Flation

  This week brought another round of the perverse spectacle of Wall Street wringing their hands over the supposedly "bad news" that the economy keeps growing and the labor market keeps thriving, at least according to the latest data. Obviously, the hand-wringing is a rational response from their perspective to the downstream effects of this news on interest rates—the latest data means that the Fed will almost certainly keep making borrowing more expensive, in its July meeting, in order to slow down wage and price growth. 

But this just pushes the question back a step further: why does our central bank need to keep battling against the very growth and labor market strength that are benefiting American workers and increasing our national prosperity? Is there no possible response to inflation, other than to fight so hard against what should be a manifestly good thing? 

Look, I understand full well why we need to combat inflation. Inflation is not a good thing—and can be ruinous for some members of society. But it's deeply troubling nonetheless to contemplate the possibility that truly the only way to address it is to try to slow the economy and increase unemployment. 

After all, if this is really the case, then it renders our whole system of democratic decision-making about economic policy practically meaningless. Any gains for workers in terms of bargaining power or wages will swiftly be offset by increases in the policy rate that reduce employment, and so we're ultimately back where we started, no matter what policies we choose to enact or officials we nominally install in office, because monetary policymakers will effectively conspire to prevent American workers from ever rising too high.

I turned to the economist Abba Lerner's 1972 pamphlet Flation to try to find some way out of this cruel dilemma. I was hoping he could find some way to avoid the Scylla of inflation and the Charybdis of unemployment, other than by just steering the same narrow course between the two via the gloomy inevitability of monetary "fine-tuning." 

And though I was not disappointed in this—he does in fact showcase instances in which a third possibility, along a different policy vector, could be possible—alas, these alternative solutions are not really applicable to our present inflationary pressures. Lerner was writing in the midst of the 1970s-era inflation (which would only get worse in the years following his book), and while it has many parallels to our present situation, it differs from it in one key circumstance: the '70s inflation was accompanied by recession ("stagflation"), whereas ours is not. And Lerner's proposed third way really only applies to the former unusual confluence of events. 

Lerner begins by acknowledging that the prototypical kind of inflation—which he dubs "Inflation I"—is best resisted through exactly the types of policies the Fed is presently pursuing. Inflation I, he writes, is the sort of inflation caused by excess demand—too much money chasing too few goods, and thereby driving up prices of the limited supply available. When this type of inflation occurs, the only way out is truly to limit the amount of demand in the economy by pulling money out of it—such as by raising interest rates. 

Lerner reminds us, however, that this is not the only possible type of inflation—or, at least, not the only circumstances that give raise to inflation. There is also a situation in which inflation occurs even in the midst of recession—this was the specter of "stagflation" that beset the 1970s. As Lerner points out, such a recessionary inflation could only be seen as fundamentally baffling and mysterious according to the tenets of traditional economics. From the perspective of market mechanisms, after all, such a confluence shouldn't be possible. The lack of available buyers should force sellers to lower their prices, instead of raising them, in order to woo customers back. 

If markets actually behaved with perfect flexibility, Lerner points out, this is indeed what would occur; just as—again, if markets behaved according to theoretical constructs—the Great Depression should have been impossible, because prices and wages should have rushed downward to meet the collapse in demand, and the whole system should have righted itself. Yet, this did not occur in the case of the Depression, Lerner notes, because social institutions existing outside of markets worked to prevent wages and prices from falling too far too fast. This was the great insight of Keynes, which made his revolution in economic thought possible. 

What the Keynesians had missed, though—Lerner argues—is that the same extra-market social factors can operate in an even stronger fashion as well. Just as social forces can prevent wages and prices from going down with perfect flexibility to meet reduced demand, so they can combine to force wages and prices up even when the collective demand in society will not support these higher earnings. This is what occurs when those whom Lerner dubs "administrators"—including labor unions but also politicians and capitalists angling for a bigger share of profits than the actual demand for their products will sustain—gain sufficient power in society to drive up prices without regard to the available demand to purchase at those rates. 

This is the confluence of events that leads to "Inflation II," in Lerner's terminology, which we could also call "stagflation." (Lerner also identifies a further, closely-related form of inflation—Inflation III—which is likewise induced by powerful "administrators," but which is caused by expectations of future inflation, which become a self-fulfilling prophecy, rather than by a straightforward attempt to appropriate more in earnings than the economy's demand will sustain. This form of inflation too could have been responsible in part for the stagflation of the time.)

When society is experiencing the second or third kind of inflation, rather than the first—Lerner writes—then we are indeed justified in looking beyond the usual "fine-tuning" (or, in his terminology, "functional finance") to address it. After all, if the inflation is occurring alongside a recession, then sucking more demand out of the economy will not do anything to prevent it—plainly, the inflation is not being caused by an excess of demand, since otherwise there would not be a recession. Some further means must be found of combatting it: and for this, Lerner suggests a system of temporary price and wage freezes, accompanied by fiscal and monetary stimulus to bring levels of spending up to current prices, ending the recession through "instant prosperity" while dampening inflationary expectations through the "freeze." 

