Three cheers for inflation?

Economist and economic historian Nicholas Crafts is back in the public eye with a new pamphlet for CentreForum. Those with long memories of his previous controversial stances won’t be surprised to know this pamphlet does not take a mainstream approach to economic history or economic policy, instead praising part of the 1930s and calling for more inflation.

The two are linked because he splits Britain’s economic record in the 1930s in two, arguing that in the second half of the 1930s higher prices helped fuel a strong economic recovery:

Over fiscal years 1932/33 and 1933/34 the structural budget deficit was reduced by a total of nearly 2 per cent of GDP as public expenditure was cut and taxes increased, the public debt to GDP ratio stopped going up while short term interest rates stabilized at about 0.6 per cent. Yet, from 1933 to 1937 there was strong growth such that real GDP increased by nearly 20 per cent over that period.

In the early 1930s, fiscal consolidation without a compensating boost from monetary policy was not conducive to recovery and ran the risk of prolonged stagnation in a difficult world economic environment which had little to encourage business investment and exports. The potential parallels with today are readily apparent.

As now, in the 1930s interest rates were reduced to an extremely low level, leaving little scope for further economic boosts from shaving fractions of a percent off them. Yet what really matters is not the headline interest rate but the real interest rate, i.e. after allowing for inflation. So if you can’t cut the headline rate much more because it is already so close to zero, you can instead cut the real interest rate by upping prices. As Crafts argues,

The key to recovery was the adoption of credible policies to raise the price level and in so doing to reduce real interest rates by raising the expected rate of inflation. This provided monetary stimulus even though, as today, nominal interest rates could not be cut further. Fiscal stimulus was not a factor in the UK recovery until after 1935 when rearmament began…

A close approximation to the successful 1930s policy would be to commit to a price-level target which might entail an average rate of inflation of about 4 per cent for three years. Crucially, this would have to be clear and credible so that the inflation was fully anticipated by the public and it would work by reducing the real interest rate.

It is a provocative argument and one which comes with one additional advantage: higher inflation eats away at the value of accumulated debt, both government debt (the cause of so much political debate and strife) and also the less talked about but still important large levels of private debt that burdens huge swathes of the population.

Of course inflation is not exactly a policy without costs, economic or political. Eating into the savings of pensioners in particular is never popular. However, it’s not only a provocative but also well-argued case from Nick Crafts which is well worth a read in full.

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8 Comments

  • Inflation would get us out of the mess the three main parties created with their fiscal and monetary agreement in the mid-2000s (Yes, Labour were in charge, but there was no opposition the other two parties agreed with their policies and are therefore just as culpable). However, inflation of profits at the expense of wages when the fundamental imbalance is personal debt, doesn’t sound altogether convincing. Unfortunately, the monetary stimulus has so far succeeded in pushing up property prices in the South-East (where the financial services industry that has also benefitted from the stimulus is largely based) and preventing them from sliding elsewhere.

    Monetary stimulus is needed. Debt forgiveness through inflation is sadly necessary. However, what we need to prevent is the misallocation of capital that caused the problem in the first place. Sadly, our financial services industry and house prices have been propped up by the stimuli. All we need to do to put this right is to whack a Land Value Tax on the private rental market – house prices would fall, the banksters would have to take a hair-cut, first-time buyers would be able to buy at a sensible price, those that took on too much debt would still be receiving their forgiveness, the problems of the housing market would be solved almost instantaneously and the monetary stimulus might actually stimulate economically useful activities rather than aiding the land value gamblers.

    As the Daily Mash put it the other day (in response to the insanity of the government underwriting sub-prime lending): “If it’s broke fix it with the thing that broke it ”

    We’re doomed.

  • Aaarrgghhh – inflation does not reduce the levels of debt unless we have wage inflation.

    If we have high price inflation without wage inflation is makes paying off personal debt harder not easier.

    If I have a £30,000 income, a £10,000 debt and the my gas bill goes up from £1000 to £2000 a year then my debt has shrunk relative to my gas bill but given I pay both out my wages I have £1000 less to pay off my debt.

    If we are going to deliberately pursue an inflationary policy than you’d be better giving everyone a few thousand £. Then at least they could pay off debt and those without it could be protected from the effects.

  • And bugger anyone who lives on a fixed income.

  • Timak – Nick knows this, which is why he called for pre-announced inflation. This would then be taken into account by wage negotiators. If the firm and the staff know that inflation will be c. 4%, then both sides can build it into their calculations. We want wage a price inflation. That is why the policy needs to be pre-announced – otherwise we get the effects that you outline.

    Jayu – virtually no-one is on a fixed income. Pensioners are sometimes alleged to be, but the state pension would rise with inflation, as would almost all defined benefit pensions (teachers, nurses, etc). Those who are living in part off their savings would take a hit, but bluntly they are already taking a hit, and the last thing that they need is 10 years of Japanese style non-growth and ultra-low interest rates.

    Steve – Nick is very clear in the paper that the policy works best with flexible housing supply, so that greater demand for housing translates into more houses, not higher prices.

    (Declaration of interest: I commissioned and edited this paper at CentreForum, and am Nick’s co-author with my academic hat on.)

  • @tim leunig
    Thanks for the response.

    Slashing base rates had the effect of increasing demand for housing (particularly buy-to-let as the meagre returns began to look OK compared to interest on savings) and decreasing supply of existing stock to the market – the lower costs encourage people to hoard houses they would otherwise have disposed of. We need the monetary stimulus, but we don’t need greater demand in the form of cheap credit and decreased supply caused by low base rates. Building more houses is clearly a good thing, but it doesn’t address the immediate decrease in supply from the base rate slashing. Fiscal measures need to be taken – a tax on all housing would lead to a government being lynched, but something targetted at BTL would be more palatable.

  • Bill le Breton 27th Nov '11 - 10:39am

    Tim,
    Isn’t this price level targeting? When I pointed sumner to to the article in the FT about this paper he said it was New Keynsian. Surely if the ‘announcement’ was for NGDP at 5% then as inflation falls over the next 12 months we should see some increase in real output.
    You’ll hate this but if the housing was commissioned by local government and paid for by cheques drawn on the government’s acount at the bank of england then we would have both the increase in the money supply and the supply of housing.

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