Wednesday, June 23, 2010

Don't Fear the Next Inflation, If It Comes

Copyright, The New York Times Company

Economists disagree about the prospects for inflation. But inflation may be something to welcome, not fear.

Prices in the economy ultimately depend on the demand for goods relative to the demand for dollars and related assets (such as Treasury securities) whose values are specified in dollars. Prices in the economy increase – that is, there is inflation – when demand for goods increases more than demand for dollars and related assets.

Economists agree that the deflation of 2008-9 – when prices fell in the economy – resulted from a “flight to quality,” a rather sudden reduction in demand for goods and increase in demand for dollars. They agree that, in principle, inflation will occur in the future if demand suddenly shifts in the opposite direction.

But there is a lot of debate as to what will happen to the relative demand for goods, and therefore disagreement about the future of inflation. Some economists say investors over the next several years will continue to demand dollars, so future deflation is the more likely danger. Continued glimpses of deflation – such as the fall in the consumer price index from April to May 2010 – give some support to that view.

Other economists, including John Cochrane of the University of Chicago in this recent paper, say our government budget is on an unsustainable path, with lots of public spending promised and elected officials who lack the political will to raise taxes. The Treasury, they say, will make ends meet by flooding the market with Treasury securities, thereby causing inflation.

Clearly our government has promised a lot of public medical care, as well as much spending on pensions both for future Social Security recipients and for retired public employees. Few elected officials want to crusade for higher taxes. But our aging population and public medical spending that grows faster than the rest of the economy are nothing new to 2010.

History certainly has examples of high inflation that resulted from dire fiscal situations. But there are also many examples of governments that fueled new spending programs by raising taxes or by cutting other spending. Our government may well raise taxes, cut military spending or cut spending on certain types of health care.

So the real question is whether the economic damage from inflation is more or less than the economic damage of raising payroll taxes, implementing a national sales tax or paring some of the government’s spending promises.

The answer is that inflation is less costly now than it usually is. Inflation would alleviate some damage done by the housing market to the wider economy. Specifically, inflation would raise prices of homes, among other things. Higher housing prices would pull a number of mortgages out from under water – the case when more is owed on a mortgage than the market value of the house that collateralizes it – and thereby reduce the number of foreclosures.

So even if our government had its fiscal house in order, the reason to expect inflation is that inflation wouldn’t be so bad right now.

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