Federal Reserve Board Governor Lawrence B. Lindsey discusses the consequences of inflation in developed economies in this speech presented to the Government Bond Club of New England on March 12, 1992.Inflation (Finance) ; Monetary policy

Lawrence B. Lindsey

English

Research Papers in Economics

eOONOMIG
GOMMGNTCIRY
Federal Reserve Bank of Cleveland
The Case for Disinflation
by Lawrence B. Lindsey
March 15, 1992
JLhank you. It is a pleasure to be here
tonight. Quite frankly, this time every
four years, it's nice to be almost any-
where but Washington, D.C. And, since
you've just endured the Super Tuesday
limelight, I'll bet you all know what I
mean. The Olympics are over and the
baseball season has yet to begin. And
life just wouldn't be the same without
some contest to stir the blood. So I sup-
pose we should be grateful for these
Tuesday night events.
My aim tonight is to look beyond
tomorrow's bond market, beyond next
Tuesday, and even beyond November.
There is a major unreported economic
story occurring in America, the conse-
quences of which will have a profound
impact on our nation's economy for the
rest of this decade.
The story I'm speaking of is the con-
tinuing reduction in the underlying rate
of inflation. Let there be no mistake
about it; the Federal Reserve is com-
mitted to the attainment of price stabil-
ity. Furthermore, largely due to actions
which took place before I joined the
Fed, we have a good chance to achieve
effective price stability in America by
mid-decade. This is not widely under-
stood and certainly not appreciated in
financial markets. But, it is one of the
factors which makes me very optimis-
tic about America in the 1990s.
This commitment by the Fed reflects a
revolution in monetary policy thinking
throughout the economics profession.
The underlying policy approach to in-
flation which is taught today just down
the river is radically different from what I
learned as a student. This revolution in
thinking might better be termed a counter-
revolution. The so-called New Macroeco-
nomics has rediscovered the case for
price stability that was largely taken for
granted in the pre-Keynesian era. The ex-
perience of the last two decades has
taught that there really is no attractive
long-term policy trade-off between unem-
ployment and inflation. At best, lower
unemployment can only be attained tem-
porarily at the price of permanently
higher inflation. Indeed, the case is now
becoming clear that low inflation may
actually enhance economic performance.
Still, the case for price stability has not
been widely appreciated by the public
at large. I believe that one of the rea-
sons for this is the prevalence of three
myths about inflation which persist
from an earlier period of economic
policy. Tonight, I would like to address
these myths.
The first myth is that inflation is good
for investment and therefore for eco-
nomic growth. In fact, the opposite is
the case: price stability will aid in the
process of capital formation. The pub-
lic finance profession has long pointed
out the pernicious effects of inflation
on savings and capital formation in our
tax system. The usual remedy suggested
by the profession is effective indexa-
tion, so that taxes are levied on real in-
come and not on nominal income. The
legislative changes needed to accom-
plish this are not in sight. Achieving
price stability will accomplish the same
end without legislative action.
On March 12, Federal Reserve Board
Governor Lawrence B. Lindsey spoke
to the Boston-based Government Bond
Club of New England about the con-
sequences of inflation in developed
economies. "The Case for Disinflation"
offers an intriguing perspective on this
important topic. Here, we reprint Dr.
Lindsey's address in its entirety.
ISSN 0428-1276Consider, for example, the effect of
taxation and inflation on the real after-
tax return to savers. Imagine a world of
8 percent bond yields, where 4 percent
represents real interest and 4 percent a
compensation for inflation. A 25 per-
cent nominal tax rate translates into a
50 percent tax on the real interest. In
the absence of inflation, the effective
tax rate on real interest income is the
same as the statutory rate, or 25 per-
cent. Disinflation, or I should say zero
inflation, thus halves the real tax rate in
our example.
A similar story could be told about
capital gains. It is clear from tax return
data that a substantial portion of real-
ized capital gains represents the effect
of inflation. To this must be added the
effect of inflation on the basis of invest-
