Tyler Cowen wrote a thoughtful piece expressing skepticism about the economy’s responsiveness to inflation and how some economists are now just assuming, with little evidence, that growth would be highly responsive to a helicopter money drop.
In my upcoming book, The Upside of Inequality: How Good Intentions Undermine the Middle Class, I argue that risk-averse savings, as evidenced by near-zero interest rates, and lesser-skilled labor, of which there is a near-unlimited supply both from immigrants and offshore workers, no longer constrain growth. Does inflation stimulate growth? It depends. Today growth is constrained by the economy’s capacity and willingness to take risk, of which properly trained talent and equity are core components. Properly trained talent, for example, can generate good ideas that are less risky to implement. And it can implement ideas more effectively and with less risk than less skillful workers.
This constraint on the economy’s capacity and willingness to take risk can grow especially acute when the economy is undergoing a structural transition—when it is transitioning from a manufacturing-driven economy to a knowledge-driven economy, for example. At those times, the economy needs to take unfamiliar risks in order to grow. And its prior accumulation of assets is less useful for managing these new risks and are therefore less valuable.
When the economy discovers unexpected risk—the threat of terrorism after 9/11 or the inherent instability of U.S. banking recognized after the financial crisis—consumers and investors discover they are bearing more risk than they desire and dial back consumption and investment to compensate. Growth slows and unemployment rises or wages fall. Seen from this perspective, the concept of unexplained “animal spirits” is largely a misnomer.
The economy may logically overreact to a shock in the absence of clarifying information, which it will gradually acquire. In the case of 9/11, time proved the risk of terrorism was less than expected. In the face of this realization, growth recovers. In other cases, the uncovered risks may prove to be more enduring—surprisingly unstable banks for example. In both cases, the economy may get caught in a Keynesian paradox-of-thrift negative feedback loop, albeit not an illogical never-ending loop. As long as cash sits idle there is little imminent risk of inflation.
When the economy retreats to cash in order to reduce risk, an unexpected threat of inflation may temporarily drive risk-takers to increase consumption or investment if they find no better alternative. And this might prevent a temporary lull in demand from permanently damaging the economy. (Or they might sit in cash regardless and discover that there is little imminent risk of inflation.)
But where the uncovered risk and subsequent dial back is permanent and where the threat of inflation becomes expected, consumers and investors should eventually find alternatives to cash for reducing risk—investing in unproductive real estate that they otherwise wouldn’t buy, for example. In this case, fiscal and monetary stimulus may stimulate demand but it just further misallocates resources that ultimately must be reallocated largely through trial and error—i.e., increased risk-taking—in order to reaccelerate growth in the long run. Under these circumstances, we should expect productivity and growth to slow.
My concern with debating the extent to which the threat of inflation accelerates growth, is that it is highly circumstantial. Without carefully delineating the circumstances of each recession, it’s misleading to look back and measure the effect of inflation, or the threat of inflation, on the speed of a recovery. In the case of 9/11 it may accelerate recovery whereas today, where the circumstances are different, it may slow it. Averaging its historical effect may measure little more than the frequency of different types of recessions.