Monetary Central Planning and the State, Part 1: A Little Bit of Inflation Never Hurt Anyone. Right?

When I was an undergraduate majoring in economics in the late ’60s and early ’70s, several of my professors made much of the distinctions between “trotting,” “galloping,” and “creeping” inflation. Trotting inflation was usually defined as a 5 to 10 percent annual rate of increase in the general level of prices that, if not controlled, might accelerate into a galloping inflation of 10 to 20 percent a year; galloping inflation ran the risk of becoming a “runaway” inflation; runaway inflation could change into a hyperinflation; and hyperinflation might lead to a monetary collapse if not stopped in time.

But creeping inflation, my fellow students and I were told, need not be a problem. Creeping inflation was a rate of general price increase of 1 to 5 percent a year. A creeping inflation of 3 to 5 percent could still significantly eat away at the purchasing power of money when continued over many years, but it was “manageable.” Furthermore, a low creeping inflation could be good for the economy.

After John Maynard Keynes wrote his famous book, The General Theory of Employment, Interest and Money, in 1936, the economists who became known as the Keynesians argued that workers suffer from “money illusion.” Or in Keynes’s own words, “A movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices.”

Suppose that a general economic depression develops in an economy and prices, in general, fall by, say, 20 percent. If workers were to accept an equivalent cut in the general level of wages, employers’ labor costs would have declined in line with the prices they now receive for the products they sell. Employers could afford to maintain production and employ the same number of workers as they had before the depression began. Furthermore, workers would be no worse off in terms of their real incomes. It is true that their money wages would now be 20 percent lower, but so, too, would be the prices of the goods they bought with their smaller money incomes. At the lower level of money prices, their lower money incomes would still be able to buy the same quantities of goods and services as before the start of the depression.

Keynes, however, argued that workers suffer from “money illusion.” They think only in terms of the nominal dollars in their paychecks, not in terms of their “real wages,” i.e., in terms of the real purchasing power of what their money wages can buy. As a consequence, workers would strongly resist any significant cut in their money wages, even if the result were to be high and prolonged unemployment.

The answer, Keynes proposed, was to decrease real wages, and, therefore, the cost of hiring labor, through price inflation. Precisely because workers suffer from money illusion, they would not ask for higher money wages to compensate for the loss in their consumer buying power due to the rise in prices. Higher prices for products with relatively unchanged money wages would improve or create the profit margins out of which would come the incentives for employers to expand production and hire back the unemployed.

In the Keynesian view, government budget deficits are the mechanism for bringing this about. Government would take in less tax revenue than it spent on goods and services. The net addition of government spending in the economy through money creation (or borrowing of “idle” savings accumulating in banks) to finance the budget deficit would be the device through which “aggregate demand” could be stimulated and prices “creepingly” pushed up.

Keynes’s argument for a little bit of managed inflation as a healthy stimulus to production and employment had, in fact, been made many times before him and had been criticized, as well, as a merely temporary panacea. For example, Francis A. Walker, one of the most prominent American economists of the late 19th century, argued in his book Money, Trade, and Industry (1889) that a “gradual . . . inflation upon profits is very direct and simple. . . . It gives a fillip to the zeal of the employing classes, and in the immediate present promotes production without necessarily inducing any [negative] reaction whatsoever. . . . It will have the maximum of good and the minimum of evil effects” as long as it is “a slowly progressive depreciation of money.”

But the belief that a permanent stimulus for greater production and employment can be secured by a steady and low rate of price inflation was criticized by the Swedish economist Knut Wicksell in his book Interest and Prices (1898):

“If a gradual rise in prices, in accordance with an approximately known schedule, could be reckoned on with certainty, it would be taken into account in all current business contracts; with the result that its supposed beneficial influence would necessarily be reduced to a minimum. Those people who prefer a continually upward moving to a stationary price level forcibly remind one of those who purposely keep their watches a little fast so as to be certain of catching their trains. But to achieve their purpose they must not be conscious of the fact that their watches are fast; otherwise they become accustomed to take the extra few minutes into account and after all, in spite of their artfulness, arrive too late.”

In this century, first Irving Fisher and then Milton Friedman argued the same point as Wicksell. They pointed out that prices for finished consumer goods tend to be relatively flexible and responsive to changes in market demand. The prices of factors of production, such as labor, on the other hand, tend to be contractually fixed for longer periods of time. As a result, if there is an unexpected increase in general market demand due to inflation, prices of finished goods will begin to rise sooner and before the prices of the factors of production. Profit margins will be temporarily widened by the price inflation. But as contracts come up for renewal and general information about the rate of price inflation comes to be known, workers and other resource owners will bargain for higher wages and prices. Why? For two reasons. First, the attempt to expand production simultaneously in many sectors of the economy because of widened profit margins will strain the market for scarce factors of production, naturally resulting in a bidding up of their prices, including the wages of labor.

