At Brookings’ semi-annual presentation of economics papers, which I attended on Friday, one of the participants made an interesting point: the fear of nominal losses made the crisis much worse than it had to be.
He was referring to the problem of mutual funds “breaking the buck”, which I described during the financial crisis. When the value of the Reserve Primary Fund share went below a dollar, all hell broke loose in the money markets; it was essentially a bank run on the shadow banking system.
As the speaker pointed out, this happened because people were abnormally afraid of nominal losses. In an environment where inflation and returns are very low (as they were prior to the crisis), the risk of nominal losses grows. That is to say that if money market returns had been 7%, and inflation, say, 5%, then Reserve Primary would have been very unlikely to break the buck; its shareholders would simply have had to accept a 4% return rather than 7%. Unhappy for the shareholders, but not disastrous.
But as soon as the fund broke this psychological level, people started to worry that an investment which they had treated as cash would become, for want of a better phrase, uncashlike–it could lose its nominal value. They fled.
In practice, there’s no reason that we should be more worried about nominal losses than real ones. But we are.
That led another participant to point out that if the Fed targeted 3+% inflation, rather than 2%+/-, these sorts of “irrational” stickiness problems would be considerably eased. So would wage stickness, which is though to lead to unemployment. So why don’t they target a higher rate?
That’s a question that a lot of people are asking, such as Tyler Cowen and James Surowiecki. Some of the possible answers:
1) People hate inflation. They just hate it–as I find out every time I point out that inflation allows us to get around the fact that workers in industries where demand is falling are extremely reluctant to take nominal pay cuts. Politicians are thus biased towards controlling it.
2) The central banking system is run by and for bankers. Oh, there are lots of academics around, but they are academics who study banking. The regulators spend all their time with the bankers they regulate. This biases them towards the interests of the holders of capital. Which is to say, against the inflation which erodes the value of that capital.
3) The central bank is afraid that it will lose credibility if it promises 3% inflation and doesn’t deliver. The increasing complexity of the financial markets, and indeed all markets, makes it difficult for the Fed to control what happens to inflation. We saw this over the last decade or two, when inflation popped up in asset price markets but was largely quiescent in consumer goods. So there’s a real worry that trying and failing to produce this inflation could erode the power of the Fed, which rests in large part on its ability to convince markets that it has things under control.
4) The Fed has spent decades building a reputation for credibility on a target that mostly fluctuates around 2%. Can it credibly simply shift to 3.5%? Or would creditors and others worry that 5.5% inflation was around the corner? Inflationary expectations on that level are quite harmful, and quite painful to quell; it was Paul Volcker’s determination to whip Carter-era inflation–with 20% interest rates–that gave us the Reagan recession.
5) If the Fed did produce higher inflation, senior citizens and other people who live on fixed incomes would be hurt by it. (Social Security is indexed for inflation, but seniors hold other assets, including pensions, which might take a hit.) They would call their politicians. The politicians would be further tempted to curtail the independence of the Fed.
One question I have is simply whether inflation would really be that great. It would solve some of the problems we have, but it would produce others. There’s a great temptation in policy circles to think that whenever you are plagued by a given problem, its exact opposite would be much more desirable. If we did stimulus and the economy isn’t great, then austerity must be better. If we have low inflation producing an assortment of known problems, then we’d be happier if there were much higher inflation.
I’m not saying that either of these propositions are wrong. I’m only reminding myself that we can see the problems with very low inflation here and now. We are not seeing the problems of 3-4% inflation (many people talk about 3%, or 3.5%, but targeting is never that exact; realistically, committing to 3% inflation implies willingness to counter at least slightly higher levels).
And there would be problems. Interest rates might well overshoot, particularly on long-term debt like mortgages, putting a crimp in the housing market and other asset markets where debt finance is important. Senior citizens would be very unhappy, and might well put a greater strain on the public purse. Tax brackets* would creep even faster unless congress was vigilant. In that situation, we might well have a bunch of pundits asking, “Wouldn’t it be great if inflation were lower?”
I find the case for 3% inflation mostly quite appealing. But I worry about the myopia that is always induced by a current crisis.
* It is pointed out in the comments that this is an inelegant phrasing: the AMT and the like are not technically “Tax brackets”.
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