What’s so bad about inflation?
In contrast to the tiny costs of inflation, the costs of unemployment are enormous
I'm recovered from the flu, but it turns out it was that dirty rotten swine thing, after all. There I was, four days in bed, feeling lousy. At least I was able to use my laptop, even if nobody wanted to come near me. I can't imagine why. The flu has helped, however, with the diet I have been on since I left the Monetary Policy Committee of the Bank of England. Down 17 pounds and counting.
But to business. In his speech to the Tory conference, David Cameron discussed what he felt was the way out of the economic crisis. His three options were as follows, and I quote:
“Option one: we can just default on the debt. Not pay it. Other countries have done that in the past. But I don't think anyone in this country wants to go down that road.
“Option two: we could encourage inflation, which would wipe out the value of the debt, making it easier to pay off. But that's not just an economic disaster, it's a social disaster, too. It doesn't just wipe out debts, it wipes out people's hard-earned savings.
“So we have the third option - for me, the only option. We must pay down this deficit. The longer we leave it, the worse it will be for all of us."
So let's take a look at each of these. I like one; see if you can guess which.
Option one. Cameron is telling the markets that he has even considered the possibility of defaulting on the debt. He is more economically naive than I thought. All he had to say, on this issue, was that such a possibility would be unthinkable in a century of Thursdays and then change the subject.
Option three. This is a non-starter, as I have said many times. Lesson number one in a deep recession is you don't cut public spending until you are into the boom phase. John Maynard Keynes taught us that. The consequence of cutting too soon is that you drive the economy into a depression, with the attendant threats of rapidly rising unemployment, social disorder, rising poverty, falling living standards and even soup kitchens. Such proposals could push the British economy into a spiral of decline that would be almost impossible to reverse for a generation. In a deep recession, the choice is "the government does it, or nobody does it". It is public spending versus no spending. You don't worry about paying off the debt when you are at war: you have other priorities. Win the war first. Nope, not that one.
So that brings us to option two. Thanks, Dave, this looks a pretty darn good idea to me, even if you disagree. Just reflate the debt away. Moderate inflation would lift people out of negative housing equity. A few years of inflation of roughly 5 per cent or so would be very attractive right now. Maintain the monetary stimulus and if necessary expand it further for the foreseeable future, and keep the fiscal stimulus going. Too much is better than too little. And, for goodness' sake, don't start paying back the public debt until we are well out of recession.
What would be so bad about a bit of inflation? Would it really be a social or an economic disaster? Actually, probably neither. Some possibility of inflation some time in the future isn't worth worrying about. As for Cameron's point about savings, savers always have the option of protecting themselves from inflation by investing in index-linked products, such as index-linked saving certificates from National Savings & Investments. In any case, if we had lots of inflation we would know what to do about it. The Bank of England would tighten monetary policy. The chances of runaway inflation right now are essentially nil.
In contrast to the tiny costs of inflation, the costs of unemployment are enormous, not least because of the lost output involved. Unemployment is a stressful life event that makes people unhappy. It increases susceptibility to illness, mental stress and loss of self-esteem, leading to depression and reduced life expectancy. The unemployed appear to have a higher propensity to commit suicide. As unemployment rates increase, crime rates tend to rise, especially property crime.
Increases in the unemployment rate lower the happiness of everyone, not just the unemployed. The fear of becoming unemployed lowers a person's subjective well-being. Unemployment is especially harmful to the young, as it causes permanent scars rather than temporary blemishes. In normal times, a 1 percentage point increase in unemployment lowers people's well-being twice as much as a 1 percentage point increase in inflation. The so-called misery index is nearer to two than to one. Today, a 1 percentage point increase in inflation would raise, not lower, our well-being.
It also has to be said, the whole intellectual basis for an inflation target is dead: set a target, establish an independent central bank with a committee of economists whose sole purpose is to target inflation only and economic nirvana will be guaranteed. It didn't turn out that way for the Bank of England. Various members of the MPC are still burbling on about the importance of the inflation target. Sorry, but that whole idea is dead and buried. It failed. It didn't deliver the promised stability, far from it. It unloaded on us the worst financial shock in a hundred years. The Great Moderation was just luck.
Unemployment matters most
Now is the time to consider getting rid of the inflation target altogether, or at least changing it. The last thing we want is for the MPC to start raising rates or reversing quantitative easing any time soon. Now is the time to consider explicitly including unemployment in the MPC's mandate. Another option would be to switch to the all-items retail price index, which includes mortgage payments, and stands at -1.4 per cent compared with 1.1 per cent for the consumer price index, which the Bank of England has to target currently. Both would have the effect of keeping monetary policy loose for longer.
The legislation does allow for the government, if the national interest demands it, to give instructions to the Bank on interest rates for a limited period. These feel like "extreme circumstances" to me. Demand away, Alistair.
To repeat: unemployment matters more than inflation, in this world rather than in the made-up dreamworld most economists live in. Time to keep the man on the Clapham omnibus in a job. So, Dave, I vote for option two, please.
David Blanchflower is professor of economics at Dartmouth College, New Hampshire, and at the University of Stirling
Watch an interview with Prof Blanchflower on YouTube