Zero Inflation; G. Selgin

Zero inflation is, to be sure, a more realistic goal for monetary policy than such things as "full employment" or economic "fine-tuning." Nevertheless, it is far from being the ideal policy its advocates proclaim it to be. Price Stability or Stability of Spending? The zero inflation norm goes back to classical economics and has inspired count less monetary-reform proposals during the last 100 years. One would think that such a longstanding ideal must be solidly grounded Dr. Selgin is Assistant Professor ofEconomics at the University of Georgia and the author ofThe Theory of Free Banking. in theory. But the truth is otherwise. In fact the zero inflation ideal is largely dogma, founded upon the unrealistic assumption of a stagnant or stationary economy where the productivity of labor and capital never changes. In such a stationary economy, price sta bility goes hand-in-hand with stability of total spending, or "aggregate demand,"

measured in dollar terms. Economists gen erally favor stability of money spending because it allows the typical producer tojust recover his money costs of production, avoiding depression on one hand and over expansion of industry on the other. Thus stability of "aggregate demand" avoids de viations of real output from its "natural". level. But zero inflation implies stability of spending only in a stationary economy. In a growing economy with more to be bought, stability of money spending requires falling prices. In an economy where productivity is declining, stability of spending requires that prices generally rise. Because they overlook the reality of changing productivity, propo nents of zero inflationwrongly conclude that the benefits of stable spending can be had by keeping the price level constant. Debtor-Creditor Justice A popular argument for zero inflation is that unanticipated price-level movements lead to unfair transfers of wealth. When 288 "ZERO INFLATION": A FLAWED IDEAL 289 prices rise unexpectedly, debtors gain at the expense of creditors because loans are re paid in dollars having less purchasing power than when the loans were originally made.

When prices fall, creditors profit at the expense of debtors. Zero inflation, it is claimed, would prevent such unjust trans fers. Although the argument is valid for a static economy, a zero inflation policy enforced in the face of changing productivity would itself lead to unjust redistribtions of wealth. Any overall change in productivity implies a change in real income for the economic community taken as a whole. Distributive justice then becomes, not a matter of avoid ing "windfall" transfers of wealth, but one of deciding how an increase or decline in overall wealth should be shared. Imagine the consequence of an unanticipated, all around doubling of productivity in the United States. A halving of product prices would, here as when productivity is con stant, double the real burden represented by each dollar of debt. But most debtors would be compensated by a doubling of their real earnings. Creditors, in turn, would enjoy a higher real return on their loans. But their gain would merely reflect a pro rata share of similar gains being enjoyed by the rest of society. To deprive creditors of their share by stabilizing the price level would be arbi trary at best.

Moreover, a zero inflation policy that would be arbitrary when productivity is improving could lead to disaster were pro ductivity to fall significantly. Zero inflation would then require a forced contraction (via tight money) of spending to offset the normal tendency for the prices of scarcer goods to rise. Debtors would find their real income reduced, but the amount of real income needed to repay each dollar ofdebt would be unchanged. Few people would call the re sulting rash of defaults and bankruptcies "just. " Helping Prices Do Their Job Another argument for zero inflationis that price-level changes interfere with the price system's ability to allocate resources. Be cause it takes time and effort to make moneyprice adjustments, changes in the relative values of different goods should be signaled with as few moneyprice changes as possible. Otherwise the risk is great that incomplete or incorrect price adjustments will lead to economic waste. Proponents of zero inflation claim it would allow the price system to do its job with a minimum of moneyprice changes by eliminating any need for general price changes to offset changes in the supply of or demand for money.

This argument, too, is only valid for a static economy: When productivity changes, a change in the general price level is not only consistent with, but essential to the efficient working of the price system. Such a price-level change merely reflects changes in real costs of production. Suppose for instance that the cost of producing com puters falls to half its former value, while the cost of producing other goods remains un changed. The relative price of computers needs to fall below its former level. If the public continues to spend the same amount of money on computers, buying proportion ately more units as the money price falls, the needed relative price adjustment is easily made by halving the money price of com puters, leaving other money prices un changed. Money spending would remain stable with no need for any increase in money supply. A zero inflation policy, in contrast, to keep the average level of prices constant, would require a monetary injec tion to enhance spending so that the price of computers falls by less than one-half and all other prices rise slightly. The zero-inflation policy clearly places a greater burden upon the price system, with greater opportunities for misdirection of resources.

Likewise, the best way to handle a/all in output, ·like an OPEC-inspired cut in oil production, is to allow the fall to be reflected in higher prices. Manipulating the money stock to keep prices from rising would reduce the price-system' s ability to convey useful information about the true state of resource scarcity.