How Did We Get into a 2-Percent Inflation Trap?

It is now over 50 years since Paul Samuelson and Robert Solow published their famous paper “Analytical Aspects of Anti-Inflation Policy,” now remembered mainly for offering the Phillips Curve as a menu of possible combinations of unemployment and inflation, reflecting a trade-off between inflation and unemployment. By accepting a bit more inflation, policy-makers could bring down the rate of unemployment, vice-versa. This view of the world enjoyed a brief heyday in the early 1960s, but, thanks to a succession of bad, and sometimes disastrous, policy choices, and more than a little bad luck, we seemed, by the late 1970s and early 1980s, to be stuck with the worst of both worlds: high inflation and high unemployment. In the meantime, Milton Friedman (and less famously Edmund Phelps) countered Samuelson and Solow with a reinterpretation of the Phillips Curve in which the trade-off between inflation and unemployment was only temporary, inflation bringing down unemployment only when it is unexpected. But once people begin to expect inflation, it is incorporated into wage demands, so that the stimulative effect of inflation wears off, unemployment reverting back to its “natural” level, determined by “real” forces. Except in the short run, monetary policy is useless as a means of reducing unemployment. That theoretical argument, combined with the unpleasant experience of the 1970s and early 1980s, combined with a fairly rapid fall in unemployment after inflation was reduced from 12 to 4% in the 1982 recession, created an enduring consensus that inflation is a bad thing and should not be resorted to as a method of reducing unemployment.

I generally accept the Friedman/Phelps argument (actually widely anticipated by others, including, among others, Mises, Hayek and Hawtrey, before it was made by Friedman and Phelps) though it is subject to many qualifying conditions, for example, workers acquire skills by working, so a temporary increase in employment can have residual positive effects by increasing the skill sets and employability of the work force, so that part of the increase in employment resulting from inflation may turn out to be permanent even after inflation is fully anticipated. But even if one accepts Friedman’s natural-rate hypothesis in its most categorical form, the Friedman argument does not imply that inflation is never an appropriate counter-cyclical tool. Indeed, the logic of Friedman’s argument, properly understood and applied, implies that inflation ought to be increased when the actual rate of unemployment exceeds the natural rate of unemployment.

But first let’s understand why Friedman’s argument implies that it is a bad bargain to reduce the unemployment rate temporarily by raising the rate of inflation.  After all, one could ask, why not pocket a temporary increase in output and employment and accept a permanently higher rate of inflation? The cost of the higher rate of inflation is not zero, but it is not necessarily greater than the increased output and employment achieved in the transition. To this there could be two responses, one is that inflation produces distortions of its own that are not sustainable, so that once the inflation is expected, output and employment will not remain at old natural level, but will, at least temporarily, fall below the original level, so the increase in output and employment will be offset by a future decrease in output and employment. This is, in a very general sense, an Austrian type of argument about the distorting effects of inflation requiring some sort of correction before the economy can revert back to its equilibrium path even at a new higher rate of inflation, though it doesn’t have to be formulated in the familiar terms of Austrian business cycle theory.

But that is not the argument against inflation that Friedman made. His argument against inflation was that using inflation to increase output and employment does not really generate an increase in output, income and employment properly measured. The measured increase in output and employment is achieved only because individuals and businesses are misled into increasing output and employment by mistakenly accepting job offers at nominal wages that they would not have accepted had they realized that pries and general would be rising. Had they correctly foreseen the increase in prices and wages, workers would not have accepted job offers as quickly as they did, and if they had searched longer, they would have found that even better job offers were available. More workers are employed, but the increase in employment comes at the expense of mismatches between workers and the jobs that they have accepted. Since the apparent increase in output is illusory, there is little or no benefit from inflation to outweigh the costs of inflation. The implied policy prescription is therefore not to resort to inflation in the first place.

