Larry Ball and Paul Krugman: The 4% Solution
Paul Krugman writes:
The Four Percent Solution: Larry Ball makes the case that we would be a lot better off with a 4 percent inflation target rather than the 2 percent that is now central bank orthodoxy. Intellectually, this position is hardly outlandish; indeed, Ball’s case is very similar to the case Olivier Blanchard made three years ago, just stated more forcefully and with more evidence. The basic point is that a higher baseline for inflation would make liquidity traps, in which conventional monetary policy is up against the zero lower bound, less likely and less costly when they happen. Ball estimates that if we had come into this crisis with an underlying inflation rate of 4 percent, average unemployment over the past three years would have been two percentage points lower. That’s huge — it amounts to millions of jobs and trillions of dollars of extra output.
There are two main arguments against a higher inflation target. One is that events like the current crisis almost never happen. My view would be that the costs of this crisis are so large — and the difficulties we’ve had in responding so grotesque — that even if they were once-in-75-year events, that should be enough to warrant different policies. But Ball also argues that the risk of liquidity-trap events is much greater than conventional wisdom would have you believe…. The other argument is some kind of slippery slope thing: you decide that 4 percent is OK, and the next thing you know you’re Jimmy Carter, or maybe Weimar. As Ball says, there is really no evidence for this fear….
The point is that the conventional 2 percent target is a prejudice, nothing more; it once rested to some extent on studies suggesting that 2 percent was enough to make the zero lower bound a non-problem, but we now know how utterly wrong that view was…. What do we want? Four percent! When do we want it? Now!
The case for 4% inflation: According to Ben Bernanke (2010a), the Federal Open Market Committee unanimously opposes an increase in its inflation goal, which ‘would likely entail much greater costs than benefits’. I examine the case for a 4% inflation target in a recent essay (Ball 2013) and reach the opposite conclusions to those of Chairman Bernanke: A 4% target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe. This important benefit would come at minimal cost, because 4% inflation does not harm an economy significantly….
Mishkin (2011), for example, argues: “Although [the zero bound] has surely been a major problem in this recent episode, it must be remembered that episodes like this do not come very often. Indeed, we have not experienced a negative shock to the economy of this magnitude for over seventy years. If shocks of this magnitude are rare, then the benefits to a higher inflation target will not be very large because the benefits will only be available infrequently.” In my view, Mishkin understates the risk of the zero bound. If we look beyond the US, the crisis of 2007-2009 is not unique in recent history…. More generally, history suggests that the zero bound is dangerous if central banks target 2% inflation. In my paper, I make this point by examining the eight US recessions since 1960…. Three of the eight recessions began with inflation rates between two and three percent…. One of the three is the Great Recession of 2008-09, when the zero bound constrained monetary policy severely…. In five of the eight recessions since 1960, inflation began above 4%…. But what would have happened if inflation had started at 2%?… history suggests that, with a 2% inflation target, the lower bound on interest rates is likely to bind in a large fraction of recessions.
Would 4% inflation hurt the economy? Economists have suggested various costs of inflation, such as variability in relative prices and distortions of the tax system. But research has not shown that these effects are quantitatively important for moderate inflation…
Yuriy Gorodnichenko and Michael Weber (2013) have what I believe is the only serious argument against a 4%/year inflation target: that the degree of nominal price rigidity our economy has is almost impossible to rationalize unless there are remarkably large costs to changing nominal prices. Their results are powerful enough to make me pause before endorsing Larry Ball's position, but only pause: I do endorse Larry Ball's proposal for a 4%/year inflation target.