Krugman vs Meltzer

Recently (Monday, May 4), readers of the op ed section of The New York Times were handed a special treat. At the bottom of the page, there was the column of their regular contributor, the Nobelist, Paul Krugman, expressing his deep concern about falling wages and deflation (or falling prices). At the top of the page, in an unusually long article, Allan Meltzer, a well-known conservative economist (a professor of political economy at Carnegie Mellon University), expressed his deep concern about inflation.

So who has it right? Readers of this blog will not be surprised when they hear that I think Krugman has it right and that Meltzer is all wet. Even Krugman was irked enough by what Meltzer wrote to openly criticize him that very day on his blog, first quoting him: "Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation."

He followed this up with a chart that shows what happened in Japan between 1991-2003. Its money supply went up and its deficits went up, but inflation went down. Japan "experienced deflation," Meltzer notwithstanding. Specifically, during those twelve years of increasing money supply and increasing deficits, prices fell about 2 ½ percent. (Given there is no way of measuring "the prospect of sustained currency devaluation," Krugman omitted this in his chart.)

Elsewhere, on the Nouriel Roubini blog site, Krugman argues that interest rates (and therefore by implication, inflation rates) will only go up if (US) government solvency is in question. Because the rest of the world is in such dire straits, he thinks that the solvency of the dollar is not in question (at least by implication, in the near future).

Krugman’s argument on wage rates is a variation of his argument on deflation (falling prices). He believes that falling wage rates are in essence all but taking place, citing a BLS (Bureau of Labor Statistics) report that the "average cost of employing workers in the private sector rose only two-tenths of a percent" recently and suspects "overall wages (will) start falling later this year."

If this happens, it won‘t lead to employers hiring more workers because they are now cheaper (supply and demand), the pre-Keynesian view as to how we will get out of the Great Depression, but (in a variation of the paradox of thrift–see the initial article in this series), less income will lead to less consumption leading to higher unemployment.

Krugman concludes that we need a real recovery, not just stabilization. This means: "more stimulus, more decisive action on the banks, more job creation."

But Meltzer is so concerned about inflation that he writes, "It doesn’t help that the administration’s stimulus program is an obstacle to sound policy." Yes, in the name of stable prices Meltzer is apparently willing to allow unemployment to reach astronomical levels–thirties level is implied–and this would mean the American people (and its economy) would truly be forced to go through the wringer.

This is unalloyed fanaticism. Some might even come to the conclusion that Meltzer, credentials notwithstanding, is simply a wing nut. (Wikipedia: a derogatory American slang term for a person who holds strongly right-wing political beliefs, shortened from right wing nut.")

Meltzer argues, unconvincingly (to me) that the Fed is no longer independent but is simply the monetary arm of the treasury, "bailing out A.I.G., taking on illiquid securities from Bear Stearns and promising to provide as mush as $ 700 billion of reserves to buy mortgages." Since all this began during the Bush Administration, Meltzer is arguing that the Fed is under the control of two very different Treasury departments. Isn’t it more likely that Bernanke is trying to have the Fed do its utmost to prevent this super-serious downturn from turning into a full blown depression?

Without its independence, the Fed, in Meltzer’s view, will be unwilling to stop the inflationary surge when it comes. I doubt this, but more shortly.

Meltzer praises the efforts of Paul Volcker during his chairmanship of the Federal Reserve. In order to stop double-digit inflation (or even the possibility the inflation rate might increase), Volcker was willing in 1981-82 to drive up interest rates to astronomical heights–the prime rate reached 21.5 percent (mentioned by Meltzer) and mortgage rates were above 17 % (not mentioned). Volcker’s hard line policies are defensible given the situation. But there are at least three things missing or not emphasized in Meltzer’s account of things.

First, he understates the impact of oil prices when he writes that 1979 rates of inflation were "worsened by the oil shock." Both in the early 1970's and in the late 70's oil was the primary cause of inflation, as OPEC on two separate occasions raised the price of oil by cutting back output. Without these increases–and the impact of oil prices then were greater than they are now–it is doubtful inflation would have been a major problem. Perhaps Meltzer minimizes the impact oil prices had on inflation then, because they are not a factor in today’s world and certainly not a cause for concern about inflation, which is what Meltzer is all about. Simply put, the threat of inflation is much lower, because the oil situation is under control, Meltzer not withstanding.