ments which end up as capital losses.
The net effect of our tax system cou-
pled with current levels of inflation is
to make the effective tax rate on real
capital gains well over 50 percent. Dis-
inflation would mean a real cut in the
effective tax rate on capital gains. Zero
inflation would provide a real boost to
after-tax returns to savings and invest-
ment by reducing our currently very
high effective tax rates.
Disinflation could also accelerate capi-
tal formation by substantially improv-
ing the tax treatment of productive
equipment by increasing the present
value of depreciation deduction sched-
ules. The effective tax rate on new cor-
porate investment depends on the pres-
ent value of depreciation deduction
schedules, which in turn depends on
the nominal discount rate. Prevailing
nominal discount rates are likely to fall
point for point with the inflation rate,
thus increasing the present value of the
stream of depreciation deductions on
plant and equipment. Disinflation from
4 percent to zero would induce nearly
the same reduction in the after-tax cost
of industrial equipment as a 3.5 percent
investment tax credit.
There is a widespread consensus in the
economics profession that higher rates of
saving and capital accumulation would
be beneficial to the U.S. economy. Nu-
merous schemes have been advanced to
achieve this end through the tax system.
The point is that disinflation would
achieve much the same result.
Somehow a fallacy has developed in
the thinking of many people that easy
money—or inflation—is good for in-
vestment. It is not. Consider both the
post-War miracles of Japan and Ger-
many and our own history. The German
concern with inflation predates the sec-
ond world war and has been central to
German economic policy. Yet the Ger-
man economic miracle of the 1950s
and 1960s occurred in the midst of
price stability. During the 1980s, the
Japanese inflation rate was less than
half of the American inflation rate. Here
at home, the level of net private domes-
tic investment in GNP was greatest dur-
ing the 1950s and early 1960s, when in-
flation was at its lowest. The evidence
suggests that low inflation is not only
consistent with rapid industrial growth,
but may actually enhance the process.
The second myth about inflation is that
it is good for making the income dis-
tribution more equal. At first glance,
the logic behind this myth seems com-
pelling. Money creation and the conse-
quent inflation provide funds for the
state by eroding the real value of finan-
cial wealth. As financial wealth is rela-
tively concentrated, this represents a
highly progressive and redistributive
form of taxation. In addition, inflation
transfers real assets from creditors to
debtors, effecting a private redistribu-
tion in addition to the one carried out
directly by the state.
Whatever the merits of this story in the
short run, inflation cannot be viewed as
a successful long-term instrument of
redistribution. Financial markets adapt
to policy changes and will ultimately
equilibrate at prices that preserve ex-
pected real returns. Let us consider our
recent experience.
Much has been made recently of the
apparent rise in inequality of the distribu-
tion of income over the past 20 years.
Contrary to the myth about inflation and
income distribution, this increase in in-
equality has occurred in the midst of a
sustained period of inflation. While many
factors affected the changes in the dis-
tribution of income over the period, a cur-
sory look at the statistics suggests that
inflation may actually have had the oppo-
site effect than one would assume.
The statistic most often cited to high-
light the rise in inequality is the in-
creased share of income received by the
top quintile of households. In 1967, the
top quintile received 43.8 percent of in-
come. In 1990, this figure was 46.6 per-
cent. In other words, an additional 2.8
percent of household income was re-
ceived by the top quintile. By contrast,
in 1967, interest income represented 7.6
percent of personal income. In 1990,
this figure was 15.4 percent. Further-
more, most of this interest income went
to households in the top quintile. In
other words, the rising share of interest
income in the economy, in large part
due to a market reaction to inflation,
was three and one half times as big as
the rise in the share of income going to
the top quintile.While clearly not defin-
itive, these statistics should make us
seriously question the efficacy of infla-
tion as an instrument of redistribution.
In fact, lower inflation should help to im-
