Summary
Higher levels of unemployment are not necessary to manage inflation. Targeting purchasing power is less harmful. The income tax code can be used to fight inflation.
In the 1970s, when the U. S. suffered its worst case of inflation, there was no agreed upon course of action to systematically address the issue. Many options were considered, but there was no consensus. Inflation lingered until the Federal Reserve, under the direction of Paul Volker, continued to raise interest rates until it became clear to all that the rapid expansion of the previous two decades was over. It was here, and with the ascendancy of a neoliberal political regime, that the concept of the permanently underperforming economy was ushered in. Austerity and a balanced budget were to be the go-to strategy for those in charge of economic policy. With reduced leverage, labor was to suffer the brunt of this new strategy as higher levels of unemployment became the inflation fighting tool.
Forty years of subpar economic performance has left its mark. Visions of a Great Society have long ago vanished. We are no longer the shining city upon a hill in which others gain strength. We neglect poverty, systemic racism, and environmental issues as we watch wealth inequality flourish. All because we accept a flawed narrative. We fail to address the issue of inflation properly.
A system of musical chairs has been designed for the economy. No matter how well labor is positioned to compete for a ‘chair’, there will never be enough to go around for all participants. Upgrading one’s skills may help the individual to compete more effectively, but this does not create more jobs for when the music stops. The number of jobs will always bump up against the targeted rate of inflation as an economy heats up and interest rates are raised.
Attempting to control inflation by excluding a portion of the workforce from participation lacks imagination. It is a resignation to the unpleasant aspects of a political system that only obeys the power of money. It is the expedient way to control the possibility of accelerating inflation but far from the best. We can do better. It is our duty to understand the dynamics of inflation and put in motion proper tools for combating price instability. Only then will we be able to address larger issues that need attention.
The Prescription
The Federal Reserve (the Fed) is currently charged with a dual mandate: fight inflation and create full employment. Given the tools available, this dual mandate is an overreach. They have been handed an impossible task. The Fed can either lower interest rates, speed up investments, allow business to expand, and create more jobs, or it can raise interest rates, slow business investments, restrict expansion, and fight inflation. It cannot do both. With tools that are available to them, the Fed cannot target accelerating inflation at its source.
Prices are subject to inflationary pressures based upon the law of supply and demand. When demand is high for a given commodity and supply is low, prices tend to rise. When business is unable to increase supply to meet this increased demand, a new price level is established for that commodity. Where this happens generally, economy-wide, inflation is the result. A permanently underperforming economy is designed to interrupt the prospect of high demand. Higher interest rates and lower levels of investment creates higher levels of unemployment. With greater unemployment, some consumers are removed from active participation, and demand for goods and services falls. Limiting the possibility of high demand by way of unemployment, however, is unnecessary, inefficient, and self-defeating.
Raising interest rates to slow business expansion is just the opposite of what is needed. If inflation is evident in the data, business must be encouraged to continue producing. Instead of raising interest rates to slow economic growth, we must allow business to strive to meet higher demand. Business should continue to enjoy attractive interest rates which helps to promote growth and, depending on the severity of the economic indicators, be granted lower tax rates.
When the data suggests accelerating inflation, reducing federal spending is necessary but only a first step. The issue of consumer spending must be addressed. We must dial back consumer spending in the face of inflationary pressures until business can keep up with demand. This reduction in spending can be accomplished by way of higher levels of taxation for the individual taxpayer. Reducing disposable income in times of accelerating inflation will affect demand and bring spending more in-line with production. This process can be referred to as the Fiscal Policy Reaction Function.
Limiting the purchasing power of the consumer will help to maintain current price levels. While not attractive to most, limiting demand for goods and services in this manner has the benefit of maintaining employment levels. Once business is again able to produce at levels commensurate with demand, the inflation premium can and must be rescinded. This will allow consumer spending to return to previous levels and allow business to continue to innovate and expand.
Codifying into Law
To make the above plan of action workable will, unfortunately, require an act of Congress . . . literally. It will be necessary to codify this strategy into law. When accelerating inflation appears in the data, time will be of the essence. There will be no time for deliberation. We must agree to a solution in advance. This process, as it unfolds in real time, must be removed from the political sphere. As signs of accelerating inflation appear, tax rates must be adjusted automatically and across the board.
Early signs of inflation are readily available. These signs include tracking wage increases, observing service sector and commodity prices, examining the Baltic Dry Index where international trade is quantified, recognizing financial bubbles, and the list goes on. This process, for the most part, has been worked out by the Fed. This is the same data that is currently used to adjust the Federal Funds interest rate, when political considerations are not in play. Indicators are available that will show unwarranted demand pressures on goods and services and the need to act.
Once the proper indices are agreed upon, the formula, perhaps in the form of an algorithm or a type of machine intelligence where the power of historical data is used to its fullest extent, must be codified into law. The result of this process would then trigger an automatic response when the conditions warrant. Individual income tax rates would be raised or lowered based upon the outcome of this analysis. Deliberations on a proper course of action must be decided in advance as the lessons of the 1970s has revealed. Timely action is the key to managing inflation.
Compelling action among rabid partisans will be the challenge. It must be recognized, however, that this approach to fighting inflation is a potential win-win. The business community continues to expand with this strategy, and labor enjoys higher rates of employment. Consensus may be possible given that forestalling inflation and higher levels of employment are in everyone’s interest.
Conclusion
The current prescription of limiting overall economic growth to combat inflation is not efficient and is counterproductive. We do not need to engineer a permanently underperforming economy to address the prospect of accelerating inflation. A more targeted approach can allow for higher levels of employment and a more robust economy. We can look to the data for answers and use the tax code to help regulate demand. A more institutionalized approach to managing inflation is possible. The health of the economy and social cohesion depends on our ability to make this happen.
