A Little Inflation is No Vice

by Will on September 10, 2010

While we’re sitting here with 1 percent inflation, falling prices in some sectors, private money tied up in treasury bonds, and both the Federal Reserve and the congress sitting on the sidelines stroking their beards and warning of the consequences of action, I’m going to defer yet again to David Hume, who gave the first accurate account of monetary policy (today seems to be David Hume Day for me):

The good policy of the magistrate consists only in keeping it [the amount of money], if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches. A nation, whose money decreases, is actually, at that time, weaker and more miserable than another nation, which possesses no more money, but is on the encreasing hand. This will be easily accounted for, if we consider, that the alterations in the quantity of money, either on one side or the other, are not immediately attended with proportionable alterations in the price of commodities. There is always an interval before matters be adjusted to their new situation; and this interval is as pernicious to industry, when gold and silver are diminishing, as it is advantageous when these metals are encreasing. The workman has not the same employment from the manufacturer and merchant; though he pays the same price for every thing in the market. The farmer cannot dispose of his corn and cattle; though he must pay the same rent to his landlord. The poverty, and beggary, and sloth, which must ensue, are easily foreseen.

In short, putting a little more money in the economy greases production and industry. Sucking money out causes needless unemployment and idle capacity. It’s true that the Federal Reserve is in a tight spot, since their main mechanism for increasing the amount of money is to loan new money to the banks. It doesn’t work when the banks take the money and put it in treasury bonds and other safe, low-yield investments, rather than loaning it to businesses and individuals. Right now that’s what the banks will do. But that means that the Fed chairmen need to do some creative thinking about surmounting that problem. The best idea I’ve heard is that they should announce a 4 percent inflation target. Then financial institutions won’t want to put their money in treasury bonds that pay 3 percent or less, but will invest in ways that puts more money in the hands of people and businesses. Also, the government could just spend a bunch of money, but apparently that’s politically impossible. The paralysis of all who could do something is frustrating.

Here’s an awesome video of Milton Friedman explaining the same thing. He’s doing it at a time of high inflation, so he urges tighter money policy. That doesn’t apply under present conditions: we’re in the opposite situation.

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