But inflation is not constant or predictable. Indeed, the aura of uncertainty is one of its most insidious costs. Individuals and firms are forced to guess about future prices when they make economic decisions. When the autoworkers and Ford negotiate a four-year contract, both sides must make some estimates about future inflation. A contract with annual raises of 4 percent is very generous when the inflation rate is 1 percent but a lousy deal for workers if the inflation rate climbs to 10 percent. Lenders must make a similar calculation. Lending someone money for thirty years at a fixed rate of interest carries a huge risk in an inflationary environment. So when lenders fear future inflation, they build in a buffer. The greater the fear of inflation, the bigger the buffer. On the other hand, if a central bank proves that it is serious about preventing inflation, then the buffer gets smaller. One of the most significant benefits of the persistent low inflation of the 1990s was that lenders became less fearful of future inflation. As a result, long-term interest rates dropped sharply, making homes and other big purchases more affordable. Robert Barro, a Harvard economist who has studied economic growth in nearly one hundred countries over several decades, has confirmed that significant inflation is associated with slower real GDP growth.
It seems obvious enough that governments and central banks would make fighting inflation a priority. Even if they made honest mistakes trying to drive their economies at the “speed limit,” we would expect small bursts of inflation, not prolonged periods of rising prices, let alone hyperinflation. Yet that is not what we observe. Governments, rich and poor alike, have driven their economies not just faster than the speed limit, but at engine-smoking, wheels-screeching kinds of speeds. Why? Because shortsighted, corrupt, or desperate governments can buy themselves some time by stoking inflation. We spoke about the power of incentives all the way back in Chapter 2. Still, see if you can piece this puzzle together: (1) Governments often owe large debts, and troubled governments owe even more; (2) inflation is good for debtors because it erodes the value of the money they must pay back; (3) governments control the inflation rate. Add it up: Governments can cut their own debts by pulling the inflation rip cord.
Of course, this creates all kinds of victims. Those who lent the government money are paid back the face value of the debt but in a currency that has lost value. Meanwhile, those holding currency are punished because their money now buys much less. And last, even future citizens are punished, because this government will find it difficult or impossible to borrow at reasonable interest rates again (though bankers do show an odd proclivity to make the same mistakes over and over again).
Governments can also benefit in the short run from what economists refer to as the “inflation tax.” Suppose you are running a government that is unable to raise taxes through conventional means, either because the infrastructure necessary to collect taxes does not exist or because your citizens cannot or will not pay more. Yet you have government workers, perhaps even a large army, who demand to be paid. Here is a very simple solution. Buy some beer, order a pizza (or whatever an appropriate national dish might be), and begin running the printing presses at the national mint. As soon as the ink is dry on your new pesos, or rubles, or dollars, use them to pay your government workers and soldiers. Alas, you have taxed the people of your country—indirectly. You have not physically taken money from their wallets; instead, you’ve done it by devaluing the money that stays in their wallets. The Continental Congress did it during the Revolutionary War; both sides did it during the Civil War; the German government did it between the wars; countries like Zimbabwe are doing it now.
A government does not have to be on the brink of catastrophe to play the inflation card. Even in present-day America, clever politicians can use moderate inflation to their benefit. One feature of irresponsible monetary policy—like a party headed out of control—is that it can be fun for a while. In the short run, easy money makes everyone feel richer. When consumers flock to the Chrysler dealership in Des Moines, the owner’s first reaction is that he is doing a really good job of selling cars. Or perhaps he thinks that Chrysler’s new models are more attractive than the Fords and Toyotas. In either case, he raises prices, earns more income, and generally believes that his life is getting better. Only gradually does he realize that most other businesses are experiencing the same phenomenon. Since they are raising prices, too, his higher income will be lost to inflation.
By then, the politicians may have gotten what they wanted: reelection. A central bank that is not sufficiently insulated from politics can throw a wild party before the votes are cast. There will be lots of dancing on the tables; by the time voters become sick with an inflation-induced hangover, the election is over. Macroeconomic lore has it that Fed chairman Arthur Burns did such a favor for Richard Nixon in 1972 and that the Bush family is still angry with Alan Greenspan for not adding a little more alcohol to the punch before the 1992 election, when George H. W. Bush was turned out of office following a mild recession.
Political independence is crucial if monetary authorities are to do their jobs responsibly. Evidence shows that countries with independent central banks—those that can operate relatively free of political meddling—have lower average inflation rates over time. America’s Federal Reserve is among those considered to be relatively independent. Members of its board of governors are appointed to fourteen-year terms by the president. That does not give them the same lifetime tenure as Supreme Court justices, but it does make it unlikely that any new president could pack the Federal Reserve with cronies. It is notable—and even a source of criticism—that the most important economic post in a democratic government is appointed, not elected. We designed it that way; we have made a democratic decision to create a relatively undemocratic institution. A central bank’s effectiveness depends on its independence and credibility, almost to the point that a reputation can become self-fulfilling. If firms believe that a central bank will not tolerate inflation, then they will not feel compelled to raise prices. And if firms do not raise prices, then there will not be an inflation problem.
