The Price of Inequality: How Today's Divided Society Endangers Our Future (40 page)

Friedman also had views about banking regulations—like most other regulations, he thought, they interfered with economic efficiency. He advocated “free banking,” the idea that banks should be effectively unrestrained, an idea that had been tried, and failed, in the nineteenth century. He found a willing student in the Chilean dictator Augusto Pinochet. Free banking did lead to a burst of economic activity as new banks were opened and credit flowed freely. But just as it didn’t take long for America’s deregulated banking industry to bring the American economy to its knees, Chile, too, experienced its deepest downturn in 1982. It would take Chile more than a quarter century to pay back the debts that the government incurred in fixing the problem.

In spite of these experiences, the view that financial markets work well on their own—that government should not interfere—became a dominant theme during the past quarter century, pushed, as we have seen by Fed chairman Alan Greenspan and a succession of Treasury secretaries. And, again as we have noted, it served the interests of the financial sector and others at the top well, even as it distorted the economy. Moreover, even though the collapse of the financial system seemed to hit the Fed by surprise, it shouldn’t have. Bubbles have been part of Western capitalism since the beginning—from the tulip bulb mania of 1637 in the Netherlands to the housing bubble of 2003–07.
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And one of the responsibilities of monetary authorities, in ensuring economic stability, is to discourage the formation of such bubbles.
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Monetarism was based on the assumption that the velocity of circulation—the number of times a dollar bill turns over in a year—was constant. And while in some countries and in some places that had been true, in the rapidly changing global economy of the end of the twentieth century, it was not. The theory became deeply discredited just years after it was the rage among all the central bankers. As they quickly abandoned monetarism, they looked for a new religion consistent with their faith in minimal intervention in the markets. They found it in inflation targeting. Under this scheme central banks should pick an inflation rate (2 percent was a fashionable number), and whenever inflation exceeded that rate, they should raise interest rates. The higher interest rates would dampen growth, and thereby dampen inflation.
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The obsession with inflation

Inflation targeting was based on three questionable hypotheses. The first is that inflation is the supreme evil; the second is that maintaining low and stable inflation was necessary and almost sufficient for maintaining a high and stable
real
growth rate; the third is that all would benefit from low inflation.
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High inflation—such as the hyperinflation that plagued Germany’s Weimar Republic in the early 1920s—is a real problem; but it is not the
only
economic problem, and it is often not the most important one.
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Inflation, as we have noted, has not been a major problem in the United States and Europe for a third of a century. At least in the United States, the Fed had a balanced mandate
—inflation, employment, and growth
—but in practice the focus was on inflation, and until recently any central banker who suggested otherwise risked becoming a pariah. Even as the United States faced unemployment of 9 percent—and hidden unemployment that meant that the true unemployment was much higher—three “inflation hawks” on the Fed board voted to raise interest rates because of their single-minded concern with inflation.

In 2008, shortly before the global economy collapsed, inflation targeting was put to the test. Most developing countries faced higher rates of inflation not because of poor macromanagement but because oil and food prices were soaring, and these items represent a much larger share of the average household budget in developing countries than in rich ones. In China, for example, inflation approached 8 percent or more. In Vietnam it reached 23 percent.
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Inflation targeting meant that these developing countries should have raised their interest rates, but inflation in these countries was, for the most part,
imported
. Raising interest rates wouldn’t have much impact on the international price of grains or fuel.
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As long as countries remain integrated into the global economy—and do not take measures to restrain the impact of international prices on domestic prices—domestic prices of food and energy are bound to rise markedly when international prices do.
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Raising interest rates can reduce aggregate demand, which can slow the economy and tame increases in prices of some goods and services, especially nontraded goods and services. But unless they are taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. If global food and energy prices are going up at 20 percent a year, for the
overall
inflation rate to be 2 percent would require wages and prices elsewhere to be falling. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.
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For inflation hawks the economy is always at the edge of a precipice: once inflation starts, it will be difficult to control. And since the cost of reversing inflation—disinflation, as it’s called—is so large, it is best to address it immediately. But these views are not based on a careful assessment of the evidence. There is no precipice, and mild upticks in inflation, if they look as if they might become persistent, can easily be reversed by tightening credit availability.
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In short, it was simply wrong that the best way to maintain high employment and strong growth was to focus on inflation. The focus on inflation distracted attention from things that were far more important: the losses from even moderate inflation were negligible in comparison to the losses from the financial collapse.

Doing someone else a favor

As we’ve seen, there is a rationale in standard economic models for keeping inflation low, but those models are misleading. On the basis of those models, advocates for keeping inflation low argue for low inflation because it would be good for the economy as a whole. They don’t single out the bondholders as the big recipients of the benefits of low inflation. Inflation, as it is put, is the cruelest tax. It affects everybody indiscriminately and especially the poor, who are least able to bear it. But ask someone who has been out of a job for four years what he would prefer—another year of unemployment or a slight increase in inflation from, say, 1 percent to 2 percent. The answer is unambiguous. The toll unemployment takes on workers is high and hard to manage. Better some job whose pay has declined in real terms by a few percent than no job.

