Inflation and Risk-Aversion

by Reihan Salam

Back in January, in a speech at the University of Michigan, Fed Chairman Ben Bernanke said, “I don’t believe significant inflation is going to be the result of any of this,” referring to QE3, the Fed’s ambitious bond-buying program. Bernanke’s critics were skeptical. Many assumed that the $85 billion-a-month program would spend inflation spiraling out of control. Yet for now, at least, it looks like Bernanke was right and his critics were wrong. Josh Mitchell of the Wall Street Journal reports:

A key gauge of inflation fell in April to its lowest level on record, a reduction that could take pressure off the Federal Reserve to wind down an $85 billion-a-month bond-buying program despite other signs of a strengthening economy.

Core prices, which exclude volatile food and energy costs, rose 1.1% in April from a year earlier, the Commerce Department said Friday. That matched the smallest increase in underlying prices since the agency began tracking them in 1960. Overall prices rose even less—just 0.7% in April from a year earlier.

A strengthening economy should boost inflation over time as consumers demand pay raises and firms gain latitude to boost prices. But considerable slack across the economy—due to high unemployment and weak demand—have kept inflation tame during the four-year recovery.

If anything, I’d argue that Bernanke’s real mistake is not embracing the Reagan-Volcker inflation target of 4 percent, or better still a nominal GDP level target set to grow at an annual rate of 4.5 percent, as it would, among other things, facilitate the deleveraging process, encourage risk-taking, and allow for real wage decreases in sector that might otherwise shed jobs. The potential role of somewhat higher inflation in encouraging risk-taking is relevant to another article in the Wall Street Journal, Ben Casselman’s impressionistic report on America’s rising risk-aversion:

In 1982, new companies—those in business less than five years—made up roughly half of all U.S. businesses, according to census data. By 2011, they accounted for just over a third. Over the same period, the share of the labor force working at new companies fell to 11% from more than 20%.

Both trends predate the recession and have continued in the recovery.

Investors, meanwhile, appear to be losing enthusiasm for startups. Total venture capital invested in the U.S. fell nearly 10% last year and has yet to return to its prerecession peak, said PricewaterhouseCoopers.

The share of capital going to new business ventures has fallen even faster, PricewaterhouseCoopers data show, and is more concentrated: Silicon Valley took 40% of venture funding in 2012, up from about 30% in the late 1990s.

Casselman offers a number of theories as to why risk-taking might have declined, ranging from the rising cost of medical care, onerous licensing requirements, and an aging population. His most promising suggestion is the following:

One barrier for prospective entrepreneurs may be the growing dominance of large corporations in nearly every industry, which make it tough for new ventures to gain a foothold. A small bookstore no longer needs just a better selection or a friendlier staff than the crosstown competition—it also has to compete with national chains and, increasingly, such Internet retailers as Amazon.

For the first time since such records have been kept, the Census found in 2008 that more Americans worked for big businesses—those with at least 500 workers—than small ones. The trend has continued since.

This is a strong case for the “invisible foot,” i.e., reforming the tax and regulatory environment to level the playing field for start-ups that are more likely to generate job-creating, quality-of-life-enhancing innovations than more risk-averse, set-in-their-ways incumbent firms. But Casselman doesn’t mention the role of inflation. One reason why new companies played a much bigger role in 1982 might be that the higher inflation rate of that era meant that investors were more willing to take a flier on young entrepreneurs. I don’t mean to suggest that inflation is some kind of panacea. It’s obviously not. But Reagan-Volcker inflation in the neighborhood of 3-4 percent could help address the risk-aversion problem.

On a loosely related note, Josh Barro sees the Fed’s embrace of a more aggressive monetary policy as a win for reformist conservatives — the key is that advocates of monetary easing only had to persuade Bernanke and a handful of his allies in the Fed, which is much easier than persuading politicians of the virtues of your various ideas.