Why Oh Why Can't We Have a Better Press Corps? Yet More Misinformation from the Washington Post Edition
A 2% Inflation Target Is too Low...

Shoe Leather Costs

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Live at the Economist: Economist Debates: Inflation: Guest:

Some of Bennett McCallum's arguments seem to me to be simply wrong—or at the very least unsupported. For example:

In developed economies … there is now a downward bias in the reported inflation values … Today we pump our own gasoline, arrange our flight schedules without the help of a travel agent, and ring up our own grocery purchases … our product purchases now come supplied with fewer services … [and so while] true inflation was often overstated in the past, today it is most likely understated by the official price statistics."

Some of Mr McCallum's arguments I simply do not understand. For example:

An increase in the target inflation rate would tend to undermine the rationale for central bank independence. Furthermore, it would constitute an additional movement away from recognition of the economic necessity for intertemporal discipline. Indeed, legislators could take an increase in the inflation rate expected over the future as a signal that their society is not willing to embark on serious budget-cutting fiscal reforms."

What does choosing between 2%, 3% or 4% as your long-term target inflation rate have to do with central-bank independence? Or intertemporal discipline? Or with the willingness of a government to—as did the Clinton government I worked for—try to balance spending promises and taxes, as opposed to the unwillingness of the governments Mr McCallum has supported—the Reagan and Bush governments—to do so?

None of these are clear to me.

Some of Mr McCallum's arguments apply to other economies with very different institutions from ours. For example, he talks about:

  1. shifting from using open-market operations to reduce short-term nominal safe interest rates as our standard tool of demand management to some other tool;
  2. somehow, without lowering short-term nominal interest rates below zero, managing demand by depreciating the dollar to boost exports;
  3. eliminating currency so that there would be no problem with the Federal Reserve making the short-term safe nominal interest rate negative.

As I read these, I flash immediately to an exchange from the movie "Toy Story":

Buzz Lightyear: "I would like you to know that even though you tried to terminate me, revenge is not an idea we promote on my planet."
Woody the Cowboy: "Oh … That's good."
Buzz Lightyear: "But we're not ON my planet, ARE we?"

So I believe that I should spend my time discussing Mr McCallum's main argument, the one that I think applies to this world, that I understand and that I do not believe is wrong. It is Mr McCallum's argument—picked up from Milton Friedman—that the right inflation rate for a modern economy should be something like –3% per year. Yes, that is MINUS THREE PERCENT PER YEAR: DEFLATION at the rate of 3% per year.

As I understand it, the idea is that the government issues two kinds of debt: bonds which pay interest, and currency which does not pay interest but which is legal tender. If only the inflation rate were –3% per year, currency would be more valuable than it is in this world because the ongoing deflation would mean that you would not have to sacrifice earning real interest to hold your wealth in the form of money. As a result everybody would carry lots of cash on their person at all times, and you would not have to waste time going to the bank to replenish your cash (or to transfer wealth from your interest-earning portfolio to your cheque account) when you were running out.

Say that if cash in my pocket earned the same real rate of return as bonds in my portfolio, I would carry more cash and find myself having to stop at the ATM only once a quarter rather than once a week. Say it takes me six minutes to go the ATM. Say my time is worth $30 per hour at the margin. Say that other portfolio swaps I would no longer have to do are of equal value. Then I would gain $6 per week or $300 per year from a deflation rate of 3% per year. Say I am representative of 200m American adults.

That is a net welfare gain of $60 billion a year for America from this "reduced shoe leather wear" effect of having an inflation target of –3% per year.

The lost production from the recession that began in 2008 has so far amounted to $2.6 trillion. The meter is still running at a current rate of $1.04 trillion per year. It will be at least $4 trillion before we are through.

How often would we hit the ZLB if we had a target inflation rate of –3% per year? Scanning back over the past, we would have hit it now, in 2001, in 1992, in 1987, in 1982, in 1975 and in 1971—at least seven times in the past 40 years, once every six years.

Those other episodes would not have proved to be as bad as this one, with its $4 trillion of output losses. But they would have been bad.

A $60 billion per year welfare gain in reduced time spent shuffling assets seems to me a high price to pay for an appreciable upping of the chances of an expensive macroeconomic disaster like the one we are now going through. We need the power to boost economy-wide aggregate demand when there is a private-sector scramble for liquidity or safety or duration putting downward pressure on total spending. That is a valuable thing to have. A 2% per year inflation target gives us some such power, and a 3% or 4% per year inflation target would give us more. A –3% per year inflation target would give us none at all.