Wall Street pundits used to argue that inflation hurt poor retirees, but that argument was also incorrect, since Social Security goes up with inflation
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and recipients are therefore protected. In periods in which markets work well, workers are also protected. Higher prices increase the (marginal) return to workers, and so should increase their pay commensurately.
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It is mainly because in periods in which inflation has historically been high, there were also large shocks to the real economy, that inflationary episodes were often accompanied by decreases in real income for workers.

Bondholders aren’t doing anyone else a favor when they maintain vigilance over inflation, and especially not when they persuade the monetary authorities to increase interest rates. They are merely helping themselves. And it’s a one-sided bet: if the central bankers are overly vigilant, and inflation is lower than they expected, or prices are actually induced to decline, bondholders win both because of the higher interest payments they receive and because of the higher value of the money that they get back when the bond comes to maturity.

No trade-offs

Precrisis economic analysis argued not only that government intervention was not needed—because markets by and large were efficient and stable—but also that it was ineffective. Bubbles, so the logic went, didn’t exist. But even if there were a bubble, government couldn’t be sure whether there was one until after it broke; and even if it could tell, the only instrument at its disposal was the blunt instrument of interest rates. It was better just to let the bubble run its course, since cleaning up the mess afterward would be cheaper than distorting the economy to prevent a bubble from surfacing.

If the leaders of the Fed hadn’t been so wedded to the notion that there were no bubbles, it would have been obvious to them (as it was to economists like Robert Shiller, of Yale, one of the country’s leading experts on housing),
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that the unprecedented rise in housing prices relative to incomes
almost surely represented a bubble
. In addition, the Fed didn’t have to rely on interest rate changes to dampen the bubble—it could have increased down payment requirements or tightened lending standards. Congress had given the Fed authority to do so in 1994. The Fed in its allegiance to market fundamentalism had tied its own hands.

Economists have, similarly, provided the Fed with reasons not to attempt to address unemployment. People in a dynamic economy have to move from job to job, and that takes time, which creates a
natural
rate of unemployment. To push the economy beyond that natural rate pushes the economy to ever-accelerating inflation (in this view). As the unemployment rate falls even briefly below the natural rate, inflation increases; but then market participants come to expect that rate of inflation, and so they build that into their wage and price increases. Eventually—and, in the eyes of these economists, soon—the central bank will have to give in, allowing unemployment to return to the natural rate. But then, according to this view, a further price will have to be paid to bring down the inflation rate. To do that, unemployment will have to be higher than the natural rate. Otherwise inflation will simply persist. Their contention is that the benefits of the temporary low unemployment are far smaller than the costs—in higher inflation and subsequent high unemployment.

These ideas provided intellectual comfort to central bankers who didn’t want to do anything about unemployment. But there were strong grounds for skepticism about these ideas: some countries, like Ghana and Israel, have managed to bring down their inflation rates very quickly at little cost. The underlying hypothesis that there is a stable relationship between the unemployment level and the rate of
acceleration
of inflation has not withstood the test of time, and the even stronger hypothesis underlying the claim that the costs of disinflation are greater than the benefits of allowing slightly higher inflation has really never been well established.
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The use of the term “natural” unemployment rate suggests that it is “natural” and natural things are good, or at least unavoidable. Yet there is nothing natural about the high level of unemployment we see today. And these ideas are being used by those that don’t want government to take steps to do anything about it. There is, I believe, considerable scope for lowering the unemployment rate. There are millions of Americans who have jobs but are working part-time or short hours
simply because there is not enough total demand in the economy.
Whatever one’s guess about the level of the “natural” unemployment rate today—and whether one believes that the concept of natural unemployment is at all relevant—it is clear that increases in aggregate demand would be beneficial.
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Of course, government needs to do more than just increase total demand; it has to help individuals change sectors, from where they were needed yesterday to where they will be needed tomorrow. These “active labor market policies” have proven effective in several countries, especially in Scandinavia. Cutbacks in government spending for such programs will not only lower total income by lowering demand but also lead to a higher level of natural unemployment, if such a thing exists. State funding cuts in higher education—which have been especially large in science, engineering, and health care fields because these fields are especially expensive to teach—mean that some jobs in these fields are going unfilled, and the cuts disproportionately reduce the ability for the poor to receive more training and get good jobs.
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C
ONCLUDING
C
OMMENTS

For most people, wages are the most important source of income. Macroeconomic and monetary policies that result in higher unemployment—and lower wages for ordinary citizens—are a major source of inequality in our society today. Over the past quarter century macroeconomic and monetary policies and institutions have failed to produce stability; they failed to produce sustainable growth; and, most importantly, they failed to produce growth that benefited most citizens in our society.

In light of these dramatic failures, one might have anticipated a quest for an alternative macroeconomic and monetary framework. But just as the banks—which argue that no system is accident proof, that they have been the victims of a once-in-a-century flood, and that our current recession is no reason to change a system that works—have been remarkably successful in resisting reregulation, many of those who held the erroneous beliefs about macroeconomics that led to the flawed monetary policies have been unrepentant. They have been reluctant to change those beliefs. The theory was correct, they claim; there were only a few flaws in implementation.
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In truth the macroeconomic models placed too little attention on inequality and the consequences of policies for distribution. Policies have been based on these flawed models both helped create the crisis and have proven ineffective in dealing with it. They may even be contributing to ensuring that when the recovery occurs, it will be jobless. Most importantly, for the purposes of this book, macroeconomic policies have contributed to the high level of inequality in America and elsewhere.