Why Is A Positive Inflation Rate A Good Thing?

One of the questions that often comes up in economic discussions is: why is a positive inflation rate seen as a good thing? There are a few angles to this question, which makes it somewhat more complex. I am somewhat ambivalent on the subject, but I believe the best answer lies in the area of political economy, not economic theory.

Introduction

My trigger for this reflection was this tweet by David Collum. I only scanned the associated Twitter thread only briefly; my thinking seemed to run on different lines from the discussion that I saw there.

I am interested in serious answers to a simple question: Why is inflation above 0% considered a good thing? What is a cogent argument for this claim?

— Dave Collum (@DavidBCollum) August 7, 2018

Although he describes the question as simple, his phrasing buries some subtle points.

The first issue I see is the question: a good thing for whom? Are we discussing the national interest, or what is good for individuals? Readers of a libertarian disposition might make an argument along the lines of "there is no such thing as society," and all that matters is giving the best outcome for individuals. Mainstream economists might take a similar line, but bury the argumentation in the sludge of utility theory. This is really a question of political theory or economics, but most of my arguments are based on the belief that there is a national interest, and that national interest can diverge from what individuals would like to happen.

In particular, there is a fetish among a sizeable group of the population that "money" needs to preserve purchasing power. Whenever I hear those arguments, I think of Séraphin from the film Séraphin: un homme et son péché (word-for-word translation: Séraphin: A man and his sin, but released with the English title Séraphin: Heart of Stone), a miser who dies clutching his hoard of precious coins in his burning house. Modern money is a token, it is used to grease the wheels of commerce, but there is no reason to expect it to be exchangeable for goods at a fixed price. Otherwise, the implication is that prices cannot change, which means that they cannot the precious market information that the same people who worry about purchasing power tend to be concerned about. Obviously, opinions can vary about that issue, but it is clear that there is no national interest in pretending that can fix the market value of inherently worthless tokens, even if some citizens want to believe otherwise.

Once we put the concerns about individual welfare aside, the most important is what context positive inflation is discussed in: are we discussing the current institutional context (in most countries), or a hypothetical discussion of a new institutional arrangement?

In the current institutional arrangement, it is very easy to see why positive inflation is seen as a good thing. We generally make arrangements based on the assumption of some positive rate of inflation (outside Japan, at least). We have formalised this with 2% inflation targets. The only reason that inflation is below that is generally because we had a recession. Recessions represent a waste of human resources, and are thus not in the national interest. So in this case, positive inflation being good can be viewed as it being an absence of a bad.

There is also a useful distributional aspect to this expected inflation. Politically, I believe that we can throw the interests of people hoarding coins under the bus, but we need to look out for the interests of the middle class. (This can be justified on the purely pragmatic grounds of preserving the social order; and coin hoarders are too insignificant a political force to matter.) The standard pattern of life for the middle classes (at least in the Anglo countries) is to contract a large mortgage debt, typically around child-bearing age. These large debt burdens are expected to be reduced by steady income growth, which is the result of gaining job experience, as well as inflation. If wage growth drops below expectations, that debt burden will become onerous. Countries with economically crippled middle classes face weak demand, and we get the post-Keynesian hysteresis story. (See this article by J.W. Mason for a longer discussion.)

The final way of approaching the question is to step away from the current context, and ask whether we ought to change the institutional framework? That is, set the inflation target to zero.

The first question is whether such a target is feasible. Many people have developed beliefs that suggest that fiat currency economies need nominal growth and inflation to function. This is obviously not true; Japan has been functioning for decades as a very fiat currency nation with pretty close to price level stability. The transition from an expectation of positive inflation to price stability might be painful, but once achieved, real economic performance should theoretically be about the same.

However, are there reasons why price stability might be a bad idea? There's a lot of mainstream theory on that topic; determining the societal optimal level of inflation was a giant swamp research dollars were dumped in when inflation targeting was the big theoretical fad. Currently, there might be more worries about the Dreaded Zero Lower Bound (DZLB). As regular readers might know, I take such mainstream theory with a large grain of salt.

I could try to discuss the economic theory questions associated with price stability. My view is ambivalent. (From an MMT perspective, the question shows up in how the Job Guarantee wage is set. From an inflation control perspective -- which is how the policy is being sold -- the coherent policy choice is to a have a fixed wage growth, with 0% growth as an option.) As a result, I would argue that the economic theory is a red herring: what matters is political economy.

The one undoubted advantage of inflation is that it obliterates any notion of "normal prices." Back when I was a kid in the 1970s, having oldsters wail about how much common items cost in previous decades was extremely common. People don't do that any more; almost all price anchors have been obliterated.

On paper, that sounds bad. Won't that create a more inflationary environment? In practice, not really. Other than the gold coin-clutching crowd, nobody really worries about inflation (other than gasoline prices). As a result, we don't see the fights over indexation that were common in the 1970s. (The demise of union power probably contributed as well.) It is perhaps not surprising that inflation models calibrated on pre-1990 data break; there are no second round effects that give the inflation cycle its juice.

The real advantage is that we are much more immune to policy idiocies. Since we no longer have a price level to revert to, there will not be any call for depressions (at least outside the ECB...) to restore price level parities. On paper, we could have a price level target, and not attempt to restore previous price levels. In practice, we have plenty of historical evidence that fixed price level targets is what the hard money crowd would push for. Given that almost the rest of 1920s economic dogma has returned, we need to be thankful that natural price levels are still a relic.

(c) Brian Romanchuk 2018