Tuesday, January 26, 2010

Wanted at the Fed: An Inflation Dove

I was just reading that Janet Yellen, recently mentioned as a possible replacement for Fed chair Ben Bernanke, is considered on Wall Street to be an "inflation dove," which means that she considers maintaining full employment to be -gasp!- "as important" as controlling inflation.

I also wonder about Brad DeLong at Berkeley. He was in the Treasury Department in the Clinton Administration. He's a free trader, which I guess is neither here nor there when it comes to monetary policy (and not necessarily bad in any case), but I like that he's an economic historian.

In any case, we strongly need someone who will put reducing unemployment tops on the list. I know, from personal experience, how unemployment can convulse a family. My dad, a middle manager in corporate America, died at age 41 after being laid off from five separate companies in five years. Chasing new work forced him to move his young family from Kansas to Texas to Iowa in the space of two years. Then, just as he seemed to find stability in a new job in Iowa, the brutal double-dip recession of 1980 - 1982 cost him his job again. He never recovered from that one.

The costs to my family of that loss are obvious. But the costs are broader than that. When the economy lost my dad, it lost a certain amount of knowledge and experience, and the productivity that went with it. Now I can't say with certainty that if my dad hadn't lost his job of 11 years in 1978, that he wouldn't have died five years later anyway. And, the vast majority of unemployed people will survive, obviously. And, I'm not arguing for an open-ended dole. But, research has shown over and over that bouts of unemployment, especially for the father in a family, carry with them permanent and "baked-in" costs, both to the unemployed person's family, and to the economy at large. I just ask that these costs of unemployment to productivity and economic growth be somehow factored in when the balance between inflation and unemployment is being struck.

Yes, reducing unemployment by tolerating higher inflation transfers money from the financiers to the workers. But given the enormous increase in inequality over the last 30 years, most of it driven by skyrocketing returns to capital, I'd say it's time for a re-balancing.

Image: oddsock, via a Creative Commons license.


Anonymous said...

Interesting post. As usual, I don't know very well what I'm talking about so perhaps you or my fellow readers will correct this.

But I was under the impression that the long-term correlation between inflation and employment had been disproven, and even the short-term correlation is in doubt.

But even if you could solve long-term unemployment with a higher rate of inflation, isn't there a case to be made that the deleterious effect on the elderly (where inflation erodes the savings they're supposed to be living off of) is not worth the tradoff of dislocation in the job market for younger Americans? Haven't really thought about it much. But it seems pretty complex even if one "knew" what the actual economic effect of policies would be.

Keep up the good work!


C - Log said...

Hi Alex,

Thanks for your thoughtful comments. You're right that the causal relationship between inflation and employment is murky at best. Perhaps a better way to phrase what I'm getting at is that the "scoring" of the two threats at the Fed is out of whack.

For example, inflation right now is relatively low. I understand that Wall Street and small savers are worried about possibly increased inflation should the Fed try a strategy such as quantitative easing (they can't really lower interest rates any further) to try to stimulate the economy and put people back to work.

Meanwhile, though, while there is this fear of possible inflation in some indeterminate future, there is actual unemployment and underemployment out there right now, causing short-term damage and long-term "scarring" to the economy of the type that John Irons talks about in the article I linked to in the post. Yet, the Fed has done next to nothing about this persistently high unemployment, while sending strong signals to Wall Street that it will do whatever is necessary to keep prices stable.

As for the deleterious effect on the elderly: This is something I really need to look into more closely. My hunch is that this problem is overstated. Here's why: The low-income elderly don't have much in the way of savings anyway, and their Social Security payments rise in step with inflation due to annual COLAs. As for the "middle income" elderly, who might be depending on a nice safe money market or government bond fund or fixed annuity to supplement their Social Security, yes, they will lose some real income to higher inflation. But as always, it's a question of priorities, and who's going to get hurt. I would submit that all else being equal, making the middle-income elderly to in effect subsidize the unemployed and get them back to work is preferable to doing nothing, especially when you, again, factor in the long-term effects of high unemployment on reduced human capital, R&D spending, etc.

