September 15, 2003

Greenspan wrong to prod inflation

By James W. Coons

We have witnessed this past summer a watershed event in monetary policy-making. After decades of striving for lower inflation, the Federal Reserve now seeks higher inflation.

The shift is unprecedented in modern times and wrongheaded. To paraphrase Warren Buffet, the Fed promoting rising prices is like a father encouraging his teenage son to have a healthy sex life. These things too easily take care of themselves. Human nature being what it is, they often go too far.

By promising to hold short-term interest rates at today’s long-time low for an extended period, the Fed reinforces the misimpression that it can control interest rates. In a very narrow and short-term sense, the Fed does control the federal funds rate – a rate central to the process of money and credit creation. In reality, though, Federal Reserve Chairman Greenspan is not much different from that man behind the curtain.

The Fed announces a target for the rate and makes adjustments to the supply of bank reserves necessary to hit that target. What goes largely unnoticed and unsaid is that the right level changes with economic conditions and no one ever knows for sure what it is. Eventually, the wrong choice sets in motion forces that ultimately require the Fed to abandon its chosen target level for another. So, who’s zoomin’ who?

To call this control in any meaningful sense is like saying that a surfer controls the wave he rides on. Ignoring that the Fed responds to the economy as much as it affects it leads to confusion about what the Fed can reasonably achieve and whether it is pursuing the right policies to achieve it.

The fear of deflation that underlies the Fed’s sudden embrace of higher inflation is misplaced. Deflation – or a sustained decline in the general level of prices – is a symptom of economic depression, not a catalyst. The Great Depression was not sparked by deflation. It was the product of disastrous tax and trade policies in the aftermath of rampant speculation, which in turn brought on deflation, which in turn made things even worse.

Worries that low inflation might slip into deflation are ungrounded. Price stability is a broad plateau, not a razor’s edge. Just as a modest rate of inflation does not spontaneously cumulate into an upward price spiral, a modest rate of deflation would not plunge the economy into another Great Depression.
In fact, Milton Friedman long ago argued persuasively that the optimal rate of change in the price level is slightly negative. That is, a small dose of deflation is best. To wit, the U.S. economy prospered with mild deflation during the final quarter of the 19th century.

Deflation would actually bring some benefits, although I am not rooting for it. Investors would not only escape tax liability for phantom capital gains already claimed by inflation. They would reap tax-free gains on the portion of any real return resulting from deflation.

It is true that deflation would raise the real burden of debt. But it is not clear that sticking it to debtors by raising the real value of their debts with deflation is any worse for the economy than sticking it to creditors by eroding the real value of their credits with inflation – a punishment they have endured for decades without preventing the economy from flourishing.

The historic reversal by the Fed arises in no small part from Greenspan’s refusal to accept a statutory inflation target. International evidence is overwhelming. The single most effective way to achieve low inflation and maintain it is to officially tell the central bank to keep inflation low.

Better yet would be a legal mandate for the Fed to preserve the purchasing power of the dollar. A dollar today would buy a dollar’s worth tomorrow. No one would be concerned that the Fed would risk deflation to avoid inflation, because all “flation” would be outlawed.

Greenspan is gambling that he can deftly raise the target short rate by just the right amount at just the right time. He has done it before and might pull it off again. But decades of hard-won inflation-fighting credibility are on the line. The cost of failure would be great.

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