Thursday, June 21, 2012

In Which Ben Bernanke Turns me into William Jennings Bryan

On July 9, 1896, William Jennings Bryan gave a famous speech in which he uttered the words, "you shall not crucify mankind upon a cross of gold." In a nutshell, he was speaking out against the gold standard's deflationary effects on the American economy. Basically, he was complaining that the gold standard was constraining economic growth by not providing enough inflation. That's essentially how I feel after yesterday's FOMC (Federal Open Market Committee) statement. I'm not really going to delve into their extension of Operation Twist, because it likely won't do much to help the economy. Instead, I'm going to run through sort of a thought experiment on the trade-off between inflation and unemployment.

First, some basic economics. For those of you who don't know, there's something called the short-run Philips Curve, which looks a little something like this: 

Basically, the way it works (in theory) is that there's a short-run trade off in the nominal economy between the unemployment rate and the rate of inflation. So basically, higher inflation will yield lower unemployment, and higher unemployment will yield lower inflation. Generally speaking, this has held true over the past 50 or so years, with some exceptions (in which inflation was caused by real shocks to the economy, like the oil embargoes in the 1970s). Here's a graph of the unemployment rate (red) versus the inflation rate (blue):

You'll notice how, most of the time, spikes in unemployment correspond fairly well with dips in inflation. Like I said, exceptions to this exist, and the model has limitations. Economics isn't an exact science. But anyways, why is there such a trade-off?

During a recession, whether its caused by the Fed or by a financial crisis, unemployment goes up. When people don't have jobs, they obviously spend money less. Less money changing hands in the economy means that demand goes down for goods and services, so prices fall (or rise more slowly.) This is the basic Aggregate Demand/Aggregate Supply model that many of you have probably seen at some point. 

So when demand shifts to the left (drops) on the graph, you'll note that prices fall. Basically what I just said. On the flip side, when demand increases, prices go up because more people want limited amounts of goods. So raising prices is a way to ration limited goods. That's a pretty simplified version of the way things work. 

In any case, how is this relevant to Ben Bernanke, the Fed, or William Jennings Bryan? Well, think about it like this: Right now, the Fed has made an explicit promise to keep inflation at 2% basically no matter what. This is a self-defeating and stupid plan, given the circumstances. Think of it this way: in the 1980s, Paul Volcker, then Chairman of the Fed, clamped down on inflation, which had been running persistently high. He did this by tightening money  tremendously, causing unemployment to spike to 10%. Without getting too technical, he raised interest rates a great deal to kick inflation to the curb. Remember the Philips Curve? This is a perfect example of it in action. The costs of reducing inflation to a lower level were increased unemployment for a certain amount of time. That is to say, we were forced to tolerate a certain amount of elevated unemployment to bring inflation down.

Now let's imagine a world in which inflation is low, has been very low, and looks like it will remain low for the forseeable future. Let's also imagine that unemployment is elevated well above what we'd like it to be and has been for several years. We're not just imagining, though, because that's the situation we face today. So shouldn't we, like Volcker's Fed in the 80s, have to tolerate certain costs? Instead of higher unemployment, though, we would face a period of slightly higher inflation in order to bring down unemployment. Effectively, the situation has been reversed. Yes, elevated inflation is bad, and it is damaging in the long run for the economy, but so is persistently high unemployment.  

This brings be to the Fed's 2% inflation target. Having an explicit 2% inflation target makes a robust recovery a nearly impossible prospect. But that's basically what Ben Bernanke reiterated yesterday--a firm 2% target. That would be like Paul Volcker circa 1981 saying, "Oh, we're committed to keeping unemployment low, but we're also going to bring down inflation." It can't really be done, so far as I can tell. Keeping a 2% inflation ceiling in place serves only to keep any prospect of recovery a distant dream, at best. 

And before anybody jumps on me as some sort of a money-printing inflation-lover, let me point out that different circumstances often necessitate different policy choices. By all means, keep a 2% inflation target when unemployment is at 5% and the economy is doing just fine. However, the idea that we should cling to one whilst unemployment is at 8.2% seems, at best, foolish. So why are we doing just that?

Somebody? Anybody?

P.S. Matt Yglesias has an excellent post about how a jobs boom necessitates higher inflation for a period of time. I found in incredibly relevant to this post.


  1. My answer to your concluding question would be model risk. Often policy makers don't trust ivory tower models enough to use them. Rightfully so, I think.

    Noah Smith nails it:

  2. Yeah, I've read that post before and I think he's right to make those points. But the problem I have right now is best explained by this post by Sumner:

  3. Sometimes I feel like Sumner thinks the FOMC is a magical wizard committee that can just wave a wand and set inflation at a certain level. 5.5% inflation isn't the issue. The issue is the RISK of even higher inflation than that. We don't know how much Fed action it would take to put a dent in unemployment, and we don't know what kind of inflation risks those actions would entail.

  4. There are always model uncertainties though. Doing nothing carries with it the very certain risk of having persistently high unemployment.

  5. Prolonging the recession by a few years is not so bad compared to runaway inflation expectations and the potential ramifications thereof.

  6. So what would be your prescription for improving the recovery, such as it is?

  7. I think the status quo is not so bad monetary-policy-wise. Sometimes the best medicine is just chicken noodle soup, sprite, and daytime television.

  8. This comment has been removed by a blog administrator.


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