What Should We Do About Inflation? (Part 1)
The appropriate response depends on the cause of the problem.
Prices are rising too fast. The U.S. Consumer Price Index has been rising about 0.7% each month since early 2021 and is currently rising at a yearly rate of 10%.
This is toxic. Despite significant income and wealth gains over the period, Americans are about as pessimistic about the economy as they were during the depths of the global financial crisis thanks to negative “news heard about price changes”. The change in the outlook has translated into a sharp decline in the net approval ratings for incumbent federal politicians.1
Simply recognizing that inflation is a problem, however, is not the same as knowing what to do about it. Despite an apparent consensus that something must be done, there is little agreement about what should be done. Some of the more popular proposals include pushing the economy into a downturn, outlawing price increases, heightening antitrust enforcement, boosting government spending on investment and research, and opportunistically rolling back regulations on everything from housing to immigration to trade.
While (some) of those ideas may be worthwhile for their own sake, determining which, if any, is the appropriate response to the inflation we are currently experiencing requires understanding the specific dynamics driving recent price increases.
In what follows, I will lay out my framework for thinking about inflation in general as well as my analysis of the main forces causing inflation to be such a problem now. Space constraints require that I share my detailed thoughts on how to manage the challenges of the current situation in a subsequent note.
Inflation as Adjustment Mechanism
There are many ways to determine who gets what. Tribal chieftains might dole out choice cuts of meat as favors. Communist or wartime governments allocate rations. In a state of anarchy, armed gangs take what they want by force. Market-based societies use prices and money+credit: people buy what they want according to their preferences and according to how much spending power they have at their disposal.2 The price of any individual good or service (or asset) is therefore the result of how much money and credit people are willing to spend on it vs. how much is actually available.3
Prices of specific items can go up and down for all sorts of reasons relating to changes in both supply and nominal spending power. The Patagonian Toothfish became far more popular—and pricier—once its name was changed to “Chilean Sea Bass”. Californian Merlot prices and sales temporarily dipped after Paul Giamatti used colorful language to express his disdain for the varietal in a movie. Housing costs in New York City rose far more than in Detroit after 1970, despite being comparable before then. Assets that come to be viewed as safe collateral appreciate far more than those that do not.
None of these changes should be understood as inflation or deflation, but as shifts in relative prices. Inflation is when prices in general are going up. But “in general” is where things can get tricky.
At any given point in time, businesses in a market-based system are capable of producing a wide range of goods and services. They are constantly adapting to compete with each other to deliver more of what consumers (and other businesses) want, while shedding excess capacity that is unneeded. As efficiencies improve, new technologies are invented and deployed, populations grow, and as businesses continue to invest in expanding their productive potential, the scope for consuming more and more goods and services continues to rise.
The job of macroeconomic management is making sure that there is enough nominal spending power available to absorb all that additional production—but not so much that it pushes up prices across the economy. Ideally, the result is a steady increase in living standards alongside stable prices (on average).
From this perspective, it’s useful to think of three basic scenarios (not mutually exclusive) that could cause inflation to emerge:
Society’s ability to produce goods and services keeps growing roughly in line with its longer-term trend, but for various reasons policymakers allow (or actively encourage) nominal spending power to rise substantially faster. Instead of translating into higher living standards, the surfeit of money and credit leads to higher prices. The policy error could come from political pressures to goose spending beyond what is economically sustainable, or it could simply be an honest mistake during a period when the trend growth rate was slowing down for other reasons.
Nominal spending power was growing more or less in line with productive capacity, but then something happens to disrupt production. Inflation results as roughly the same amount of money and credit is used to bid up the prices of fewer goods and services. Policymakers could try to push money and credit down to meet the new (lower) level of supply, but that would create substantial costs for society and risk pushing the economy into a debt crisis.
Both nominal spending and productive capacity continue proceeding as normal, but sudden massive changes in what people want to buy relative to what’s available creates significant shortages (and gluts) across a wide range of categories. Businesses try to respond, but it takes time to change the mix of workers and machines even as the need to adapt increases demand for investment inputs. In theory, policymakers could avoid inflation in this scenario by ensuring that prices fall enough in the out-of-favor categories to offset the price increases for in-demand goods and services, but calibrating everything correctly would be challenging. Moreover, the large drops in income for certain segments of the economy would create significant risks even if other sectors were experiencing windfalls.
Crucially, while the inflation in scenario 1 is the result of a mistake, inflation in scenarios 2 and 3 is chosen by policymakers as the least worst way to manage a painful social change outside of their control. (Hence the orthodox view that central banks need to be wary of overreacting to commodity price spikes.) Inflation in those scenarios helps businesses and consumers adjust from one order to another. The alternative would be for policymakers to deliberately introduce a mismatch between incomes and debts that would lead, in the extreme, to mass bankruptcies, foreclosures, and business liquidations.
The danger, as I have explained before, is that even if tolerating excessive inflation might seem to be the best policy at any given point in time, it could still turn out to be the wrong policy over time. Prolonged inflation runs the risk of changing consumers’, workers’, and businesses’ behaviors in ways that undermine living standards. Once people switch from thinking that inflation is nothing to worry about to thinking that inflation is a significant financial risk that needs to be hedged, everyone is in trouble.