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If Paul Krugman Gets the Higher Inflation He Wants, the U.S. Will Return to Recession

December 10, 2014 in Economics

By Alan Reynolds

Alan Reynolds

U.S. inflation was 1.7% over the past year according to the consumer price index, or 1.4% as measured by personal consumption expenditures (PCE). That may sound like good news, yet we are being told it is actually very bad. “The Fed needs a clear strategy for getting the inflation rate higher,” warns a recent news report, “after falling short of its 2 percent target for 28 consecutive months.” Several eminent economists now argue that a 2% target is much too low, and the Fed must openly aim for 4% inflation to avoid “secular stagnation.”

But this wrongheaded advice is based on dubious theory. In fact, inflation does not cause economic booms and economic booms do not cause inflation.

The phrase, “secular stagnation,” which dates back to economist Alvin Hansen in 1938, was resurrected a year ago by Treasury Secretary Larry Summers at an International Monetary Fund event. According to the e-book Secular Stagnation, “A workable definition for secular stagnation is that negative real interest rates are needed to equate saving and investment with full employment.” Since the Fed has kept the federal funds rate at zero for six years, secular stagnationists say the only way to get the real, inflation-adjusted fed funds lower is to push inflation higher—to 4%.

You can’t simply induce sustainable economic growth by having central bankers fiddle with inflation.”

Paul Krugman’s explanation

New York Times columnist Paul Krugman explains that, “People have to believe in higher inflation, which produces an economic boom, which yields the promised inflation. A necessary … condition for this to work is that the promised inflation be high enough that it will indeed produce an economic boom if people believe the promise will be kept.”

Why does Krugman theorize that “high enough” inflation would produce an economic boom? “Investors expect inflation,” he explains, “which makes them willing to spend more, which pushes the economy to full employment, which then generates the inflation investors expected.”

This whole construction rests on flimsy foundations. For one thing, the pretense that central banks have the knowledge and skill to hit some precise inflation target is just academic hubris. Since the Fed can’t hit a 2% target with sufficient precision to please secular stagnationists, why assume the Fed could hit a 4% target?

Secular stagnationists also define real interest rates in ways that have no relevance to private incentives to borrow or save. Krugman defines real interest rates …read more

Source: OP-EDS

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