Tuesday, June 3, 2008

Weighing in on Inflation

A couple weeks ago I noted that all the cool kids were writing about inflation. At that time, pretty much everyone agreed that inflation was bad; the only disagreement was over exactly how bad it was. Now that Paul Krugman has weighed in on inflation -- taking the "don't worry, be happy" approach -- inflation is the hot topic again. Krugman argues that we shouldn't worry about inflation unless it leads to a wage-price spiral, à la the 1970s. Because there's no evidence of a wage-price spiral right now, Krugman believes the Fed should continue to focus on avoiding a financial meltdown. It's true that once inflation becomes embedded via a wage-price spiral, it will be difficult to contain without inducing a deep recession. It's also true that embedded inflation is the most severe threat inflation poses. But does that mean we should ignore inflation up until the point where we see evidence of an actual wage-price spiral? I have to believe the answer is "no." Surely there are indicators that we can look at to determine whether inflation is in danger of becoming embedded. Surely a wage-price spiral doesn't come out of nowhere. It seems to me that one of the most important indicators is consumer expectations of inflation. Consumers have to expect a certain level of inflation to start demanding significantly higher wages to compensate for inflation. And, as Tum Duy notes on Mark Thoma's site, major price increases by big companies such as Dow Chemical should also signal that the conditions necessary for a wage-price spiral are taking shape. On the other hand, Krugman rightly notes that whereas unions played a major role in the wage-price spiral of the '70s, there are comparatively few unions today. Can a wage-price spiral take hold in the U.S. with so few unions to demand huge wage increases? We don't know. Ultimately, I'm probably leaning more towards Krugman's position. Embedded inflation and a financial meltdown are among the most severe threats to an economy. We know how to deal with embedded inflation, because we did it in the '70s. We don't know how to deal with a full-scale financial meltdown. The last time we saw a financial meltdown (in 1929), the economy looked absolutely nothing like our current economy. That means we have virtually no precedent in dealing with a financial meltdown. For that reason, I'd rather risk embedded inflation than a financial meltdown.