Second, he does what most conservatives do. He ignores the inflationary impact of Reagan’s tax cut of 1981. He argues that a "decisive change of attitudes (on combating) inflation didn’t take place until the spring of 1981, but ignores that Volcker in part was responding to the inflationary potential of the Reagan tax cut, a potential to drive inflation to triple digit levels, if not countered resolutely.

Reagan is portrayed by Meltzer as a hero, when in actuality he was anything but. His tax cut led to Volcker’s hard line which pushed unemployment rates to double digits–the highest since the Great Depression (a level challenged, alas, by the recession we are currently in). Conservatives–even those who put countering inflation as their first priority–have rarely if ever been able to face up to the irresponsibility of Reagan’s tax cut.

Third, he points to Volcker’s success in bringing inflation down to (just) "below 4 percent," a potential level it seems he will not tolerate today and one we are far below as I write.

After all his ranting and raving, what is Meltzer really saying about inflation? He asks, "When will it come?" And then he answers, "Surely not right away." In his next sentence, he writes "sooner or later." Well, is this not a mouse roaring? Some day (when–2013?) inflation will rear its ugly head and the Fed will not do what is required. This is a reason to be scared out of our boots? In short, Meltzer is so obsessed about the possibility of inflation in the distant future, he is willing to have us chance a major depression by doing nothing to counter the downturn. No stimulus. Nada.

Some time back Krugman argued that when the time comes–and inflation rears its ugly head–the Fed will simply raise interest rates enough to stop it. And I suspect Bernanke, if he is still chairman (or whoever replaces him) will simply raise rates.

But there is a problem. When inflation is externally caused–oil, for example–we get something that first arose in the 1970's, stagflation. This is simultaneous unemployment (stagnation), at high levels, and inflation, at high levels. And when this occurs there are no easy answers. Unemployment is probably worse that inflation, in general, since wages usually keep up with the inflation, approximately, but high rates of inflation that are not countered tend to accelerate. One is soon facing devastating levels of inflation that are potentially so disruptive that the economy can no longer function (or function in a meaningful way).

Under ordinary circumstances downturns cause inflation to be reduced as demand for labor and goods diminishes. But as I have already pointed out, a problem may arise, as Krugman has indicated, if government solvency is in question. I am not sure about government solvency when you pay your debts in your own currency, but I do believe that much of the world is deeply troubled by the fact that money is being printed by the US at astronomical levels. There are three intertwined aspects to this–the enormous and unprecedented trade deficit; the gigantic and perhaps unprecedented budgetary deficit that we are going to have (unprecedented at least in peace time); and, lastly, the various Federal Reserve bail-outs and acquisitions, separate from the budgetary stimulus–of A.I.G. and Bear Stearns–and the $700 billion of reserves to buy mortgages it is providing.

At the moment the alternatives to holding the dollar are suspect–especially the Euro. But the time may not be distant when fear will take over and though no holder of immense amounts of dollars, say China, wants to see the dollar crash, the likelihood that this can be permanently avoided do not seem to me to be high. But there is no precedent and therefore the word "likelihood" is not exactly used scientifically. However, if the Dow can decline about 23 % in a day, as it did in 1987, is a dollar collapse unimaginable? Given the fact that the factors that are potentially weakening it are not going away–after all, the trade and budge deficits will continue at high, possibly unprecedented, levels barring a miracle far less likely than the Red Sea parting.

If the dollar depreciates, then we have stagflation. That can lead to a politics that is ugly and conservative (or worse). Last time, before it was obvious we were losing our competitive edge, stagflation led to Ronald Reagan. If somehow the dollar doesn’t depreciate, or the depreciation is mild and steady, then the prospects for the future will depend on how we are able to compete in a world in which our competitors pay their workers peanuts. There are no scenarios for a rosy future.

But, for the time being, there is little reason to worry about inflation. This means that we should ignore the worries of Meltzer and listen to Krugman–"more stimulus, more decisive action on the banks, more job creation." Otherwise, we’ll face "years of deflation and stagnation."