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Column: Hooray for inflation

U.S. President Barack Obama applauds after announcing his nomination of Janet Yellen (C) to head the Federal Reserve as outgoing Fed chair B
U.S. President Barack Obama applauds after announcing his nomination of Janet Yellen (C) to head the Federal Reserve as outgoing Fed chair B

Nicholas Wapshott

There have been some extraordinary headlines in recent days. Here's the Economist: "The perils of falling inflation." Here's the Financial Times: "The euro zone needs to get inflation up again."

For those with memories of hyper-inflation and "stagflation" in the 1970s, these cogent pleas for higher prices is heresy, an irresponsible clamor for the return of an ever-changing fiscal landscape that led to widespread misery and economic turmoil.

A little history. By the mid-'70s the Western world was engulfed in an inflation typhoon — with prices rising rapidly and out of control. As companies increased prices to keep up with the higher costs of basic raw materials — such as oil, deliberately hiked way beyond the norm by the Organization of the Petroleum Exporting Countries — trade unions demanded higher wages to protect their members' standard of living. This led to higher costs, and higher prices, and so on.

The world became entangled in an apparently unstoppable upward spiral, like a crazy dog chasing its tail. Governments were blamed for it and broken by it, and new bold champions promising to slaughter the inflation dragon were elected in their place.

President Ronald Reagan here and Margaret Thatcher in Britain largely owed their precipitous rise to voters' weariness with the curse of inflation. And they both turned to economist Milton Friedman as a savior.

A perceptive student of economic history, Friedman and Anna Schwartz concluded that inflation was caused neither by rising costs nor the push of increased wages, but the amount of money in the system. As Friedman put it, "inflation is always and everywhere a monetary phenomenon." Monetarism was born and Keynesianism was put aside. A new Age of Inflation emerged — where inflation was the key indicator by which all government and central bank policies were measured.

It was not so much the Iranian hostage crisis that ditched President Jimmy Carter, but rather his failure to conquer inflation. He had appointed Paul A. Volcker, a Democrat, to be chairman of the Federal Reserve. But Volcker's prescription — to deliberately trip a recession to reboot the economy, and then keep a tight control of the money supply — came too late to save Carter from defeat after a single term.

Reagan's appeal for a return to "sound money" rang true with voters, and he kept on Volcker to finish the job. The result: inflation was licked, for a long while.

Fast forward to the fall of 2008, the collapse of the stock market and the freezing up of the financial system. Ruinous deflation became a serious risk. The emergency measures taken around the world, including the near $1 trillion injection of public money as a stimulus to keep the economy from total collapse, appeared to fly in the face of Friedman and all his works.

I say "appeared to" because Friedman is often misunderstood — not least by those who say they are devoted to him. Friedman and Schwartz had explored the reasons for the Great Depression and concluded that rather than the pricking of a stock prices "bubble," as Friedrich Hayek contended, the slump resulted from too little money in the system.

Friedman thought President Herbert Hoover should have pumped vast amounts of cash into the system, through public spending or what is known today as quantitative easing (QE). Friedman's embrace of ideas that are an abomination to today's conservatives explains, in part, why his centenary last year was barely celebrated: Most conservatives have switched their allegiance from Friedman to Hayek.

Friedman's main preoccupation was with inflation, but he was not against rising prices per se. He believed a certain amount of inflation was good for the economy — as long as it was kept in check. In practice, average inflation at or around 2 percent was considered optimum to keep the economy as a whole on track.

Inflation is good for business. It lubricates the wheels of commerce, allowing businesses to set prices at a level at which decent profits can be made. It automatically reduces wages over time, meaning workers have to return to employers each year simply to keep pace with the dropping value of their incomes.

But there are downsides, too. If inflation is too rapid, businesses find it hard to plan ahead and err on the side of higher prices, so as not to get caught out. People on fixed incomes, particularly those dependent on pensions and annuities, can slip behind as they watch their hard-earned savings melt away.

We are stuck now in a period of near stagnation, with growth ticking up but horribly fragile. Despite the Friedmanite prescription of QE, generously applied by Federal Reserve Chairman Ben Bernanke, Friedman's most distinguished disciple, growth remains elusive. Coming out of a slump as deep and treacherous as the 2008 Great Recession was always going to be a slow affair and those who blame it all on the current administration only betray their ignorance — or cynicism. To suggest that high growth can be instantly restored by slashing government spending and paying off the national debt is as rational as the gobbledygook spouted at the Mad Hatter's tea party in "Alice in Wonderland."

With the Tea Party rump in the House preventing any fiscal measures by the administration, and with the European Union stuck in a deflationary spiral thanks to austerity, there is growing pressure on both sides of the Atlantic to try to energize economic activity by provoking inflation. So far, no one who can make that happen is listening, since they are still trying to keep the world economy from slipping into ruinous deflation and another general recession.

The European Central Bank last week reduced interest rates to a record 0.75 percent. Bernanke, after frightening the markets by hinting that QE would be "tapered" soon, is keeping interest rates low and has extended QE to the horizon. The message from the central banks is clear: if you are thinking of borrowing to invest and create jobs, be assured, cheap money is here to stay.

The central bankers are right. This is no time to pretend that all is well and that a little more inflation is in order. Inflation will return in its own good time. But right now a hike in interest rates would deter borrowing, undermine the frail housing market revival, kick the stock market in the teeth as investors rush to safer, more predictable savings havens, and stifle the mewling recovery in its crib.

So, enough with the talk of cranking up prices and interest rates. The best way to get the world spinning faster is to increase economic activity — not to slow it.

(The author is a Reuters columnist. The opinions expressed are his own.)

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