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May 27, 1990
"Check Inflation Before It Balloons Out of Control"
San Jose Mercury News
By Timothy Taylor
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IN August 1971, a conservative Republican president, Richard Nixon, made what Business Week at the time called "one of the most radical reversals of policy in all political history." He abandoned the free market, imposed wage and price controls, and prohibited price increases anywhere in the U.S. economy.

He took that step because inflation had been 4.5 percent in the first six months of 1971, after having topped 5 percent in both 1970 and 1971. Magazines like Fortune were warning that "in the U.S. economy continued inflation in a 4 or 5 percent range would erode, and perhaps even totally disintegrate, the orderly processes of production, distribution, and the rendering of services."

Two decades later, that dramatic rhetoric looks overwrought. After all, inflation averaged about 4.5 percent during 1988 and 1989, and the economy didn't exactly crumble.

But in the first four months of 1990, inflation increased to 6.8 percent. In that time, interest rates on long-term bonds have climbed by at least 1 percent in the United States, Japan and Germany, reflecting the market expectation that this increase is no fluke.

When should inflation become a worry? The spectrum of opinion runs from those who would write into law that inflation must be zero, to those who believe that fighting inflation is no longer worth the cost.

House Joint Resolution 409, introduced by Rep. Stephen Neal, D-N.C., would require the Federal Reserve to reduce inflation to zero over a five-year period, and maintain price stability thereafter.

By contrast, the current Federal Reserve Act says only that in setting monetary policy, the Fed should take into account "past and prospective developments in employment, unemployment, production, investment, real income, productivity, international trade and payments, and prices." These many goals put the Fed under pressure to allow some inflation, if it helps in meeting other economic objectives.

Proponents of HJR 409 argue that even low rates of inflation are economically destructive. Even at 4 percent, inflation will cut the buying power of a dollar in half in 18 years; at 6 percent, a dollar is halved in just 12 years.

In such an environment, the argument goes, paying interest in inflation-depleted dollars looks far more attractive than receiving it, so borrowing is encouraged and saving stagnates. When prices are changing frequently and by large amounts, they thus provide less clear economic signals, leading to greater economic inefficiency. Businesses and individuals look for ways to shelter their assets from inflation, rather than choosing long-term investments based on economic productivity.

The picture is certainly disturbing, but it has an aura of 1971 about it. When Nixon contemplated an inflation rate of 4.5 percent, his frame of reference was that inflation had been around 1.5 percent since World War II. To him, inflation had just tripled!

But since the economy suffered double-digit inflation from 1979 to 1981, a 4 percent rate means that inflation has been cut by more than half. Workers and investors and businesses have all learned how to go with the flow of inflation with cost-of-living adjustments, adjustable mortgages, money market accounts, and contracts that automatically adjust for inflation. With these financial innovations, the biases and uncertainty caused by inflation are surely lower than two decades ago.

However, the costs of fighting inflation remain high. Since inflation is a matter of too many dollars chasing too few goods, battling inflation means reducing the number of dollars chasing goods. Either the Federal Reserve can raise interest rates and reduce buying on credit, or Congress can raise taxes or cut spending. But whatever the method, the level of demand in the economy declines, economic output falls, and unemployment rises.

Higher unemployment means wasted human resources. If the economic slowdown sickens into recession, then the economic costs will be even higher. Fighting inflation is not cheap.

"Zero inflation" is fine as a slogan, but ham-handed as a policy. Calculating inflation requires differentiating whether price increases result from changes in quality or are just inflation, and that's a very tricky job. For example, consider trying to compare the quality difference between a compact disc and a record, or the qualities of having automatic bank tellers, or the mileage and safety features and construction of cars built in different decades.

It's impossible to draw a magic line where inflation changes from bearable to un-. But given the high costs of fighting inflation and the way that the economy is indexed against it, it was reasonable to accept the costs of 3 to 4 percent inflation from 1983 to 1989.

But if inflation is indeed edging higher, it's worth some pain from lower budget deficits or higher interest rates to rein it in. Precisely because fighting inflation is so costly, it's better to strike early, rather than waiting for it to build double-digit momentum.

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