Fed officials are prickly about political meddling. In the spring of 1993, I had dinner with Paul Volcker, former chairman of the Federal Reserve. Mr. Volcker was teaching at Princeton, and he was kind enough to take his students to dinner. President Clinton had just given a major address to a joint session of Congress and Fed chairman Alan Greenspan, Volcker’s successor, had been seated next to Hillary Clinton. What I remember most about the dinner was Mr. Volcker grumbling that it was inappropriate for Alan Greenspan to have been seated next to the president’s wife. He felt that it sent the wrong message about the Federal Reserve’s independence from the executive branch. That is how seriously central bankers take their political independence.
Inflation is bad; deflation, or steadily falling prices, is much worse. Even modest deflation can be economically devastating, as Japan has learned over the past two decades. It may seem counterintuitive that falling prices could make consumers worse off (especially if rising prices make them worse off, too), but deflation begets a dangerous economic cycle. To begin with, falling prices cause consumers to postpone purchases. Why buy a refrigerator today when it will cost less next week? Meanwhile, asset prices also are falling, so consumers feel poorer and less inclined to spend. This is why the bursting of a real estate bubble causes so much economic damage. Consumers watch the value of their homes drop sharply while their mortgage payments stay the same. They feel poorer (because they are). As we know from the last chapter, when consumers spend less, the economy grows less. Firms respond to this slowdown by cutting prices further still. The result is an economic death spiral, as Paul Krugman has noted:
Prices are falling because the economy is depressed; now we’ve just learned that the economy is depressed because prices are falling. That sets the stage for the return of another monster we haven’t seen since the 1930s, a “deflationary spiral,” in which falling prices and a slumping economy feed on each other, plunging the econo
my into the abyss.4
This spiral can poison the financial system, even when bankers are not doing irresponsible things. Banks and other financial institutions get weaker as loans go bad and the value of the real estate and other assets used as collateral for those loans falls. Some banks begin to have solvency problems; others just have less capital for making new loans, which deprives otherwise healthy firms of credit and spreads the economic distress. The purpose of the Troubled Asset Relief Program (TARP) intervention at the end of the George W. Bush administration—the so-called Wall Street bailout—was to “recapitalize” America’s banks and put them back in a position to provide capital to the economy. The design of the program had its flaws. Communication about what the administration was doing and why they were doing it was abysmal. But the underlying concept made a lot of sense in the face of the financial crisis.
Monetary policy alone may not be able to break a deflationary spiral. In Japan, the central bank cut nominal interest rates to near zero a long time ago, which means that they can’t go any lower. (Nominal interest rates can’t be negative. Any bank that loaned out $100 and asked for only $98 back would be better off just keeping the $100 in the first place.)* Yet even with nominal rates near zero, the rental rate on capital—the real interest rate—might actually be quite high. Here is why. If prices are falling, then borrowing $100 today and paying back $100 next year is not costless. The $100 you pay back has more purchasing power than the $100 you borrowed, perhaps much more. The faster prices are falling, the higher your real cost of borrowing. If the nominal interest rate is zero, but prices are falling 5 percent a year, then the real interest rate is 5 percent—a cost of borrowing that is too steep when the economy is stagnant. Economists have long been convinced that what Japan needs is a stiff dose of inflation to fix all this. One very prominent economist went so far as to encourage the Bank of Japan to do “anything short of dropping bank notes out of helicopters.”5 To hark back to the politics of organized interests covered in Chapter 8, one theory for why Japanese officials have not done more to fight falling prices is that Japan’s aging population, many of whom live on fixed incomes or savings, see deflation as a good thing despite its dire consequences for the economy as a whole.
The United States has had its own encounters with deflation. There is a consensus among economists that botched monetary policy was at the heart of the Great Depression. From 1929 to 1933, America’s money supply fell by 28 percent.6 The Fed did not deliberately turn off the credit tap; rather, it stood idly by as the money supply fell of its own volition. The process by which money is circulated throughout the economy had become unhitched. Because of widespread bank failures in 1930, both banks and individuals began to hoard cash. Money that was stuffed under a mattress or locked in a bank vault could not be loaned back into the economy. The Fed did nothing while America’s credit dried up (and actually raised interest rates sharply in 1931 to defend the gold standard). Fed officials should have been doing just the opposite: pumping money into the system.
In September 2009, the one-year anniversary of the collapse of Lehman Brothers, the chair of the Council of Economic Advisers, Christina Romer, gave a talk ominously entitled “Back from the Brink,” which laid much of the credit for our escape from economic disaster at the door of the Federal Reserve. She explained, “The policy response in the current episode, in contrast [to the 1930s], has been swift and bold. The Federal Reserve’s creative and aggressive actions last fall to maintain lending will go down as a high point in central bank history. As credit market after credit market froze or evaporated, the Federal Reserve created many new programs to fill the gap and maintain the flow of credit.”