It's also worth noting that inflation helps homeowners with mortgages, and an increasing number of elderly people are still paying off mortgages. So for them it could cut both ways.

(The specter of "What about the elderly?" is also used to oppose property tax increases and/or more accurate assessments of real estate values. Again, the poor elderly generally don't own homes, and if a middle-income elderly couple can't afford to pay the taxes on a home in an up-and-coming neighborhood, well let's just say there are worse problems than owning a home that is rising in value.)

There's a "sweet spot" in there somewhere in trying to arrive at the correct monetary policy. It can be hard to find. But I do think that because inflation is reported as a single headline number which is updated monthly, and which is also easy to see in real time at the gas pump or the grocery store, it gets more attention from policy-makers than the long-term damage to the economy caused by unemployment. (And that's leaving aside whatever outsize influence Wall Street may be exerting through its close ties to the administration.)

Thanks again for prompting me to think this through further.

C - Log said...

One more thing: You are correct to be skeptical of the ability to "know" what the actual effect of economic policies may be.

Of course this difficulty in forecasting applies to Wall Street's economists as well as to government policy-makers. Yet, and correct me if I'm wrong, the consensus on Wall Street is that a too-loose monetary and fiscal policy will inevitably result in inflation.

Anonymous said...

Well said, Senor Queso!

Of course, I’m an inflation hawk myself. As a big mortgage owner, for once I’m like a rich liberal (arguing against my class interest).

I understand the idea behind the Tobin effect but I think it breaks down when you get to actual practice. I do believe an expectation of limited inflation does allow more business people to make decisions and stimulate the economy more than actual inflation would. It's exceedingly difficult to make any commitments to a long-term project or to an early-stage business plan when expected inflation could be swinging 10% or more a year, compounding.

But as with you it appears, I'm a big believer that everything in life is a trade-off, and that's true even in economics where it's hard to know what trade-offs you're causing with a particular policy.

C - Log said...

Thanks for that expected-inflation piece as it relates to investment decisions. I do need to factor that in. It is more than just what the bondholders want.

(Or is it? As someone who I'm guessing is trying to get bondholders to fund your portfolio companies, you would know better than me.)

And: the Tobin effect? Can you say more?

Anonymous said...

Yes, you are totally right that no one knows what they're talking about when it comes to economics. A good recent example came in the '90s, when everyone was trying to figure out how the economy was galloping so quickly for so long with such rises in asset values, but no inflation. Greenspan went on record saying maybe that massive increases in productivity were the factor; others now think the problem was one that assumes inflation had to follow automatically -- maybe they're both right for all I know, but it all after the fact guesswork.

Your Hayek-Keynes video was hilarious, and Hayek said it as well as anyone: "The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

The Tobin effect is (I think) the theory that in periods of huge inflation, no one will want to invest in real assets, so their money will all go into the markets and that will drive interest rates back down, and then companies will have lots of cash resources at their disposal and that will offset the desire to do nothing for fear of inflation -- a sort of natural equilibrium. Don't think it works that way in the real world, though, on any of those fronts.

Also, it's not the bondholders that drive any of it, by the way, unless a company is in bankruptcy or very close to it ("zone of insolvency"). Until that happens, bondholders almost never have any seats at the board level, and directors are explicitly excluded to having any fiduciary responsibility to represent their interests -- it's all geared to the shareholders. The bondholders obviously don't like inflation either, so there is an advantage for heavily debt-laden companies to load up on debt before high inflation. But history shows it tends to hurt stock prices and the shareholders just as much if not more -- I think personally for the "investment decision" problems and because the Tobin theory is invalid, but I can't back that up.

C - Log said...

This reminds me of the argument some people have been making recently about how the tax code encourages companies (and homeowners) to load up on debt, I guess because they can deduct interest payments, and for some other reason that I can't remember – maybe having to do with the harsher tax consequences of raising capital by issuing new shares of stock instead?

