SKOPJE, Macedonia, Sept. 26 (UPI) -- The sin committed by most central banks is their lack of symmetry. They signal visceral aversion to inflation, but ignore the risk of deflation altogether. As inflation subsides, disinflation seamlessly fades into deflation. People -- accustomed to the deflationary bias of central banks -- expect prices to continue to fall. They defer consumption. This leads to inextricable and all-pervasive recessions.
Part I of this analysis appeared Wednesday.
Inflation rates, as measured by price indices, fail to capture important economic realities. As the Boskin commission revealed in 1996, some products are transformed by innovative technology even as their prices decline or remain stable. Such upheavals are not encapsulated by the rigid categories of the questionnaires used by bureaus of statistics the world over to compile price data. Cellular phones, for instance, were not part of the consumption basket underlying the consumer price index in America as late as 1998. The consumer price index in the United States may be overstated by one percentage point year in and year out, was the startling conclusion in the commission's report.
Current inflation measures neglect to take into account whole classes of prices, for instance, tradable securities. Wages -- the price of labor -- are left out. The price of money -- interest rates -- is excluded. Even if these were to be included, the way inflation is defined and measured today, they would have been grossly misrepresented.
Consider a deflationary environment in which stagnant wages and zero interest rates can still have a -- negative or positive -- inflationary effect. In real terms, in deflation, both wages and interest rates increase relentlessly even if they stay put. Yet it is hard to incorporate this "downward stickiness" in present-day inflation measures.
The methodology of computing inflation obscures many of the "quantum effects" in the borderline between inflation and deflation. Thus, as pointed out by George Akerloff, William Dickens, and George Perry in "The Macroeconomics of Low Inflation" (Brookings Papers on Economic Activity, 1996), inflation allows employers to cut real wages.
Workers may agree to a 2 percent pay rise in an economy with 3 percent inflation. They are unlikely to accept a pay cut even when inflation is zero or less. This is called the "money illusion." Admittedly, it is less pronounced when compensation is linked to performance. Thus, according to The Economist, Japanese wages -- with a backdrop of rampant deflation -- shrank 5.6 percent in the year to July as company bonuses were brutally slashed.
Economists in a November 2000 conference organized by the European Central Bank argued that a continent-wide inflation rate of 0-2 percent would increase structural unemployment in Europe's arthritic labor markets by a staggering 2 percentage points to 4 percentage points. Akerloff-Dickens-Perry concurred in the aforementioned paper. At zero inflation, unemployment in America would go up, in the long run, by 2.6 percentage points. This adverse effect can, of course, be offset by productivity gains, as has been the case in the United States throughout the 1990s.
The new consensus is that the price for a substantial decrease in unemployment need not be a sizable rise in inflation. The level of employment at which inflation does not accelerate -- the non-accelerating inflation rate of unemployment or NAIRU -- is susceptible to government policies.
Low inflation, bordering on deflation, also results in a "liquidity trap." The nominal interest rate cannot go below zero. But what matters are real -- inflation adjusted -- interest rates. If inflation is naught or less, the authorities are unable to stimulate the economy by reducing interest rates below the level of inflation.
This has been the case in Japan in the last few years and is now emerging as a problem in the United States. The Fed, having cut rates 11 times in the past 14 months and unless it is willing to expand the money supply aggressively, may be at the end of its monetary tether. The Bank of Japan has recently resorted to unvarnished and assertive monetary expansion in line with what Paul Krugman calls "credible promise to be irresponsible."
This may have led to the sharp devaluation of the yen in recent months. Inflation is exported through the domestic currency's depreciation and the lower prices of export goods and services. Inflation thus indirectly enhances exports and helps close yawning gaps in the current account. The United States with its unsustainable trade deficit and resurgent budget deficit could use some of this medicine.
But the upshots of inflation are fiscal, not merely monetary. In countries devoid of inflation accounting, nominal gains are fully taxed -- though they reflect the rise in the general price level rather than any growth in income. Even where inflation accounting is introduced, inflationary profits are taxed.
Thus inflation increases the state's revenues while eroding the real value of its debts, obligations, and expenditures denominated in local currency. Inflation acts as a tax and is fiscally corrective, but without the recessionary and deflationary effects of a "real" tax.
The outcomes of inflation, ironically, resemble the economic recipe of the "Washington consensus" propagated by the likes of the rabidly anti-inflationary International Monetary Fund. As a long-term policy, inflation is unsustainable and would lead to cataclysmic effects. But, in the short run, as a "shock absorber" and "automatic stabilizer," low inflation may be a valuable counter-cyclical instrument.
Inflation also improves the lot of corporate and individual borrowers by increasing their earnings and marginally eroding the value of their debts (and savings). It constitutes a disincentive to save and an incentive to borrow, to consume, and, alas, to speculate. "The Economist" called it "a splendid way to transfer wealth from savers to borrowers."
The connection between inflation and asset bubbles is unclear. On the one hand, some of the greatest fizz in history occurred during periods of disinflation. One is reminded of the global boom in technology shares and real estate in the 1990s. On the other hand, soaring inflation forces people to resort to hedges such as gold and realty, inflating their prices in the process. Inflation, coupled with low or negative interest rates, also tends to exacerbate perilous imbalances by encouraging excess borrowing, for instance.
Still, the absolute level of inflation may be less important than its volatility. Inflation targeting -- the latest fad among central bankers -- aims to curb inflationary expectations by implementing a consistent and credible anti-inflationary as well as anti-deflationary policy administered by a trusted and impartial institution, the central bank.
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