Monetary policy has always been the Achilles’ heel of conservative economics. We’ve repeatedly seen conservative policymakers work hard to create a successful free-market economy, only to have their efforts undone by a devastating period of deflation. In the 1920s, the U.S. economy did well with all levels of government spending only about 10 percent of GDP. All those efficiencies were lost in the subsequent decade. Nominal GDP fell by half between 1929 and 1933, opening the door to big-government statism. Similarly, the neoliberal reforms in Argentina during the 1990s were discredited by the deflation of 1999–2001. In each case, markets got blamed for what was actually the fault of a dysfunctional monetary regime.
Unfortunately, many conservative economists are too dismissive of the costs of deflation. They claim that wages and prices can adjust to any increase in the value of money. But if this were so, there is no reason to believe that wages couldn’t adjust to any decrease as well — and high inflation would also be of no concern. In fact, deflation tends to be far more costly than the sorts of mild inflation that we tend to see in the U.S.
Once the devastating costs of deflation are acknowledged, one can no longer imagine an earlier age when the dollar was “as good as gold.” A gold standard stabilizes the price of one good, gold itself, at the cost of allowing instability in the overall price level. Long-term inflation was near zero under the 19th-century gold standard, but like the man who drowned in a lake with an average depth of three feet, long-term price-level stability can mask a great deal of short-term instability. Prices were at about the same level in 1913 and 1933, for example.
Nor can we avoid the pitfalls of previous gold-standard regimes by getting government out of the picture. If governments did not hold gold reserves for monetary purposes, the value of gold would be even more closely tied to fluctuations in the industrial demand for the metal. In recent years, almost all metals prices have become highly unstable, as rapid industrialization in Asia has pushed up their prices relative to those of other goods. Fixing the nominal price of gold will not lead to price stability.
For better or worse, conservatives need to acknowledge that we live in a fiat-money world, and we need to figure out a way of managing paper money that does the least damage to the broader economy. That means we can’t dodge the hard questions of macroeconomics and blithely assert that we oppose the Fed’s “meddling” in the economy.
There is no laissez faire in fiat money. If the Fed holds the money supply constant, it will be changing the interest rate and the price level. And if it holds interest rates constant, it loses control over the price level and money supply. As a result, many economists now favor some sort of inflation-targeting regime. The most famous example is the Taylor Rule, which did keep inflation tolerably low and stable for two decades. But inflation targeting has several defects that in my view make nominal income (or GDP) stabilization a better goal.
One well-known argument against inflation targeting is that there are times when price-level fluctuations are desirable. George Selgin pointed out that during a productivity boom, it might be better to have a mild deflation in order to prevent labor markets from overheating. Conversely, a negative supply shock ought to make inflation rise: We don’t want to force all non-energy prices to fall to make up for an oil embargo.
Most of the problems that are believed to flow from an unstable price level actually result from nominal-income instability. The aggregate nominal income in the economy is the sum of each person’s income, measured in current dollars. Since most debts are nominal (i.e. not indexed to inflation), nominal income is the best measure of a person’s ability to repay their debts. In 2009, the U.S. saw the biggest fall in nominal GDP (NGDP) since 1938. It is thus no surprise that we had a debt crisis: Borrowers almost always have trouble repaying debts when nominal income comes in much lower than was expected when the debts were contracted.
Some people overlook this problem because they focus on the most spectacular debt problems, the cases where borrower behavior would have been irresponsible regardless of the future path of NGDP: the subprime mortgages in America, the government borrowing in Greece, or the decision by the Irish government to absorb the liabilities of irresponsible banks. But those cases are merely the tip of the iceberg; the sort of systemic debt problem now faced by the Western world goes far beyond these isolated cases, and can be explained only by the fall in nominal income.