First, do you think that the private sector was too heavily leveraged and did that contribute to the economic meltdown? Feel free to disaggregate "private sector" if need be.

And second, what do you think of this argument that the tax code encourages firms and homeowners to take on too much debt? I know I've heard you comment about the way that the mortgage interest deduction encourages people to buy a larger house than they otherwise would – great for realtors and the homebuilding industry, maybe not so good for the rest of us.

Anonymous said...

Interesting stuff. Well, whether the private sector was "too heavily" leveraged is hard to say -- it's a little bit of a normative judgment call really, but I'd have to say 'no'. To my knowledge, there's been nothing out of the ordinary over the last few years as far as companies defaulting on debt -- even at the height of the meltdown. There were some cases of companies having trouble refinancing maturing debt at the height, but that's not a good metric for having too much debt (just unlucky timing for maturity), and virtually all of them got it done eventually.

Whether leverage (or over-leverage) was a cause of the meltdown, I think is a pretty clear 'no.' The meltdown was really a financial sector meltdown more than a corporate America meltdown. It was caused by the nominal value of debt assets dropping catastrophically, which then triggered the holders' balance sheets all of a sudden to look terrible, which then triggered (basically) some old-fashioned bank runs, which then triggered everything we know about.

But the debt holdings that dropped so much in nominal value were all these crazy bundled mortgage strips or derivatives -- not general corporate debt.

As for the tax code, it definitely incentivizes taking on debt. Whether it's "too much" debt is hard to say -- that sort of depends on the specifics, I guess. In our case, we would have gotten the same house, but perhaps taken a smaller mortgage. That's not necessarily a better outcome for the economy or markets, though -- being able to take on more debt (because of the tax benefit) allowed us to keep more money in the stock markets, spend more on products and services, etc.

Further, it's not clear to me that it was the tax deductability of it that led to the housing boom or bust. The more annual income you have, the more the deductions matter (as you have more income in the highest bracket). But I don't think the default rate was really that high in that group, and you can certainly argue if you have that much annual income you should be able to carry the payments. I guess if you lose your job and have no savings, it's a problem because you oan't sell your house quickly enough. But it struck me from reading stories that the defaults came more from lower income families getting their first house, or middle income families who were really stretching and bought "too much" house.

If that's true, it was probably easier availability of mortgages rather then the lure of tax benefits that caused the problem.

C - Log said...

Very much appreciate your knowledge, experience, and insights. Thanks for taking the time to share them.

C - Log said...

Even the IMF now says it wants an inflation dove.

From Friday's Wall Street Journal:

The International Monetary Fund's top economist, Olivier Blanchard, says central bankers should consider aiming for a higher inflation rate than they do currently to lessen the chances of repeating the recent severe recession.

Mr. Blanchard, a macroeconomist on leave from the Massachusetts Institute of Technology, said the global economic downturn revealed flaws in macroeconomic policy, especially the reliance primarily on interest rates to manage economies. Although Japan had fallen into a decade-long funk despite low inflation and low interest rates, "most people convinced themselves that the Japanese didn't know what they were doing," Mr. Blanchard said in an interview.

In a new paper with two other IMF economists, Giovanni Dell'Ariccia and Paolo Mauro, Mr. Blanchard says policy makers need to consider radically different approaches to deal with major banking crises, pandemics or terrorist attacks.

In particular, the IMF paper suggests shooting for a higher-level inflation in "normal time in order to increase the room for monetary policy to react to such shocks." Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.

At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

C - Log said...

A commenter in Krugman's blog post on this had a good thought: Instead of calling ourselves "Inflation Doves," we should call ourselves "Employment Hawks."

We liberals/progressives really do have a problem with accepting the other side's labeling when it doesn't serve our purposes.

(I remember back to the early 1980s anti-nuclear-weapons movement, when SANE/FREEZE was much better branding than "peace movement" or "doves." Even a tough-guy Senator could sign on to something that was "SANE.")

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