Even if we accept it as valid, this argument works only when the economy is starting from a position of full employment. But if output and employment are below their natural or potential levels, the argument doesn’t work. The reason the argument doesn’t work is that when an economy starts from a position of less than full employment, increases in output and employment are self-reinforcing and cumulative. There is a multiplier effect, because as the great Cambridge economist, Frederick Lavington put it so well, “the inactivity of all is the cause of the inactivity of each.” Thus, the social gain to increasing employment is greater than the private gain, so in a situation of less-than-full employment, tricking workers to accept employment turns out to be socially desirable, because by becoming employed they increase the prospects for others to become employed. When the rate of unemployment is above the natural level, a short-run increase in inflation generates an increase in output and employment that is permanent, and therefore greater than the cost associated with a temporary increase in inflation. As the unemployment rate drops toward the natural level, the optimal level of inflation drops, so there is no reason why the public should anticipate a permanent increase in the rate of inflation. When actual unemployment exceeds the natural rate, inflation, under a strict Friedmanian analysis, clearly pays its own way.

But we are now trapped in a monetary regime in which even a temporary increase in inflation above 2-percent apparently will not be tolerated even though it means perpetuating an unemployment rate of 8 percent that not so long ago would have been considered intolerable. What is utterly amazing is that the intellectual foundation for our new 2-percent-inflation-targeting regime is Friedman’s natural-rate hypothesis, and a straightforward application of Friedman’s hypothesis implies that the inflation rate should be increased whenever the actual unemployment rate exceeds the natural rate. What a holy mess.

13 Responses to “How Did We Get into a 2-Percent Inflation Trap?”


  1. 1 Steve June 11, 2012 at 9:57 pm

    “Thus, the social gain to increasing employment is greater than the private gain, so in a situation of less-than-full employment, tricking workers to accept employment turns out to be socially desirable, because by becoming employed they increase the prospects for others to become employed.”

    If people care about absolute wealth (or absolute employment) rather than relative wealth (or relative employment) this is all true. I wonder if this isn’t about the relatively well employed being able to thumb their noses at the unemployed. How cynical of me! This is what happens when I comment late at night…

  2. 2 Julian Janssen June 11, 2012 at 11:07 pm

    Ah, but MAYBE the NAIRU has increased (lol). Yeah, the argument(s) for inaction don’t add up, so one has to wonder whether this is like the Iraq war, where “reasonable” explanations are put up for an either irrational war or for a cause that none dare identify (the roll back of the welfare state, maybe?)…

    BTW, here’s a post on the Great Depression’s causes (alternative explanation)…

    http://socialmacro.blogspot.com/2012/06/balance-sheet-great-depression.html

  3. 3 Lorenzo from Oz June 12, 2012 at 1:05 am

    It is depressing, the power of simple narratives. Such as “inflation variability bad”.

  4. 4 David C June 12, 2012 at 4:43 am

    It’s even more amazing in Europe, where the ECB is sticking to a 2% inflation cap (or maybe even 1.5%) while countries like Spain have unemployment rates of 25%. Half of all young people in Spain are without jobs. That surely must result in long-term damage to society (at best), and could lead to social unrest that is painful to contemplate.

  5. 5 Tas von Gleichen June 12, 2012 at 11:48 am

    That’s certainly a mess. I would still not flood the system with more currency. Just like Milton says it’s really not an input that is going to be worth it. There are so many reasons why a economy is suffering from high unemployment. Increasing the money supply is not the way to fix it. You need to go back to the root cause. Find the problem and fix it. Sometimes suffering needs to happen before things get better. In that time we do not need hand outs.

  6. 6 Wonks Anonymous June 12, 2012 at 12:20 pm

    You version of Friedman’s argument sounds a lot like Austrian Business Cycle Theory, in which economic actors are fooled and growth is illusory.

    The seventies was before my time, but didn’t we have high unemployment combined with high inflation during stagflation? Was that because real factors had raised NAIRU? I think people are wrong to jump to real factors now, because inflation is still low, but denying a constant natural rate of unemployment would be an obvious response to your post.

  7. 7 Benjamin Cole June 13, 2012 at 10:20 pm

    Excellent blogging. Print more money, as Friedman advised for Japan. As a not inconsiderable side-benefit, we monetize the national debt (through QE), deleveraging our nation.