Did we drop cash out of helicopters? Almost. It turns out that the Princeton professor who advocated this strategy (not literally) a decade ago for Japan was none other than Ben Bernanke (earning him the nickname “Helicopter Ben” in some quarters).
Beginning with the first glimmers of trouble in 2007, the Fed used all its conventional tools aggressively, cutting the target federal funds rate seven times between September 2007 and April 2008. When that began to feel like pushing on a wet noodle, the Fed started to do things that one recent economic paper described as “not in the current textbook descriptions of monetary policy.” The Fed is America’s “lender of last resort,” making it responsible for the smooth functioning of the financial system, particularly when that system is at risk of seizing up for lack of credit and liquidity. In that capacity, the Fed is vested with awesome powers. Article 13(3) of the Federal Reserve Act gives the Fed authority to make loans “to any individual, partnership, or corporation provided that the borrower is unable to obtain credit from a banking institution.” Ben Bernanke can create $500 and loan it to your grandmother to fix the roof, if the local bank has said no and he decides that it might do some good for the rest of us.
Bernanke and crew pulled out the monetary policy equivalent of duct tape. The Federal Reserve urged commercial banks to borrow directly from the Fed via the discount window, gave banks the ability to borrow anonymously (so that it would not send signals of weakness to the market), and offered longer term loans. The Fed also loaned funds directly to an investment bank (Bear Stearns) for the first time ever; when Bear Stearns ultimately faced insolvency, the Fed loaned JPMorgan Chase $30 billion to take over Bear Stearns, sparing the market from the chaos that later followed the Lehman bankruptcy. In cases where institutions already had access to Fed capital, the rules for collateral were changed so that the borrowers could pledge illiquid assets like mortgage-backed securities—meaning that when grandma asked for her $500 loan, she could pledge all that stuff in the attic as collateral, even if it was not obvious who would want to buy it or at what price. That gets money to your grandma to fix the roof, which was the point of all this.7
Monetary policy is tricky business. Done right, it facilitates economic growth and cushions the economy from shocks that might otherwise wreak havoc. Done wrong, it can cause pain and misery. Is it possible that all the recent unconventional actions at the Federal Reserve have merely set the stage for another set of problems? Absolutely. It’s more likely, at least based on evidence so far, that the Fed averted a more serious crisis and spared a great deal of human suffering as a result. President Barack Obama appointed Federal Reserve chairman Ben Bernanke to a second four-year term beginning in 2010. At the ceremony, the president said, “As an expert on the causes of the Great Depression, I’m sure Ben never imagined that he would be part of a team responsible for preventing another. But because of his background, his temperament, his courage, and his creativity, that’s exactly what he has helped to achieve.”8 That’s high praise. For now, it seems largely accurate.
CHAPTER 11
International Economics:
How did a nice country like Iceland go bust?
In 1992, George Soros made nearly $1 billion in a single day for the investment funds he managed. Most people need several weeks to make a billion dollars, or even a month. Soros made his billion on a single day in October by making a huge bet on the future value of the British pound relative to other currencies. He was right, making him arguably the most famous “currency speculator” ever.
How did he do it? In 1992, Britain was part of the European Exchange Rate Mechanism, or ERM. This agreement was designed to manage large fluctuations in the exchange rates between European nations. Firms found it more difficult to do business across the continent when they could not predict what the future exchange rates would likely be among Europe’s multiple currencies. (A single currency, the euro, would come roughly a decade later.) The ERM created targets for the exchange rates among the participating countries. Each government was obligated to pursue policies that kept its currency trading on international currency markets within a narrow band around this target. For example, the British pound was pegged to 2.95 German marks and could not fall below a floor of 2.778 marks.
Britain was in the midst of a recession, and its currency w
as falling in value as international investors sold the pound and looked for more profitable opportunities elsewhere in the world. Currencies are no different than any other good; the exchange rate, or the “price” of one currency relative to another, is determined by supply relative to demand. As the demand for pounds fell, so did the value of the pound on currency markets. The British government vowed that it would “defend the pound” to keep it from falling below its designated value in the ERM. Soros didn’t believe it—and that was what motivated his big bet.
The British government had two tools for propping up the value of the pound in the face of market pressure pushing it down: (1) The government could use its reserves of other foreign currencies to buy pounds—directly boosting demand for the currency; or (2) the government could use monetary policy to raise real interest rates, which, all else equal, makes British bonds (and the pounds necessary to buy them) more lucrative to global investors and attracts capital (or keeps it from leaving).
But the Brits had problems. The government had already spent huge sums of money buying pounds; the Bank of England (the British central bank) risked squandering additional foreign currency reserves to no better effect. Raising interest rates was not an attractive option for the government either. The British economy was in bad shape; raising interest rates during a recession slows the economy even further, which makes for bad economics and even worse politics. Forbes explained in a postmortem of the Soros strategy, “As Britain and Italy [with similar problems] struggled to make their currencies attractive, they were forced to maintain high interest rates to attract foreign investment dollars. But this crimped their ability to stimulate their sagging economies.”1
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