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For release on delivery 7:30 pm EST March 12, 1992 The Case for Disinflation Address by Lawrence B. Lindsey to The Government Bond Club of New England Boston, Massachusetts March 12, 1992 THE CASE FOR DISINFLATION Thank frankly, you. this It time is a pleasure every four anywhere but Washington D.C. to be years, here it's tonight. nice to Quite be almost And, since you've just endured the Super Tuesday limelight, I'm 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 suppose we should be grateful for these Tuesday night events. My aim tonight is to look beyond tomorrow's beyond next Tuesday, and even beyond November. bond market, There is a major unreported economic story occurring in America, the consequences 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 continuing reduction in the underlying rate of inflation. the Federal stability. Reserve is Let there be no mistake about it; committed to the attainment of price Furthermore, largely due to actions which took place before I joined the Fed, we have a good chance to achieve effective price stability understood and in America by mid-decade. certainly not appreciated This in is not financial widely markets. But, it is one of the factors which makes me very optimistic 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 inflation 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 Macroeconomics has rediscovered the case for price stability that was largely taken for granted in the pre-Keynesian era. The experience of the last two decades has taught that there really is no attractive long term policy tradeoff between unemployment and inflation. At best, lower unemployment can only be attained temporarily 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 reasons 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 economic growth. In fact, the opposite is the case; price stability will aid in the process of capital formation. The public 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 indexation, so that taxes are levied on real income and not nominal income. The legislative changes needed to accomplish this are not in sight. Achieving price stability will accomplish the same end without legislative action. Consider 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 percent nominal tax rate translates into a 50 percent tax on the real interest. absence of inflation, income is the same In the the effective tax rate on real interest as the statutory rate, or 25 percent. 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 realized capital gains represents the effect of inflation. To this must be added the effect of inflation on the basis of investments which end up as capital losses. The net effect of our tax system coupled with current levels of inflation is to make the effective tax rate on real capital gains well over 50 percent. Disinflation 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 investment by reducing our currently very high effective tax rates. Disinflation could also accelerate capital formation by substantially improving the tax treatment of productive equipment by increasing schedules. the present value of depreciation deduction The effective tax rate on new corporate investment depends on the present value of depreciation deduction schedules, which in turn depend 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 beneficial rates to of the saving U.S. and capital economy. accumulation would be Numerous schemes advanced to achieve this end through the tax system. have been 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 - - o r inflation -- is good for investment. not. It is Consider both the post-War miracles of Japan and Germany and our own history. The German concern with inflation predates the second world war and has been central to German economic policy. Yet the German 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 domestic investment in GNP was greatest during the 1950s and early 1960s when inflation 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 distribution more equal. behind this consequent myth seems compelling. Money creation and the inflation provide funds for the state by eroding the real value of financial wealth. concentrated, this As financial wealth is relatively represents redistributive form of taxation. real At first glance, the logic assets from creditors to a highly progressive and In addition, inflation transfers debtors, effecting a private redistribution 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 returns. equilibrate at prices that preserve expected real Let us consider our recent experience. Much has been made recently of the apparent rise in inequality of the distribution of income over the past 20 years. Contrary to the myth about inflation and income distribution, this increase in inequality has occurred in the midst of a sustained period of inflation. While many factors affected the changes in the distribution of income over this period, a cursory look at the statistics suggests that inflation may actually have had the opposite effect than one would assume. The statistic most often cited to highlight the rise in inequality is the increased share of income received by the top quintile of households. percent of income. In 1967, the top quintile received 43.8 In 199 0, this figure was 46.6 percent. In other words, an additional 2.8 percent of household income was received 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. Furthermore, 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 definitive, these statistics should make us seriously question the efficacy of inflation as an instrument of redistribution. In fact, lower inflation should help to improve one of the very important measures of economic opportunity in America: home ownership. The fact is: lower inflation and interest rates greatly increase the affordabilitv 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. complicated statistic that If one uses a slightly more adjusts for housing quality, the favorable affordability comparison dates back to 1973. Let us be clear on why this is the case. Higher inflation and interest rates impose a form of forced saving on homebuyers. They must pay an inflation premium in their mortgage payment which is offset by a rise in the nominal value of their home. inflation lowers this forced saving component. Lower A lower cash flow is needed to finance an identical house as a result. While the change may not lower the long term net benefits of homeownership, it does allow more people to afford their own home. that this is the surest sign we have that I would argue disinflation will increase economic opportunity in America. The third myth about inflation is that America's international competitive position. widely discredited. it helps improve This myth is now 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 America. international trade, a Not only policy does price from which stability we enhance 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 efficient markets. Today, we have devised financial arrangements that allow for stability even in the midst of unstable currency values. Individuals engaging in international trade may, to some extent, hedge their foreign exchange risks in futures markets. While this achieves stability, it is not a free lunch. real resources. the benefits of price The hedging process consumes Clearly the more stable are currency values, 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. these activities are avoided today. the risks, and therefore the In general But, their potential increases costs of international trade. Establishing the dollar as a stable currency, one not subject to persistent inflationary pressures, will help lower these risks and therefore enhance world trade. Such a policy will also enhance the value and role of the dollar in world markets. developments in Europe. have a single To see this most easily, consider recent If all goes according to plan, Europe will 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. - is managed in a way that If this currency -- the ECU- conveys stability, it may gradually replace the dollar as the world's reserve currency. not benefit from this occurrence. America would Thus, our need to achieve price stability for international reasons involves 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 displaced from this role. In sum, I think the case for disinflation in the 1990s is a strong one. the costs While disinflation is not a costless process, most of in benefits are vigilant. reducing ones we inflation have can reap These benefits already been borne. in the years ahead include increased if we capital The remain formation, expanded economic opportunity particularly home ownership, and an expanding role for our country in an expanding world economy. If true, then we will soon be enjoying the fruits of a revolution -or counterrevolution - - in economic thought.
@FedFRASER