Sunday, March 27, 2011

Easy Money

There appear to be new rumblings from the think tanks and the blogosphere about reviving an old economic saw: whether we should be sacrificing low inflation to prop up employment. Hopefully, it will be dismissed as quickly as it crops up, which seems to be about twice a year anymore.

First, a quick economic primer. This is badly simplified, but it will get us to where we need to go. When the economy grows too quickly, we get an inflation problem and prices tend to rise. The Federal Reserve (or any central bank) has the tools to effectively slow down the economy and keep inflation low. It's generally the policy of most western capitalist democracies to maintain a low inflation rate and a modest unemployment rate (usually around 4-5%). Low inflation is desirable since a little inflation does very little harm, but batting it down to zero or less does a lot more harm than good, so a low but steady inflation rate seems to work the best.*

Likewise, the reverse is true: if the economy needs to get going to hire workers, they can prime the money supply to speed the economy along. Overall, the Fed wants the economy to grow, just not too fast--so by manipulating the money supply, they can even things out.

Of course, there are benefits and drawbacks to both. Obviously as consumers, we feel the pinch both ways--higher prices and lost jobs both being bad things.

But for many, high inflation doesn't seem to be a bad thing. Who cares if prices are high if no one has any money to spend anyway? High inflation also has the extra added populist bonus that it makes loans easier to repay--since money is worth less, you're repaying loans with cheaper money than what you borrowed. Many progressives content that as long as you rig up gasoline prices and food from exploding, the government should have no problem flooding the economy with easy money to bring down employment.

The problem is that we've been here before. The major debates from the turn of the century pitted high-inflation demagogues like William Jennings Bryan against "sound money" candidates like William McKinley. Of course, the story is not an easy rivalry of inflation vs. unemployment. For decades, economists assumed this was true: you sacrificed one to get the other. In nearly a century, the data proved this to be true: in times of high inflation, unemployment was low, and when unemployment was high, prices stayed put. But that model was busted in the 70's when we encountered stagflation--high unemployment and high inflation. We then had the reverse in the 90's, when we had both low inflation and low unemployment. What happened?

No one really knows--the economy is too complicated for simple answers like that, though that doesn't mean most economists (and lay people like me) have their opinions--but the tools we've developed in the meantime at least let us point in the right direction. We know for a fact that dumping dollars in the market will increase inflation--the question is, however, whether the economy has enough slack to absorb the new money with minimal impact, or will we see a sudden shock two quarters down the road?

In any case, purposely goosing the money supply to increase inflation is not a particularly valid solution to the problems. It's a short-term fix with some pretty obnoxious side effects; when LBJ refused to raise taxes to pay for the Vietnam war and simply turned on the printing press instead, he instigated a long decade of misery (OPEC didn't help, either). Thankfully, so far, the independent Fed has not caved to pressure. I'm not so sure that will always be the case, alas.

*For the record, there is an "acceptable" level of unemployment. 2-3% seems to be a "natural" level--people transferring to a new job field, for example, or quit/got fired for reasons unrelated to economic health.An additional point or two is added to allow things to be more fluid--badly run business that shut down, or obsolete industries withering away.  Grinding down the unemployment rate to zero would cost too much money for very little benefit, so while "full employment" sounds great, it's impractical.

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