|The New York Times
How a Little Inflation Could Help a Lot
By TYLER COWEN
BECAUSE fiscal stimulus has not yet been a striking success, perhaps
it’s time to consider new monetary remedies for the economy.
That is the argument of Prof. Scott Sumner, an economist at Bentley
College in Waltham, Mass., who is little known outside academic
circles but whose views have been spreading, thanks to his blog,
Professor Sumner proposes that the Federal Reserve make a firm
commitment to raising expectations of price inflation to 2 to 3
[I don't know why Cowen doesn't mention the fact that Krugman proposed
exactly this strategy for Japan during the 1990s.]
In his view, policy makers in Washington are doing too much with
fiscal policy — overspending and running excess deficits — and not
doing enough on the monetary side.
While his views are controversial, they are based on some assumptions
that are not. It is commonly agreed among economists that deflation
brings layoffs and sluggish investment. Yet, energy price shocks
aside, we have been seeing downward pressure on prices. Futures
markets and Treasury Inflation-Protected Securities — more precisely,
the spread between the yield on TIPS and traditional securities —
suggest current expectations that inflation will remain well under 1
percent. Economists generally agree that this is not ideal, and
Professor Sumner urges the Fed to try especially hard to overcome the
But how would the Fed accomplish this feat? This is where his
recommendations get interesting.
The Fed has already taken some unconventional monetary measures to
stimulate the economy, but they haven’t been entirely effective.
Professor Sumner says the central bank needs to take a different
approach: it should make a credible commitment to spurring and
maintaining a higher level of inflation, promising to use newly
created money to buy many kinds of financial assets if necessary. And
it should even pay negative interest on bank reserves, as the Swedish
central bank has started to do. In essence, negative interest rates
are a penalty placed on banks that sit on their money instead of
Much to the chagrin of Professor Sumner, the Fed has been practicing
the opposite policy recently, by paying positive interest on bank
reserves — essentially, inducing banks to hoard money.
[how does penalizing banks for holding reserves (used to back up
deposits) deal with the balance-sheet problem (bad loans made in the
past, toxic assets)?]
The Fed’s balance sheet need not swell to accomplish these aims. Once
people believe that inflation is coming, they will be willing to spend
In other words, if the Fed announces a sufficient willingness to
undergo extreme measures to create price inflation, it may not
actually have to do so. Professor Sumner’s views differ from the
monetarism of Milton Friedman by emphasizing expectations rather than
any particular measure of the money supply.
The Keynesian critique of this remedy is that printing more money
won’t stimulate the economy because uncertainty has put us in a
“liquidity trap,” which means that the new money will be hoarded
rather than spent. Professor Sumner responds that inflating the
currency is one step that just about every government or central bank
can take. Even if success is not guaranteed, it seems that we ought to
be trying harder.
Arguably, we can live with 2 or 3 percent inflation, especially if it
stems the drop in employment. Consistently, Professor Sumner argues
that the Fed should have been more aggressive with monetary policy in
the summer of 2008, before the economy started its downward spiral.
Somewhat tongue in cheek, he once wrote on his blog: “Like a broken
clock the monetary cranks are right twice a century; 1933, and today.”
It may all sound too simple to be true, but has the status quo been so
good as to silence all doubts? Many advocates expected that the $775
billion allocation to fiscal stimulus would be followed rapidly by
generous funding for health care and other reforms. But at the moment,
the American public, rightly or wrongly, is blanching at higher
government spending and higher taxes. In contrast, a Fed stance in
favor of mild price inflation need not require higher taxes or larger
While these arguments have not won over the economics profession,
neither have they been refuted. Economists like Paul Krugman have
suggested that a public Fed policy favoring 2 or 3 percent price
inflation isn’t politically realistic in today’s environment. Still,
mild inflation might still be a better shot than hoping for a fiscal
stimulus that is big enough, rapid enough and ambitious enough to
IF there is a flaw in Professor Sumner’s argument, it is that
aggregate demand doesn’t always drive business recovery. Circa 2007,
for reasons of their own making, various sectors of the economy were
in a vulnerable position. These included real estate, the automobile
industry and retail sales. Higher price inflation would not have
solved their problems, which stemmed from basically flawed business
models that depended on rampant credit. Still, a different Fed stance
might have limited the secondary fallout from the financial crisis.
Of course, there’s a risk that inflation could get out of hand and
rise above 2 or 3 percent. That said, the Fed has battled inflation
successfully in the past, and could do so again if necessary.
Professor Sumner has been working for 20 years on what he hopes will
be a definitive economic history of the Great Depression. In this
manuscript, tentatively titled “The Midas Curse: Gold, Wages, and the
Great Depression,” he argues that Sweden in the 1930s made a credible
commitment to expansionary monetary policy and had a milder depression
as a result.
Professor Sumner’s proposals may not be public policy now. But if
there is one thing economists should know, it is that we should not
underestimate the power of an idea.
Tyler Cowen is a professor of economics at George Mason University.
Copyright 2009 The New York Times Company