    We have successfully monetized about $2 trillion, and still have suffered no abnormal inflation, and indeed the markets expect deflation.

  8. 8 Will June 14, 2012 at 6:43 am

    Your general interpretation of the Austrian Business Cycle Theory seems spot on. Most non-Austrians dismiss it as crazy without first giving it the charitable interpretation you have (I call it a charitable interpretation since SOME self-described Austrians say crazy things that don’t make sense…and you seem to have appropriately ignored them in forming your interpretation).

    Wonks Anonymous notices similarities between Friedman’s view and the Austrians. Roger Garrison discusses the differences at length in this article: http://www.auburn.edu/~garriro/fm1pluck.htm

  9. 9 genau11 June 14, 2012 at 2:58 pm

    The 2% inflation target is there, because German Ordnungspolitik says so.

  10. 10 David Glasner June 16, 2012 at 9:39 pm

    Steve, Interesting thought. But then how would you account for those recoveries in which monetary (or fiscal) policy led to high employment and increased output?

    Julian, I agree. If we see a rapid and large decrease in output and employment and we have pretty strong grounds for believing that the dropped resulted from monetary policy, then it seems pretty implausible to attribute a slow recovery to a sudden increase in the natural rate of unemployment when inflation and NGDP growth are way below their historical trend. Thanks for the link to your post, which I think is quite reasonable in its discussion of the various interactions between monetary policy and balance sheet effects. My main criticism of Friedman is that he focused on the wrong variable, the quantity of money, when it was really the gold market in which monetary effects (including the quantity of money) were being worked out.

    Lorenzo, Yes, it is depressing. And that is also why we should be wary of simple rules.

    David, It is amazing to me that the ECB is allowed to persist in such a self-destructive policy.

    Tas, In 1982, under Ronald Reagan of blessed memory, there was a powerful recovery in which NGDP was increasing at an annual rate of over 10% a year for something like 6 consecutive quarters and inflation was running at 3 to 4% a year. Why would that not be a good model for us now?

    Wonks Anonymous, Correct; except that in Friedman’s story the fooling takes place primarily in labor markets and in the Austrian theory it is mainly in credit and asset markets. In addition, the Austrian theory, in some versions at least, implies a sharper upper turning point than in Friedman’s story. The 1970s story was complicated by the occurrence of two severe supply shocks in 1973-74 and 1978-79 when there were huge increases in the price of oil. These supply shocks were overlaid on inflation rates that were already running at excessive levels, so the attempt to bring down the long-term rate of inflation was in conflict with the optimal short-term policy of monetary expansion to accommodate the supply shock.

    Benjamin, Welcome back to the blogosphere. Your absence was noted and much lamented by us all. Inflation, for all the deserved bad press it has received, also has a proven track record in healing distressed balance sheets. It’s bitter medicine, but sometimes the patient has no choice.

    Will, Thanks. Mises (who was very cranky and not always careful in the reasoning he used to justify his conclusions) and Hayek were smart guys, and even when they went astray, there was a lot that was valuable in their arguments. The trick is to read them sympathetically and critically at the same time. That’s good advice for reading just about anyone.

    genau11, I agree. But it is self-destructive. Also, because of the way in which inflation is measured, I believe it overstates the true (or relevant) inflation rate.