The problem we face in present times, however, is the very real possibility that we are dealing with a classic Inflation I problem, not an Inflation II or III problem of the sort they had in the 1970s. After all, we are not presently in a recession. Our current inflation is accompanied—in classic fashion—by economic growth, a tight labor market, and high levels of consumer spending. Nor could the present inflation reasonably be attributed to the excess power of "administrators"—organized labor is far weaker now than it was at the time Lerner wrote. Thus, if we really are in an Inflation I spiral, Lerner's analysis seems to buttress the view that the Fed's approach of trying to shrink aggregate demand really is the only solution. We have no choice but to turn to the old tools of "functional finance." 

In fairness, Lerner countenances that such old-fashioned stiff medicine could be a possible solution to Inflation II and Inflation III situations as well. He notes that it is possible, in theory, to trigger a recession so deep that it breaks the power of organized labor and other "administrators" to influence prices, because it will create so much unemployment that even well-entrenched labor unions are abandoned or lose legitimacy and workers lose all bargaining power. However, Lerner argues in passing, this is a solution that probably no politician will actually try, because its cost in social harm and public disapproval would be so severe. 

We know in retrospect, however, that this is precisely what American policymakers did. No one ever tried Lerner's solution of throwing the fuel of economic stimulus on the ice of frozen prices: instead, as the decade continued and inflation only became worse, eventually reaching double digits by the end of the 1970s, monetary policymakers came to embrace the extreme course of action that Lerner dismisses as "politically and morally unacceptable." 

At the close of the decade, then-Fed chair Paul Volcker implemented such steep interest rate hikes that they sparked a deep recession, increased unemployment, and eventually drove down wages. These monetary policies were accompanied by other political and social changes that broke the back of organized labor, ending any significant role for Lerner's "administrators" in the setting of wages and prices going forward. 

As a result, American politicians tamed inflation alright—but at what cost? The decades that followed showed few real wage gains for ordinary workers. The immense prosperity that was unleashed by subsequent economic booms was not widely shared, and inequality skyrocketed. America chose the path Lerner had contemplated but then dismissed as too morally hideous to even treat as a serious option: and the results were not pretty, just as Lerner would have predicted. 

I'm not sure Lerner has shown us a convincing way to avoid a repetition of these perils, however—at least not one that would also banish inflation. After all, even his analysis suggests that the type of inflation we are experiencing right now—which could not be described as stagflation of either type II or type III—can only be defeated through restrictive fiscal and monetary policies. 

Yet, there are also indications in Lerner that, even if there is truly no way out of this dilemma—that is to say, we have to choose between inflation or at least a slight increase in unemployment, at least when we are dealing with the classic type of inflation we seem to be experiencing now—then we might still be better served by erring on the side of the former than the latter. This is not because inflation is an insignificant problem—Lerner emphasizes the peril and injustice it imposes, especially to people living on fixed incomes (one is reminded of the retirees in a poem by Charles Bukowski who, after having "worked a lifetime," have now been "trapped" by inflation). Rather, the choice is worth making because unemployment is even worse. If we have to choose between some mild levels of either, it would be better to chose mild inflation than mild unemployment. 

There are hints that some international economic advisors are starting to wake up to this possibility. In a world where the global economy seems to be straining at the leash to grow, some are wondering whether it is really worth resisting this growth and risking a global financial crisis and recession just to bring the rate of price increases down to 2%. As the IMF's Gita Gopinath hinted a few weeks ago, central bankers around the globe may have to ultimately tolerate a slightly higher rate of inflation than their targets, in order to avoid having their policy response overcompensate in devastating ways—such as by triggering a financial meltdown (such as nearly occurred in the US a few months ago, after a string of bank failures caused by interest rate hikes). 

We've had experience over the last few decades, after all, of several possible worlds: the world with strong organized labor and high wage growth and inflation, and the world of minimal inflation but a shattered working class and high inequality, accompanied by a constant level of unemployment. Which of these we would prefer will probably reflect our politics and our own class position. But it seems to me at least that if the choice really is between greater bargaining power for workers and slightly above-target inflation on the one hand, versus recession and unemployment on the other, I would certainly take the former. 

Lerner would too: as he writes, the negative effects of inflation on those with fixed incomes are relatively concentrated and therefore easier to address; whereas the negative consequences of unemployment afflict the entire social fabric. Inflation would therefore need to get very severe indeed before it becomes truly worth the cost to willingly increase unemployment to combat it. The Fed and all our global economic policymakers should take heed. And so, even if Lerner's specific prescriptions really only apply to the stagflationary environment of the 1970s, his broader admonitions are still very on-point today.