prove one of the very important measures
of economic opportunity in America:
home ownership. The fact is: lower infla-
tion and interest rates greatly increase
the affordability of housing in America.
The National Association of Realtors
puts out a housing affordability index.
Today, by this measure, housing is more
affordable to the typical family than at
any time since 1976. If one uses a slightly
more complicated statistic that adjusts for
housing quality, the favorable affordabil-
ity comparison dates back to 1973.Let us be clear on why this is the case.
Higher inflation and interest rates im-
pose a form of forced saving on home
buyers. They must pay an inflation pre-
mium in their mortgage payment which
is offset by a rise in the nominal value
of their home. Lower inflation lowers
this forced saving component. A lower
cash flow is needed to finance an iden-
tical house as a result. While the change
may not lower the long-term net bene-
fits of home ownership, it does allow
more people to afford their own home.
I would argue that this is the surest sign
we have that disinflation will increase
economic opportunity in America.
The third myth about inflation is that it
helps to improve America's international
competitive position. This myth is now
widely discredited. It is clear that in the
long run, only changes in real exchange
rates affect trade flows, not simply
changes in nominal exchange rates. This
means that attempts to drive down the
value of the dollar through a conscious
policy of inflation will prove ineffective.
Contrary to the myth, a policy of price
stability is doubly beneficial to Amer-
ica. Not only does price stability en-
hance international trade, a policy from
which we benefit, it also increases the
role that America, and our currency,
plays in the global economy. Let us
consider each link in turn.
A stable medium of exchange has long
been recognized as a prerequisite for effi-
cient markets. Today, we have devised
financial arrangements that allow for sta-
bility even in the midst of unstable curren-
cy values. Individuals engaging in interna-
tional trade may, to some extent, hedge
their foreign exchange risks in futures
markets. While this achieves the benefits
of price stability, it is not a free lunch. The
hedging process consumes real resources.
Clearly, the more stable are currency val-
ues, the lower these costs need be.
Complicating the instability in markets is
the potential for deliberate policy actions
by governments and central banks to gain
temporary advantages by manipulating
currency values. In general, these activi-
ties are avoided today. But their potential
increases the risks, and therefore the
costs, of international trade. Establishing
the dollar as a stable currency, one not
subject to persistent inflationary pres-
sures, will help to lower these risks and
therefore enhance world trade.
Such a policy will also enhance the
value and role of the dollar in world
markets. To see this most easily, con-
sider recent developments in Europe. If
all goes according to plan, Europe will
have a single currency by 1999. For the
first time since the second world war, a
currency zone of a size that rivals the
dollar will have emerged on the world
scene. If this currency—the ECU—is
managed in a way that conveys stabil-
ity, it may gradually replace the dollar
as the world's reserve currency. Amer-
ica would not benefit from this occur-
rence. Thus, our need to achieve price
stability for international reasons in-
volves both a threat and a promise. The
promise is expanded world trade with
the dollar as a preeminent force in
world markets. The threat is being dis-
placed from this role.
In sum, I think the case for disinflation
in the 1990s is a strong one. While dis-
inflation is not a costless process, most
of the costs in reducing inflation have
already been borne. The benefits are
ones we can reap in the years ahead if
we remain vigilant. These benefits
include increased capital formation,
expanded economic opportunity, partic-
ularly home ownership, and an expand-
ing role for our country in an expanding
world economy. If true, then we will
soon be enjoying the fruits of a revolu-
tion—or counterrevolution—in eco-
nomic thought.
Lawrence B. Lindsey was sworn in as a mem-
ber of the Board of Governors of the Federal
Reserve System on November 25,1991, to fill
an unexpired term ending January 31, 2000.
Prior to becoming a member of the Board,
he served at the White House as a special
assistant to the President for policy develop-
