The Economic Case for Robust Inflation
This morning, the on why the Fed isn’t doing more to curb the . This line of questioning was opposite that what Congress should be asking: Why isn’t the Fed doing more to encourage robust inflation?
It has become dogma that inflation is harmful to an economy. Inflation weakens the buying power of the dollar compared to other currencies and it reduces the value of cash savings. Conversely, inflation increases the competitiveness of exports and reduces the burden of existing debt. Inflation, like monetary and fiscal policy more broadly, is a tool that can be used and adjusted to improve the strength of the economy. Inflation does not necessarily hurt an economy, unchecked and excessive inflation hurts an economy, but a moderate amount of inflation at the right time can greatly help an economy. This is such a time for America.
Robust inflation would help the United States in three ways: First, it would increase the competitiveness of our exports in foreign markets; second, it would reduce both our private and our public debt burden; and third, it would stimulate spending.
A strong dollar has been the hallmark of American economic policy for the past thirty years or more. This has allowed the dollar to become the reserve currency for the world, increasing demand for the dollar, and enabling the United States to borrow great sums of money against that demand. Unfortunately, maintaining a strong dollar has made American produced products to be more expensive compared to their foreign competitors and has destroyed the US manufacturing base. Today’s job market is a reflection of the disappearance of these manufacturing jobs and the recognition within the market that service jobs alone can’t lead to full employment. Inflation would lead to a weaker dollar compared to foreign currencies and increase the competitiveness of American exports in foreign markets*. This, in turn, would benefit a resurgent American manufacturing sector, adding jobs for the American workforce and help create a more balanced economy.
At the same time that inflation would be helping the American manufacturing sector, it would be decreasing the value of both public and private debt which would make it easier to pay off that debt. The majority of debt in the United States is loaned at a fixed interest rate. For households, most debt comes in the form of home mortgages (and we’ve seen how popular Adjustable Rate Mortgages have become) and for the public, most debts are bonds held to a fixed interest rate at time of issuance. These debts are for a fixed number of dollars, no matter the value of those dollars. By reducing the value of the dollar with inflation, these debts would become less burdensome and easier to pay off for both the private and public sector.
This same reduction in the value of the dollar will decrease the value of cash savings. This will undoubtedly hurt some people, such as the elderly (which we’ll address shortly). However, the majority of Americans hold most of their wealth in either real estate (because they own their own home) or in the stock market (through their retirement plans). Inflation won’t affect the value of these two assets, their dollar value will increase with inflation. The people who will be hurt the most are relatively wealthy households and corporations that have a significant cash position. In effect, inflation redistributes wealth from the wealthy to the middle class (and has no long-term affect on the poor who own neither houses or stock, we’ll get to the short-term harm that comes to the poor later).
Reducing the value of cash savings generally sounds bad, it can hurt some people while not really helping those that need help. However, that assumes that people and companies maintain their cash position. Thankfully, those with significant cash holdings have the ability to react to changes in the economy and can invest their cash in assets that will hold their value through periods of inflation. Currently, cash is king and many companies are hoarding as much cash as possible, which has a negative impact on job growth and investment. If companies didn’t think that their cash would hold its value, they would have more incentive to spend their cash by hiring more employees and making capital investments that would benefit their company in the long term.
These are the big three benefits that robust inflation would provide for the United States: increased competitiveness of American products in foreign markets leading to increased job growth; decreased debt burden for both private and public debt leading to an increased ability to pay down that debt; and an increased incentive to invest cash reserves in capital improvements and additional employees. However, an increase in inflation wouldn’t solve all of the economic problems facing America today and in some significant ways would harm many households.
The single largest problem facing the federal government’s budget is the raising cost of health care. Even with the passage of the health care reform bill by the last Congress, the cost of health care, and by extension the price the government pays for health care (whether it’s through Medicare, Medicade, or Veterans Affairs), will continue to increase more rapidly than inflation no matter what the level of inflation is. In other words, health care costs will continue to raise some percentage faster than inflation whether inflation is 1% or 10%. Increasing the rate of inflation will not help solve this particular long-term budget problem faced by the federal government.
The rate that medical costs are raising is not the only thing that inflation won’t affect. As has already been mentioned, inflation won’t affect the underlying value of assets. Houses would retain their value and increase in price right along with inflation. The value of companies would remain the same, so the price of their stock would increase at the same rate as inflation. Inflation does not change the value of these types of assets, only the value of cash.
These two items, the increasing cost of health care and the value of fixed assets, simply won’t be affected by inflation. Any argument either for or against inflation that uses these as talking points is simply trying to lead you astray. However, that is not to say there are no downsides to inflation, because there certainly are some that have been very well documented.
Inflation will predominately hurt two groups, the poor and the elderly. The poor are hurt through their wages lagging behind inflation while the elderly are hurt by the decreased value of their savings.
Wage increases lag behind inflation. Most companies give cost of living adjustments once a year, if at all, after the inflation has happened. If there is 10% inflation in a single year, an employee’s last paycheck of the year is worth 90% the value of their first paycheck that year. As prices increase throughout the year, people living paycheck to paycheck have an increasingly difficult time adjusting to increased prices. For those workers with long term contracts, primarily union workers, the compounding affects of the inflation can be especially hard to deal with.
The elderly are hurt in a very different way through inflation. The conventional wisdom for retirement savings has been to increase the amount of cash and bonds as retirement age approaches. This has lead many retirees to have considerable cash holdings and not much in stock and other non-liquid savings. As has already been discussed, inflation decreases the value of cash savings which would cause considerable harm to many elderly American’s retirement savings. What these people have done is traded market risk for inflation risk without realizing it. Over the past thirty years, inflation has stayed fairly low and predictable, leading many to discount the true risk of inflation to their retirement savings.
Inflation will harm those in our society that can least afford that harm. But those harms can be mitigated by expanding government programs that are already in place. Social Security payments could be increased at the rate of inflation to offset some of the decrease in the value of retirees’ savings. Vouchers for life’s necessities such as food and shelter can be given to more and their value increased. Both of these policies would help spur inflation.
A policy of robust inflation would cause short-term pain across the board which would be felt much more acutely among a small segment of the population. However, it would also create huge long-term benefits to the economy. It would decrease the debt burden in both the public and private sectors. It would revitalize the American manufacturing sector and balance the job market. And it would spur investment and spending by private enterprise, which would reinvigorate the American economy. The policies of curbing inflation and maintaining a strong dollar has seriously distorted and harmed the US economy, to get back on track, we need to encourage inflation and develop programs to handle the negative externalities of such a policy.
* Conversely, foreign imports would become less competitive in America, which would get more people to “Buy American”. The net result of this would be less consumption within the United States. Some might view this as a bad thing, but lets not forget that increased consumption doesn’t lead to increased happiness. And let’s not even start to talk about the environmental benefits a reduction in consumption would create.