  11. 11 genau11 June 17, 2012 at 2:10 am

    David, the Ordnungspolitik is the short, true answer.
    Now lets take a short look at the (my) thinking behind it. After all, that explicit inflation targeting is only around for about 30 years. There are still people alive who mourn the departure from M3 money targeting.
    Inflation allows for some indirect taxation via seignorage, and more important it allows for an easier change of the sticky prices /wages. If people believe that a loaf of bread should just be 1 Dollar in eternity, it is harder to say, now it costs 1.20 .
    On the other hand, if the change is too high, people get used to it, demand linkage of wages / pension to inflation, and the “change” advantage is lost.
    Soooo, the highest simple digit target you can get away with, and most normal (not bankers , engineers, and economists : – ) still people accept, is 2.0%. In the US , maybe the UK you probably could get away with 3.0%. The way I read the FOMC beige books until 2007, was that they had a kind of implicit 2.5% target, the famous missing number “long term inflation expectation”.
    I also agree that the way CPI , PCE, HICP account for hedonism, housing, etc. the numbers can be off systematically by something like 0.2%, at times maybe 0.5%. I had recently a lengthy discussion of this across 3 different blogs. http://www.themoneyillusion.com/?p=14300#comment-157406 , kantooseconomics, and marketmonetarist, together with some detailed numerical assessment of whether Germany is already vulnerable for monetary blackmail. I explained to Scott Sumner, how the US house cost accounting works, why this is different in Europe, and why PCE ex food and energy is appropriate for the Fed and HICP or the ECB.
    This 0.2 % long term drift issue is why we don’t like any inflation linking in the Ordnungpolitik camp, which rules supreme in Germany. We don’t need an NRA to go after every politician, who is “weak on inflation”. “Deficits don’t matter”? To the gallows with him!
    It took quite some effort to radically break this expectation for the pensions. You can in fact predict the election results of the last 20 years by how generous the increases were before. “stingy raise” in an election year is a mistake, no German politician will make ever again, so much for the universal and perfectly stringent adoption of Ordungspolitik. It is Sysiphos work in Germany as well : – )
    It is so easy to get popular with promises of new social goodies. And it is the one thing I admire most about Dr. Angela Merkel, that I am not aware that she ever promised anybody new goodies, but higher consumption taxes (VAT) in 2005, and won by a tiny margin.
    Since my city of Dresden got debt free by selling public housing to the hedge fund Fortress, even the left/green folks turned into deficit hawks, and they are actually overdoing it a little bit, there are good public invest opportunities, especially with “real” significantly negative interest rates. Soo, locally, I actually have to argue for a little less of our cherished “financial discipline”.
    But it is quite a show, when my green politician sister is banging away publicly on the conservative mayor for fiscal indiscipline : – )
    Why do I tell you all the little “local” real world stuff?
    Because this is the culture, which gave you the “2.0% inflation only” targeting. I doubt that the FED would have adopted it in February 2012 without us. People overran the Swiss with flight money, until they cried uncle, and pegged their Franc to the Euro /Deutschmark, last fall and in 1978. The Nordic countries are too small to put up enough resistance, even if they would band together.
    Soo, Germany is the indispensable nation, last man standing, with the other AAA Finland, Dutch, Austria, and indirectly Poland and Czech hiding behind us. All the dirt flies right at us, and I don’t blame them : – ). And we do not succumb. We do not buy all this NGDP, long term Keynesian stuff. The central bank controls inflation, and all the rest is taken care of by financial policy, like raising taxes, cutting benefits, WTO conform subsidizes. Reunification was expensive (100% of GDP) but is the example for dealing with financial shocks. Apparently you can do with Germans harder and more open cuts than most people believe to be possible for their countries.
    But from our perspective they have to get used to that. The demographic change and the competition by China means, that for many decades now, there will be less to distribute in most western countries, and not more. Trying to inflate that away, has come to an end.
    One more thought:
    Even if for one single nation it would be the less painful way, to inflate the debt away by monetization, which Ordungspolitik strongly doesn’t believe, in a currency union without political union this creates such an incredible moral hazard to push your debt onto other countries, that you can not allow for that. A pain to see, that even both conservative Rajoy and Monti are falling for that.
    A lot of fundamentally new questions come up with the way this European Union is built. We are living in historically very interesting times. As it was the case with the start of the American Democracy, the first attempt, which really does work for quite a while now. And you have now the 3rd version of your Fed, as I see it. We just have t get through our growing pains as well, to find out how institutions in uncharted configurations work, or have to be broken up.


  1. 1 Around The Net In Ten Posts - Tuesday June 12, 2012 | Market Remarks Trackback on June 12, 2012 at 5:14 am
  2. 2 Charles Goodhart on Nominal GDP Targeting « Uneasy Money Trackback on January 23, 2013 at 7:17 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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