Can the anti-inflation reflex be tamed?

Original Reporting | ByGreg Marx | Economy, Monetary Policy, Unemployment
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October 12, 2010 — On the evening of Sept. 27, 1960, after a day of barnstorming up and down Ohio’s industrial Lake Erie waterfront, John F. Kennedy arrived at the Municipal Auditorium in Canton. The night before, Kennedy had sparred with Richard Nixon in the first televised presidential debate in the nation’s history, and his supporters were in an exuberant mood: The New York Times reported that a “screaming audience of 5,000” filled the auditorium to cheer him on.

Kennedy’s speech that night was optimistic, but it was also urgent. The post-war boom had waned, he warned, and jobs were being lost: national unemployment stood just above 6 percent; in some places, it had been stuck at 9 or 10 percent for two or three years. Like the stand-offs in Formosa and Berlin, this was a crisis — brought about by advances in automation that had displaced coal miners and textile laborers, he said, but also by the Eisenhower administration, which had pursued a policy of tight money even as steel foundries and laborers alike lay idle. Kennedy’s message was pure post-war Keynesianism: “It is time that our economy was stimulated rather than was held back,” he said, “if we are going to maintain full employment in the United States.”

To modern ears, Kennedy’s speech is full of anachronisms. Our challenges overseas are not in Formosa and Berlin but Iraq and Afghanistan, and the jobs we worry most about are not in coal mines but on factory floors and in tech labs. But what has changed most may be our sense of what represents an economic crisis, and what our government can, and should, do in response.

For the past 18 months, the nation as a whole has faced unemployment of about 10 percent; in harder-hit areas like Vero Beach, Florida, and Fresno, California, the rate stands above 15 percent. Across the country, nearly 15 million would-be workers are now without jobs. Bringing the rate down to 6.1 percent, where it stood when Kennedy spoke in Canton and again 48 years later, as the financial crisis began, would mean creating more than 5 million jobs. Achieving “full employment” — a term that has largely fallen out of favor, but that generally refers to unemployment rates of 5 percent or less — is an even larger task.

Yet the prospects for decisive action — while brighter now than they were even two weeks ago — remain uncertain, and habits of thought acquired since Kennedy spoke seem to have lost little of their power. Nowhere is this more apparent than in the halting response by the Federal Reserve — the nation’s central bank, and the most powerful economic institution in the country, charged not only with controlling inflation but also with achieving maximum sustainable employment.

The Fed’s obligations are often in tension, and since the 1970s, when an overly expansionary approach led to spiraling prices and wages that damaged the economy, central banks have generally focused — with great success — on maintaining low inflation. (The Fed does not state a goal publicly, but its implicit target is understood to be about 2 percent.) In the current climate, though, an increasingly broad range of economists, from small-government libertarians to those on the center-left, has argued that the equation is reshuffled. While they disagree about other strategies — liberal economists, for example, tend also to favor more fiscal stimulus from Congress — this group agrees that one important way to spur growth and boost hiring is through aggressive action explicitly designed to create higher (though still moderate) inflation.

Such a move would be consistent with historic periods of growth, with what top Fed officials have prescribed for other countries in the past – even, in important ways, with how many of the Fed’s top officials have diagnosed our current woes. And it would echo the dramatic moves the Fed took to prop up the financial system at the height of the crisis. It would, also, however, violate what one economist, Laurence Ball of Johns Hopkins University, calls the “dogma” of low inflation.

Indeed, when Fed Chairman Ben Bernanke delivered his address on economic policy at the bank’s annual conference in Jackson Hole, Wyoming in August, there was just one course of action he specifically rejected: the targeting of a 4 percent inflation rate. While inflation was in fact too low, Bernanke said, such a move would risk “squandering the Fed’s hard-won inflation credibility.” Instead, he outlined several other moves the bank might take — though only if things were to get worse. When, three weeks later, the Fed’s top policy-making body issued its most recent statement, the message was the same: the economy was weak, inflation was too low, and the bank might, at some point in the future, “provide additional accommodation if needed.”

How did we chart this course, from 6 percent unemployment representing an emergency to a rate of nearly 10 percent being accepted — however much it is deplored rhetorically — as the best we can do? Economic thinking has changed dramatically since Kennedy spoke, but it is hard to trace a straight line between the academic arguments of the intervening decades and the current fatalism. The best answer may be that, when central banks learned how to tame inflation, they learned the lesson so well that the taming response became reflexive. For today’s Fed to seek a moderately higher rate of inflation — no matter how well such a move accords with the analysis outlined by its own leadership — it would have to cast aside the medicine it knows how to administer, and to do so in the face of a determined minority that offers a host of competing explanations for our current troubles.

Ball: "I don’t quite understand why there isn’t more of a crisis atmosphere."

And so, while the central bank can point to a number of steps it has taken, it has, in the eyes of many observers, done far too little. If he’d been told in 2008 what the economy would be like today, Ball said, “I would say of course everybody would view that as a crisis that would have to be addressed very aggressively. I don’t quite understand why there isn’t more of a crisis atmosphere.”

Ball’s recent research focuses on a phenomenon known as “hysteresis,” or the tendency of patterns to become self-reinforcing. Hysteresis has been observed in electromagnetic systems, in cells that are dividing, even in chromosomes. Ball’s contribution, following earlier scholars, was to show that it occurs in unemployment rates too — that a sudden spike in joblessness, if left unaddressed, can become permanent, even after the economy recovers. (Differences in regulation don’t seem to explain much — both heavily regulated European labor markets and their laissez-faire counterparts in Latin America have experienced hysteresis.) And while the mechanisms behind this trend aren’t entirely clear — the loss of skills and motivation that come with being unemployed for long periods is one likely, if unproven, candidate — the imperative it creates is: policy-makers should do all they can not to let elevated unemployment persist.

So why might inflation help? Inflation is often defined as too much money chasing too few goods — if the amount of money in circulation goes up but the underlying value produced by the economy stays the same, prices will rise. One of the problems with our economy today, though, is that there’s too little money moving around. Beginning in fall of 2008, individuals, businesses, and banks stopped spending money and started hoarding it. In effect, that money disappeared from the economy. The result of this “excess demand in the market for money,” explains Karl Smith, an assistant professor of economics at the University of North Carolina, is “a lack of demand in all [other] markets.” One result: businesses are producing less than they could. Another result: they’re doing it with fewer workers.

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