Silver linings from inflation?

How would you react if a close friend made the following statement:

“Of course, I am firmly opposed to infidelity, but I’ve discovered that it’s not so bad as I had thought. I have a friend who is currently having a passionate affair that is adding spice to his life. He says that he will eventually end the relationship and then go back to being a faithful spouse, refraining from future affairs.  His partner will not discover the indiscretion, and hence no harm will be done. Again, I’m firmly opposed to infidelity, but on reflection I have grown to appreciate its silver linings.”

I suspect that you’d have roughly the same reaction as I would.

Tyler Cowen has a new Bloomberg column explaining why conservatives might benefit from a bit of inflation. It begins with a standard criticism of inflation:

I myself am not happy about an inflation rate of 4% to 5%, which seems embedded in the economy right now.

After this statement, Tyler discusses a number of benefits from the recent bout of high inflation. Toward the end, he warns readers not to be entranced by his rosy description of inflation’s effects:

Of course the Fed should put such considerations aside and stick to its mandate for price stability. The rest of us, however, are free to appreciate some of the benefits of higher inflation, at least for a while.

Hmmm. I’m reminded of Marc Anthony’s famous eulogy in Shakespeare’s Julius Caesar.  Obviously, Tyler doesn’t have space to list all of the negative effects, but readers may ask themselves if inflation actually has all the pleasant effects described in the column, then why is it “of course” the case that the Fed should stick to price stability? 

Inflation is a complex subject, and it’s not always clear what people mean by “the effects of inflation”. Supply side inflation? Demand side inflation? The welfare effects of these two shocks are radically different.  In context, it’s pretty clear that Tyler is referring to demand side inflation in the Bloomberg column, as he alludes to effects such as the reduction of the ratio of public debt to GDP (which doesn’t occur unless NGDP growth rises.)  In other words, when discussing “inflation”, Tyler is actually considering some benefits from faster NGDP growth.  So I’ll focus on demand side inflation.

I don’t want to get into a line-by-line rebuttal of Tyler’s column.  The standard model predicts that demand side inflation has important short run non-neutralities and no important long run real effects on the economy.  That also seems to be Tyler’s working assumption.  But when discussing the welfare effects of inflation, it makes more sense to focus on the long run effects.  I worry that many people think in the following terms:

1. The short run effect of inflation on X is positive.

2. The long run effect of inflation on X is zero.

3.  Therefore, the combined short and long run effect of inflation on X is positive.

I don’t know if that’s Tyler’s view, but I suspect many readers will draw that conclusion. 

In my view, that’s not how things work.  Take the example of the public debt.  It’s tempting to view inflation as a short run boom to taxpayers, as it reduces the real burden of the debt.  Perhaps if the Fed quickly gets inflation under control, there’ll be no long run damage.  Here’s Tyler:

To be clear, it is not easy to reap very large gains through this inflationary mechanism. If high inflation continues for too long, interest rates will adjust upwards to the point at which inflation may be increasing the burden of future debt. The past debt may be worth less, but the higher costs of future borrowing may, on net, push government budgets further out of balance. In that scenario, the US might end up with both tax hikes and high inflation.

So the risks are real. But there is a decent chance it will work out, at least if the Federal Reserve can get inflation back under control again fairly soon.

I don’t believe there is a “decent chance” that things will work out in this way.  That’s not to say inflation and interest rates won’t decline at some point–I believe they will.  But this sort of monetary infidelity will impose a price on future borrowings.  If inflation really were painless, the government would do it again and again.  More likely, it won’t be painless.  Investors will understand that the Fed is less committed to 2% inflation than they had previously imagined, and demand a higher inflation premium when lending to the Treasury.  (Recall the 1980s.)

It’s best to view public finance from a “timeless perspective”.  Over a period of decades and centuries, policymakers will occasionally enact inflationary policies.  Over the long run, investors will rationally adjust their behavior in such a way as to be compensated for the risk of occasional high inflation.  During actual bouts of unexpected inflation (such as the 1970s), lenders will not be fully compensated.  During other periods (the 1980s), they’ll be over compensated.  It’s analogous to the way that insurance companies over charge you during periods when you drive safely and undercharge you during years when you have a major accident.  Over the long run, insurance companies figure out a level of premiums that provides an appropriate compensation.

Tyler also looks at the impact of inflation on the wages of different segments of the labor market.  Once again, the effects of inflation are neutral in the long run, and thus any distributional effects will reverse after a few years.

Don’t be attracted by the siren song of short run monetary non-neutralities.