- Feb 11, 2010
Paul Krugman's latest editorial is a discussion of inflation. Krugman looks at a recent IMF report that analyzes "lowflation" -- inflation that is above zero, and, therefore, presumably, avoids the dangers of deflation, yet, is still very low.
First, lets talk about the case for higher inflation.
Many people understand that a falling price level is a bad thing; nobody wants to turn into Japan, which has struggled with deflation since the 1990s. Whats less understood is that there isnt a red line at zero: an economy with 0.5 percent inflation is going to have many of the same problems as an economy with 0.5 percent deflation. Thats why the I.M.F. warned that lowflation is putting Europe at risk of Japanese-style stagnation, even though literal deflation hasnt happened (yet).
Moderate inflation turns out to serve several useful purposes. Its good for debtors and therefore good for the economy as a whole when an overhang of debt is holding back growth and job creation. It encourages people to spend rather than sit on cash again, a good thing in a depressed economy. And it can serve as a kind of economic lubricant, making it easier to adjust wages and prices in the face of shifting demand.
But how much inflation is appropriate? European inflation is below 1 percent, which is clearly too low, and U.S. inflation isnt that much higher. But would it be enough to get back to 2 percent, the official inflation target in both Europe and the United States? Almost certainly not.
You see, monetary experts have long known about the case for moderate inflation, but back in the 1990s, when the 2 percent target was hardening into policy orthodoxy, they thought that 2 percent was high enough to do the job. In particular, they thought it was enough to make liquidity traps periods when even an interest rate of zero isnt low enough to restore full employment very rare. But America has now been in a liquidity trap for more than five years. Clearly, the experts were wrong.
Furthermore, as the latest I.M.F. report shows, theres strong evidence that changes in the global economy are increasing the tendency of investors to hoard cash rather than put funds to work, thereby increasing the risk of liquidity traps unless the inflation target is raised. But the report never dares to say this outright.