by Paul Krugman
But we need not make this choice. We can and should reject both fatuous promises of easy growth and mystical faith in the virtues of stable prices.
“Four Percent Follies” made the case against growth; so let me make myself even more unpopular, by making the case against stable prices.
The Economic Growth and Stability Act, proposed in 1995 by Senator Connie Mack, declares that price stability “is a key condition to maintaining the highest possible levels of productivity, real incomes, living standards, employment and global competititiveness,” and enjoins the Federal Reserve to make such stability its primary goal. It’s a confident declaration: You would never guess that there is hardly any reason to believe that it is true.
The fact, however, is that the costs of inflation at the low single-digit rates that now prevail in advanced countries have proved theoretically and empirically elusive. Very high inflation, which leads people into costly efforts to avoid holding cash, is one thing; but we are not remotely in that situation. Moreover, it is fairly certain that the costs of inflation, such as they are, are nonlinear in the actual rate: 3 percent inflation does much less than one-third as much harm as 9 percent.
Still, even if the gains from price stability are nowhere near as large as Senator Mack imagines, why not go for them? Because to do so would be very expensive. The great disinflation of the 1980s, which brought inflation rates down from around 10 percent to around 4, was achieved only through a prolonged period of high unemployment rates and excess capacity—in the United States, the unemployment rate did not fall back to its 1979 level until 1988, and the cumulative loss of output was more than a trillion dollars. There is every reason to expect that a push to zero inflation would involve a comparable “sacrifice ratio”—that it would cost as much as half a trillion dollars in foregone output to wring the remaining 3 points or so of inflation out of the system. This is a huge short-term pain for a small and elusive long-term gain.
And even this may not be the whole story: There is some evidence that a push to zero inflation may lead not just to a temporary sacrifice of output but to a permanently higher rate of unemployment. This is still controversial—the standard view, embodied in the concept of the NAIRU (non-accelerating-inflation rate of unemployment) is that there is no long-run tradeoff between inflation and unemployment—but recent work by George Akerlof, William Dickens, and George Perry makes a compelling case that this no-tradeoff view breaks down at very low inflation rates.
The NAIRU hypothesis is based on the reasonable proposition that people can figure out the effects of inflation—that both workers and employers realize that an 11 percent wage increase in the face of 10 percent inflation is the same thing as a 6 percent increase in the face of 5 percent inflation, and therefore that any sustained rate of inflation will simply get built into price and wage decisions. There is overwhelming evidence that this hypothesis is right—that 10 percent inflation does not buy a long-term unemployment rate significantly lower than that which can be sustained with 5 percent inflation.
But suppose that the inflation rate is very low, and that market forces are “trying” to reduce the real wages of some workers. (Even if average real wages are rising, there will usually be some industries and some categories of labor in which real wages must decline in order to maintain full employment). Is a 2 percent wage increase in the face of 5 percent inflation the same thing as a 3 percent wage fall in the face of stable prices? To hyperrational workers, it might be; but common sense suggests that in practice there is a big psychological difference between a wage rise that fails to keep pace with inflation and an explicit wage reduction. Akerlof, Dickens, and Perry have produced compelling evidence that workers are indeed very reluctant to accept nominal wage cuts: The distribution of nominal wage changes shows very few actual declines but a large concentration at precisely zero, a clear indication that there are a substantial number of workers whose real wages “should” be falling more rapidly than the inflation rate but cannot because to do so would require unacceptable nominal wage cuts.
This nominal wage rigidity means that trying to get the inflation rate very low impairs real wage flexibility, and therefore increases the unemployment rate even in the long run. Consider, for example, the case of Canada, a nation whose central bank is intensely committed to the goal of price stability (the current inflation rate is less than 1 percent). In the 1960s Canada used to have about the same unemployment rate as the United States. When it started to run persistently higher rates in the 1970s and 1980s, many economists attributed the differential to a more generous unemployment insurance system. But even as that system has become less generous, the unemployment gap has continued to widen—Canada’s current rate is 10 percent. Why? The Canadian economist Pierre Fortin points out that from 1992 to 1994 a startling 47 percent of his country’s collective bargaining agreements involved wage freezes—that is, precisely zero nominal wage change. Most economists would agree that high-unemployment economies like Canada suffer from inadequate real wage flexibility; Fortin’s evidence suggests, however, that the cause of that inflexibility lies not in structual, microeconomic problems but in the Bank of Canada’s excessive anti-inflationary zeal.
In short, the belief that absolute price stability is a huge blessing, that it brings large benefits with few if any costs, rests not on evidence but on faith. The evidence actually points strongly the other way: The benefits of price stability are elusive, the costs of getting there are large, and zero inflation may not be a good thing even in the long run.
Suppose you reject both the miracle cures of the growth sect and the old-time religion of the stable-price sect. What policies would you advocate?