ment (1990-91) and as associate director for
domestic economic policy (1989-90).
Dr. Lindsey worked as a research assistant
at the National Bureau of Economic Re-
search (NBER)from 1978 to 1981. He then
joined the staff of the Council of Economic
Advisers during the Reagan administration,
where from 1981 to 1984 he was, successively,
junior staff economist, Public Finance; staff
economist, Taxation; and senior staff econ-
omist, Tax Policy. In 1984, he returned to the
NBER, where he served as a faculty research
fellow until 1989.
Born July 18,1954, in Peekskill, New
York, Dr. Lindsey received an A.B.from Bow-
doin College in 1976, an MA. in economics
from Harvard University in 1981, and a
PhD. in economics from Harvard in 1985.
He was a teaching fellow (1978-81), an in-
structor (1984-85), an assistant professor
(1985-88), andan associate professor (1988-
90) at Harvard, where he also administered
the introductory economics program (1984-
89) and taught American Economic Policy
(1987-88).
Dr. Lindsey is the author of The Growth
Experiment: How the New Tax Policy Is
Transforming the U.S. Economy (Basic
Books, New York, 1990) and has contributed
numerous articles to professional publica-
tions. His honors and awards include selec-
tion as a CiticorplWriston Fellow for
Economic Research, 1988; the Outstanding
Doctoral Dissertation Award from the Na-
tional Tax Association for his work "Simulat-
ing the Response of Taxpayers to Changes in
Tax Rates," 1985; and the Noyes Prize in
Political Economy, Bowdoin College, 1976.
He was elected to Phi Beta Kappa in 1975.1992:IQ Economic Review Now Available
Economic Review is published quarterly by the Federal Reserve Bank of Cleveland. Below we present a summary of each of the three
articles contained in the most recent issue. Copies are available through the Public Affairs and Bank Relations Department, 1-800-543-3489.
Recent Behavior of Velocity:
Alternative Measures of Money
by John B. Carlson and
Susan M. Byrne
Changes in the structure of the U.S.
financial industry over the last decade
have raised questions about the
reliability of M2 as the primary guide
for monetary policy. Although the
simple ratio of economic activity to
M2—that is, M2 velocity—indicates
nothing unusual, the relationship be-
tween velocity and interest rates has
been disrupted in recent years. This
appears to be related to a breakdown in
money demand in 1988, which could
in turn be linked to the restructuring of
depositories. In this article, the authors
examine the velocities of two alterna-
tive monetary aggregates, but find that,
like M2, these measures are not imper-
vious to financial change.
Commodity Prices and P-Star
by Jeffrey J. Hallman and
Edward J. Bryden
The P-Star (P*) model forecasts infla-
tion by exploiting the stability of M2
velocity and the tendency of the real
economy to operate near its potential.
For a given stock of M2, P* is the price
level that would prevail if velocity were
at its mean and real income equaled
potential output. The ratio of the actual
price level (P) to P* can be considered
an indicator of how the current money
stock will affect inflation over the next
several years. Over shorter horizons,
other factors may be expected to influ-
ence the inflation rate. This paper
shows how the P* model can be modi-
fied to include information about the
recent behavior of commodity prices.
This modified model yields more accu-
rate short-run inflation forecasts while
still retaining the property that, over
longer horizons, only money matters.
The Causes and Consequences
of Structural Changes in U.S. Labor
Markets: A Review
by Randall W. Eberts and
Erica L. Groshen
During the initial stages of the expansion
of the 1980s, wage growth remained rela-
tively subdued. Even as the economy
picked up steam later in the decade, tight
labor markets did not drive up wages to
the extent that past experience would
have suggested. In an effort to find out
what was behind this unusual wage
restraint, the Federal Reserve Bank of
Cleveland held a two-day conference in
October 1989 on the causes and conse-
quences of structural changes in U.S.
labor markets. This article provides an
overview of those proceedings.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385
Address Correction Requested:
Please send corrected mailing label to
the above address.
Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.

The case for disinflation

http://www.clevelandfed.org/Research/commentary/1992/0315.pdf

The case for disinflation

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics