Why Economists are Rooting for Inflation

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In most people’s minds inflation is up there with unemployment as one of the main ills you don’t want an economy to come down with. But in fact a growing number of economists are arguing that rising prices are exactly what we need to cure our the current economic maladies. It may not be the best answer, but it could be the easiest one to achieve.

The latest economists to get on the inflation bandwagon are Menzie Chinn of the University of Wisconsin-Madison and Jeffry Frieden, who teaches international monetary policy at Harvard. The two professors, who wrote a book about the financial crisis called Lost Decades that was published in September, and who recently penned an article for Foreign Policy magazine, argue that the reason recoveries after financial crises are painfully slow is that credit shocks stymie everyone. Banks stop making loans in order to heal. Consumers use extra cash to pay down debts. And governments lapse into gridlock as politicians argue over who should take the hit for their countries’ debts: taxpayers, government workers or the poor. But Chinn and Frieden argue there is a way to heal banks, borrowers and the government at the same time: Higher prices.

The argument for inflation is two-fold. One, inflation would shrink the value of the debts both the government and borrowers have to pay, improving our collective balance sheets. Higher salaries would also make it easier for borrowers to pay back their loans helping banks. Two, and this might be the more important reason now, inflation pushes people and companies to spend money. If you know prices are going to drop or stay flat, then you will delay a purchase. That’s why most of us are late adopters when it comes to technology. But if you know prices are going to rise, then you will spend your money now. So increasing inflation could stimulate the economy, as well as lower our debts.

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Chinn and Friedan also argue that higher inflation could make it harder for China, and others, to continue to peg its currency to the dollar. If the dollar falls in value, that would make U.S. goods cheaper abroad and hopefully stimulate demand.

Despite fears, inflation is relatively low these days. In the past year, prices have risen 3.4%. That was up from 1.4% a year ago. But that has been falling recently. And much of the jump in the past year in inflation has come from higher gas prices. Exclude food and energy, though, and prices are up just 2.2%. Chinn and Frieden say that if the Federal Reserve were to raise its inflation target to 6% a year, from its unofficial but long understood target of 2%, that would boost demand and increase growth with few downsides.

(MORE: Is Bernanke the Most Inflationary Fed Chairman Ever?)

Some members of the Federal Reserve do seem to be on board with the idea that we need more inflation. In December, Chicago Fed Bank president Charles Evans said the U.S. central bank should be willing to allow higher than desired inflation for a time in order to lower joblessness. Ken Rogoff, too, an economist at Harvard, and co-author of an influential book on recessions and financial crises, has argued for some time that the best way to get the U.S. out of its fiscal hole would be to promote more inflation.

Not everyone agrees. Back in September, Paul Volcker, the former Fed chairman who whipped inflation in the early 1980s, wrote in the New York Times that the stimulative effects of inflation are short-lived, but the damage of higher prices can last for a long-time. Volker argued that once central banks start using inflation as a way to goose the economy, a 6% target can quickly turn into a 8% and so on. There is no end in sight. Instead, Volker says he supports new government spending to boost the economy.

(MORE: The Case for Inflation)

And that might indeed be a better way to go. Another option, also in the current issue of Foreign Policy, which is focused on the economy, is to institute a delayed consumption tax. If the government were to pass a national sales tax that didn’t go into effect until mid-2013 that might boost demand in the same way as inflation, because of fear that a new tax would make things more expensive. What’s more, it would raise money for the government and it could also be something that could be lowered in the future to help stimulate the economy the next time we get into trouble. The problem with these two options is that they would have to get passed in Washington, which isn’t doing much of anything these days and is unlikely to do anything big in an election year.

And that’s what makes inflation an intriguing solution. It’s something the Fed could do on its own, and get done now. And in part, by promising to keep interest rates low until mid-2013, the Fed has to some extent already embarked on a pro-inflation path, which, if the recent jobs report is to be believed, is working.