A shibboleth-free policy might look like this: First, adopt as an ultimate target fairly low but not zero inflation, say 3 or 4 percent. This is high enough to accommodate most of the real wage cuts that markets impose, while the costs of the inflation itself will still be very small. However, monetary policy affects inflation only with a long lag, so it is necessary to have some more operational intermediate target. A reasonable strategy is to try to stabilize unemployment around your best estimate of the level consistent with stable inflation at the desired rate, even while recognizing that such estimates are imperfect and that the structure of the economy changes over time in any case; so you should be prepared to adjust the target unemployment rate gradually down or up if inflation performance is better or worse than you expected. And of course if past misjudgments have caused inflation to move above—or below!—the target range, policy must endeavor to bring it back into line.
This policy proposal will presumably bring angry objections from both sides. The growth sect will denounce it as an acceptance of defeat, insisting that we need higher growth to raise living standards and solve our budget problems. Unfortunately, economics is not only about what you want—it is also about what you can get. Growth may be good, but achieving it requires more than simply declaring inflation dead.
Meanwhile, the stable-price sect will denounce this strategy as irresponsible, a return to the bad old inflationary ways of the 1970s. But the strategy is not outlandish—on the contrary, it is intended to be a description of the actual policies followed by several of the world’s major central banks. In particular, what I have descibed is very close to the behavior predicted by the “Taylor rule,” which successfully tracks the policies of the Federal Reserve. (It is ironic that the Fed, whose policies are in fact more growth-and employment-oriented than any other Western central bank, is the target of most of the growth sect’s attacks.) But the strategy described is also arguably a pretty good description of the behavior of other central banks, including the Bank of England and—dare we say it?—the Bundesbank, which talks a monetarist game but rarely meets its own announced targets.
Of course these sensible central banks will deny that they follow any such strategy. This is understandable. Anyone who has watched the press pounce on a novice central banker naive enough to speak plainly reali
zes why more experienced hands, however well-intentioned and clear-headed, prefer to cloak their actions in obscurantism and hypocrisy. But while hypocrisy has its uses, it also has its dangers—above all, the danger that you may start to believe the things you hear yourself saying. This is not a hypothetical possibility. Right now there are important central banks—the Banks of Canada and France are the obvious examples—which really seem to believe what they say about wanting stable prices; their sincerity is costing their nations hundreds of thousands of jobs.
It is disturbingly easy to imagine a future in which each of the great monetary shibboleths becomes the basis of policy in a major part of the advanced world. In the United States, powerful groups on both left and right now propagandize incessantly for the belief that we can grow our problems away; aside from creating the possibility that we will rediscover the joys of stagflation, this campaign seriously weakens our already faltering resolve to put our fiscal house in order. But the bigger risk is probably in Europe, where—despite a far worse employment performance than in the United States—the rhetoric of price stability goes largely unchallenged, and is likely to have growing influence over actual policy.
In particular, what will happen if EMU comes to pass? The new European Central Bank will operate under a constitution that honors price stability above all else; more important, it will feel that it must demonstrate itself a worthy successor to the Bundesbank, which means that it will try to implement in practice the kind of policy the Bundesbank follows only in theory. The result will be that Europe’s unemployment problem, which would be severe in any case, will be seriously aggravated.
Shibboleths make people feel good. Not only are they an alternative to the pain of hard thinking, but because so many people repeat them, they offer a reassuring sense of community. But we must go beyond the shibboleths, however comfortable they make us feel: Monetary policy is too serious a business to be conducted on the basis of simplistic slogans.
What Is Wrong with Japan?
When the world’s second largest economy, after forty years of impressive economic growth, stagnates for six years with no real recovery in sight, one would think that people would regard the causes of that economic stagnation as a truly burning issue. Yet even now there is a strange casualness in the way that most people—including, unfortunately, many Japanese—discuss the nation’s problems. Instead of a serious, thoughtful analysis, all one usually hears is a long list of things wrong with Japan. The country, we are told, has a weak financial sector; it is overregulated; there is not enough competition; Japanese firms are moving production to Southeast Asia; and so on. All of these things are true; nonetheless, a list is not the same as a real analysis. And in fact the tendency to explain Japan’s problems in terms of a long list of factors does real harm, because it encourages a sort of fatalism in the face of economic stagnation. After all, if there are so many problems, we cannot expect a quick fix.
The truth, however, is that matters are not that complicated. Japan has many problems—but what country does not? The main obstacle to Japanese recovery right now is not the long list of structural difficulties but a simple lack of clear thinking and courage.
For one thing, most of the items on everybody’s list of what is wrong with Japan are things that make the economy inefficient. That is, all of these things reduce the ability of the economy to produce goods and services—they limit its supply capacity. But the immediate problem with the Japanese economy is not too little supply—it is too little demand. The problem is that the economy isn’t using the production capacity it already has—a problem for which many of the items on the usual list are simply irrelevant.
Now as a general rule modern economies are not supposed to suffer from prolonged periods of inadequate demand. There is usually nothing easier than increasing demand: Just have the central bank (i.e., the Bank of Japan) increase the money supply, or have the government spend more. Why, then, has Japan suffered from low demand for more than half a decade?
