The Return of Inflation Politics

Oliver Blanchard, chief economist of the IMF, has made the suggestion to raise the central bank’s target rate of inflation to 4 % arguing this would give central banks more flexibility. He claims the current crisis shows that this has become necessary and points out deflation plagued Japan as a negative example. The IMF has started rethinking some of its long held stances in the wake of the crisis. It went that far as to release a report promoting capital controls to prevent the influx of speculative capital. This time, Mr. Blanchard is either quite on the wrong track or hiding his true motives.

I started studying with Blanchard’s introductory macroeconomics textbook and one topic covered is called the liquidity trap. It describes a situation where the central bank cannot stimulate the economy further by lowering the interest rate, that is to say a situation that exactly describes current economic reality. Saying times have changed and we need to raise the “normal” level of inflation to avoid getting into that trap again is quite shortsighted and is certainly not a lesson of this crisis. Say we hit the inflation target every year we have accumulated inflation of well above 100 % over the course of the next twenty years. That is hardly price stability. The reasons why we are in this crisis are much too complex and a repetition can be prevented in other ways such as by reforming financial systems and public spending policies. Quite likely a target inflation of 4 % would have left us in the same situation and being caught in the liquidity trap would have been, if anything, merely delayed. Somehow it seems people always start forgetting the effects of one economic evil if it hasn’t occurred in a long time. Inflation has enough negative effects to justify a goal of stricter price stability than 4 %.

If, however, the IMF is barely hiding an uneasy truth, it might do a good job convincing citizens of giving up price stability. The truth is that we have little other choice than getting prepared for much higher inflation. In the very short run overcapacities are still putting pressure on prices and create deflationary tendencies. Famously coined by Milton Freedman, inflation is always and everywhere a monetary phenomenon and in the middle run the excessive liquidity pumped into crisis-ridden economies will push inflation. A bit longer down the road is a much worse problem: governments will need inflation. It is impossible to repay national debts that are, as it is becoming increasingly evident, much higher than previously claimed. Inflating away some of the obligations will be inevitable to prevent total fiscal collapse. Inflation of 2 % will not do the trick. It is questionable whether 4 % will do.