in the Viner aggregate supply function, according to which it’s only unexpected inflation that ever matters for anything…