How should we think about inflation?

Let’s start with what inflation is. Inflation is a measure of how much prices rise over time. Alternately, it can be thought of as the decrease in the value of money over time. When people talk about how cheap things used to be, how much a dollar used to be able to buy, that’s inflation.

High inflation is bad for the economy. I think that’s pretty intuitive: we don’t like when things cost more. It’s less intuitive that a little inflation is actually a good thing, and that deflation is incredibly bad. Deflation encourages people to save money, which is theoretically a good thing. Except that it goes beyond that, it discourages investment. It makes people want to sit on money, to figuratively stuff it in a mattress, which is pretty much the definition of economic stagnation. Likewise, some small amount of inflation encourages people to invest and use money. So the best situation isn’t no inflation, it’s a very small amount.

So how much do we want, and how do we control it? The Federal Reserve, the Fed, is in charge of the dollar. That means it’s in charge of monitoring and reacting to inflation. It’s a national bank with the power to do things like set interest rates and issue currency (print money). These are the primary ways of controlling inflation, and they’re often referred to as monetary policy. The Fed has two jobs, often referred to as a dual mandate. Those jobs are to keep inflation low and keep unemployment low. To do this they set target rates, generally something like 2% inflation and 6% unemployment. There’s a tension there, because measures the Fed can use to lower one will tend to increase the other.

It’s worth pointing out that in recent history success by the Fed has often been defined as sacrificing unemployment to prevent inflation. The Fed fighting inflation was a factor or even a cause of many modern recessions.

So how does inflation fit into the great recession? Since the economic crisis hit we have had incredibly high unemployment, but the response of the Fed has been slow and timid. Charles Evans, of the Chicago Fed, said this of the seeming imbalance of priorities:

“Imagine that inflation was running at 5 percent against our inflation objective of 2 percent. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.”

The problem is largely a disagreement about inflation. On the one hand, conservative (sometimes called freshwater) economists believe that any efforts the Fed takes to improve employment will drive up inflation. Even the muted and marginally effective efforts of the Fed drew dire predictions of impending hyper inflation from conservative economists. Liberal (saltwater) economists disagree, saying that due to the unique conditions of the current economy it is nearly impossible for the Fed to drive up inflation until the economy recovers. Strangely, after four years with no significant shift in inflation very few people have changed their minds.

Beyond the question of how inflation works, though, is the question of what inflation means and how we should think about it. What happens to debt when inflation rises? Debt is worth less, thus it hurts creditors and the wealthy while benefiting debtors. Many liberal economists see it as a useful tool in accelerating recovery because it would allow us to more quickly pay off the debt built up by the housing crash.

Many conservatives, on the other hand, see inflation as the ultimate economic evil because it degrades the value of saving and debt. In this, as in many economic matters, the conservative thinking centers around moral hazard. While moral hazard is a legitimate concern, it is also unquantifiable. This makes it easy to misrepresent, intentionally or accidentally. Conservatives often treat moral hazard much more seriously when looking at the poor than the rich, and this is a perfect example.

This is also why conservatives and liberals often talk past each other on inflation. Liberals tend to think of it in technical or practical terms. An increase in inflation could degrade the value of debt and speed economic recovery. Conservatives, on the other hand, tend to think of it more in moral terms. An increase in inflation will reward reckless spending and over borrowing and punish virtuous savers. I agree with the idea that economic decisions must take morality as well as technical effects into account, but in this case I strenuously disagree with how they are assigning virtue. I think that there are as many victims as villains among the debtors, and I think that the moral hazard on the banking side, which has thus far gone unaddressed, is much more dangerous than that of the borrowers.

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