Well, there are some structural reasons. Japanese consumers still save an unusually high fraction of their income, which means that companies must correspondingly be persuaded to maintain a high investment rate if the economy is not to have too little demand. The problem is aggravated because the troubles of the banking system have restricted the flow of credit. So to push demand high enough to get the economy back to more or less full use of its capacity would require a big stimulus. Still, why not provide that stimulus?
The standard answer goes like this: Interest rates are already very low, so the Bank of Japan has done all it can. Meanwhile, the government has a severe fiscal problem, so it cannot increase spending or cut taxes. There is, in short, nothing to be done except pursue structural reforms and hope for an eventual turnaround.
This answer sounds hard-headed and responsible. In fact, however, it is based on a completely false premise—the idea that the Bank of Japan has reached the limits of what it can do.
The simple fact is that there is no limit on how much a central bank can increase the supply of money. Could the Bank of Japan, for example, double the amount of monetary base—that is, bank reserves plus cash in circulation—over the next year? Sure: just buy that amount of Japanese government debt. True, even such a large increase in the money supply might not drive down interest rates very much, since they are already so low. But an increase in Japan’s money supply could ease the economic problem in ways other than lower interest rates. It is possible that putting more cash in circulation will stimulate spending directly—that the extra money will simply “burn holes in people’s pockets.” Or banks, awash in reserves, might become more willing to lend; or individuals, with all that cash on hand, will bypass the banks and find other ways of investing. And even if none of these things happens, when the Bank of Japan increases the monetary base it does so by buying off government debt—and therefore makes room for spending increases or tax cuts.
So never mind those long lists of reasons for Japan’s slump. The answer to the country’s immediate problems is simple: PRINT LOTS OF MONEY.
But won’t that be inflationary? Well, remember that the Bank of Japan is supposed to be impotent: If it prints more money, people will simply hoard it rather than spend it. But printing money is only inflationary if people spend it, and if that spending exceeds the economy’s capacity to produce. You cannot first argue that monetary policy is ineffective as a way to increase demand, then reject a proposal to print more money on the grounds that it will cause inflation.
So why doesn’t the Bank of Japan just go out and print lots of money? The best theory I have heard is that the bureaucrats at the Bank of Japan and the Ministry of Finance are still mesmerized by the memory of the “bubble economy”—the wild speculation of the late 1980s, which pushed the prices of stocks and real estate to crazy levels (remember when the grounds of the Imperial Palace were supposedly worth more than the whole state of California?). They believe that loose monetary policy created that bubble—which may be true—and that the bursting of the bubble caused the slump of the 1990s—which may also be true. And so they are afraid to increase the money supply now for fear of repeating the experience.
There is an old joke that may be useful here: A driver runs over a pedestrian, who is left lying in the road behind his car. He looks back and says “I am so sorry—let me undo the damage”—and proceeds to back up his car, running over the pedestrian a second time. Japan’s economic managers are acting like that driver. They do not realize that 1997 is not 1987, and that doing the opposite of what they did then only compounds the country’s problems.
Seeking the Rule of the Waves
Books that propound theories of history—that is, that claim to find common patterns in events widely separated in time and space—have a deservedly dicey reputation among the professionals. When such books are good they can be very good: A classic like William McNeill’s Plagues and Peoples can permanently change the way you look at human affairs. Most bigthink
books about history, however, turn out to offer little more than strained analogies mixed with pretentious restatements of the obvious; a few have been downright pernicious.
Still, the public has a powerful and understandable appetite for theories that seem to explain it all, and so they keep on coming. David Hackett Fischer’s The Great Wave: Price Revolutions and the Rhythm of History has already generated considerable buzz. Remarkably for a book that spends most of its five-hundred-plus pages dwelling on events centuries (and occasionally millennia) in the past, a good deal of the buzz comes from the business community, not usually noted for its interest in history. Indeed, Fischer is getting favorable mention from people who tell us in the next breath that we live in a New Economy to which old rules no longer apply.
There is a reason for this peculiar affinity between a historian with an eight-century perspective and business commentators obsessed with the new; what these pundits really want, it turns out, is to use his account of alleged patterns in the distant past as an excuse to ignore the lessons of more recent history.
Fischer’s book looks promising on the face of it. Inflation is a plausible candidate for a far-ranging search for parallels and common principles. And the book also starts well, with a stirring and eloquent defense of the role of quantification in history (although my favorite along these lines is still Colin McEvedy’s introduction to The Penguin Atlas of Ancient History, which contains this immortal sentence: “History being a branch of the biological sciences, its ultimate expression must be mathematical.”). I plan to keep The Great Wave on my shelf both as a useful source of facts and figures and as a guide to data sources; the author did do a lot of homework.
It is therefore a shame that the book turns out, in the end, to be quite wrong-headed. But let us not be too harsh: It is wrong-headed in interesting ways, and we can learn quite a lot by examining how and where Fischer went astray.