Inflationistas Should Stick Their Necks Out

Be afraid, unemployment hawks! Inflationistas are abound! In response to the 2008 financial crisis, the Federal Reserve cut interest rates to nearly zero percent. More recently, the Fed resorted to quantitative easing, in which it prints money to purchase long-term assets on the open market. These policies have led to a tremendous growth in the money supply. Despite this, inflation rates have been 0.1%, 2.7% and 1.5% over the last three years, far below historical averages. What should the Fed do in this situation? Should it put the brakes on in fear of looming inflation, or should it engage in even more unorthodox policies to curtail unemployment?

Right now, inflationistas are shaking in their boots. The idea that Zimbabwe-like hyperinflation—inflation levels in the triple or quadruple digits—is right around the corner is becoming increasingly popular in anti-Fed circles. Ron Paul, libertarian author of End the Fed and one of the more famous inflationistas, now chairs the domestic monetary policy subcommittee of the House Financial Services Committee. “Gold buggers”—those who advocate a return to the gold standard—are on the rise as well. Their reasoning is largely based on a simple form of the “quantity theory of money,” which says that the amount of inflation is directly proportional to how large the money supply is. That is, if we grow the money supply, the only thing that will happen is an increase in prices, while the amount of capacity in the real economy won’t change.

On the other side of the debate, economists argue that creating expectations of inflation in an economy with high unemployment can have positive effects on the real economy. One reason is that wages (and some prices) are what economists call “sticky.” Workers and employers aren’t likely to respond to recessions by cutting wages or prices, but instead by cutting jobs or employment, which leads the economy into a deflationary spiral. In this case, higher inflation could be a good thing.

To see why, compare these two possible worlds. In the first world, there is no inflation, but workers face a 3% wage cut. In the second world, there is 5% inflation, but workers are given a 2% wage increase. For our intents and purposes, these worlds are exactly the same. But, most economists say that workers are more likely to remain employed in the second world. Workers and employers are more likely to accept a pay raise with inflation than a pay cut without inflation.

Because of this, many economists are recommending that the Fed commit to higher inflation in the short term until the economy returns to full employment. According to them, the problem is not that inflation has been too high, but that it hasn’t been high enough. Bizarrely, inflationistas are still predicting hyperinflation. The events of the past two years should have silenced them, or at least caused them to question their beliefs. But a theory that doesn’t stick its neck out, that doesn’t say what events it is ruling out from happening, is as good as no theory at all.

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