Second, as workers and resource owners buy goods and services in the market, they soon learn that their money incomes no longer go as far as they used to in the face of rising prices. In their bargaining over wages and resource prices with employers, they naturally will demand money wages and money prices for resources that at least reestablish their previous real income. Both Fisher and Friedman argued that workers over time do not suffer from money illusion. Money, as a medium of exchange, is an abode of purchasing power, and those who use money are concerned with what it will buy in the marketplace. In other words, what matters for income earners are their real wages , not merely their money wages .

Only if the rate of increase in the general level of prices were unanticipated-or not anticipated to the full extent-would the Keynesian gimmickry work. If the rate of general price inflation is correctly anticipated, then all contracts for wages and other resource prices will incorporate that information; resource prices, including wages, will tend to rise at the same average rate as the general price level. Profit margins will not be artificially widened, and there will be no permanent stimulus to greater production and employment. The amount of production and employment will reflect the actual, underlying market conditions of supply and demand existing in the economy.

Only if the actual rate of price inflation is accelerated ahead of what people expect the inflation rate to be will prices once again rise fast enough relative to the costs of production to make the Keynesian illusion temporarily reappear. But this means that if inflation is to have its stimulative impact, it must be accelerated from a “creep” to a “trot.” When “trotting” inflation no longer does the trick, it must be speeded up to a “gallop.” And when a galloping inflation no longer suffices, it must be allowed to “run away.” When runaway inflation fails to deliver the desired level of employment. . . .

The idea of a steady and successfully government-managed “creeping inflation” to ensure some desired rate of economic growth and increase in employment fell by the wayside in policy circles in the 1970s and 1980s under the attacks of monetarists such as Milton Friedman and another group of economists known as the rational-expectations theorists.

But it seems that fallacious ideas never die-especially in economics; they just retreat into hiding to reappear some other day. As an example of this, the case for creeping inflation is back.

In August 1996, the Washington-based Brookings Institution released a Policy Brief by George Akerlof, William Dickens, and George Perry, entitled “Low Inflation or No Inflation: Should the Federal Reserve Pursue Complete Price Stability?” They argue that if the board of governors of the Federal Reserve System follows a strategy of zero inflation, they will bring about unnecessary unemployment and less growth than would be possible otherwise.

Constant changes in market conditions, the authors correctly point out, require appropriate adjustments in the distribution of labor among the various sectors of the economy as well as adjustments in the structure of relative wages, reflecting the changing patterns of employers’ demands for different types of labor. If price inflation is zero, they again correctly reason, some money wages will have to rise where the demand for labor is increasing and some money wages will have to decline where the demand for labor is decreasing.

But the authors say,

“Employers almost never cut their employees’ wages because they fear that doing so would cause serious morale and staff retention problems. . . . Most people consider it unfair for a firm to cut wages, except in extreme circumstances. . . . Downward wage rigidity is indeed an important feature of the economy.”

As a result, in those sectors of the economy where money wages may have to fall but do not, employers “keep relative wages too high and employment too low.” On the other hand, most workers “do not consider it unfair if a firm fails to raise [money] wages in the face of high inflation.”

On the basis of this reasoning, they propose a monetary policy of “moderate inflation.” If market conditions change, the necessary adjustments in the structure of relative wages to attract workers into some sectors of the economy and away from others can occur without having to cut anyone’s money wage. Money wages can be kept the same in those parts of the economy where labor demand has gone down, while the increases in the money supply to generate the moderate price inflation can be used to cover a necessary rise in money wages in those sectors where workers need to be attracted.

To avoid “serious morale” problems-the new explanation for the old Keynesian presumption of “money illusion” among workers-the Federal Reserve, therefore, should make a new version of “creeping inflation” the goal of monetary policy.

In a September 30, 1996, commentary in the (London) Financial Times , entitled “Inflation Apologists,” columnist Michael Prowse scathingly took these authors to task for resurrecting this fallacious building block of old-fashioned Keynesian economics. He pointed out:

“In a zero inflation world, people could learn to accept the need for occasional cuts in money wages, just as they now accept cuts in inflation-adjusted wages. To assume this is impossible is to assume that people are permanently irrational-a poor, if not insulting, assumption on which to base any economic theory. . . . With zero inflation, relative price signals would be clearer than they are today. . . . Capitalism would function even more efficiently. And the jobless rate would tend to be lower, not higher. The pessimism of the new inflation apologists is quite unwarranted.”

Is zero-price inflation, therefore, the desirable target for a market economy and the free society? If it is, then this must imply that there remains, even in the free society, a monetary central-planning agency that has the power to implement the necessary monetary policy to bring it about. But if government central planning can be demonstrated to be economically irrational in all other aspects of economic life, on what basis can it be presumed to be able to work-and work correctly-in monetary matters? And if monetary central planning can be shown to be no less irrational than all other forms of central planning, then what should be the monetary system of a free society?

Categories: Freedom Daily Archive, Monetary Policy