Front Page Titles (by Subject) IV.: The Inflation Trap - The Collected Works of James M. Buchanan, Vol. 10 (The Reason of Rules: Constitutional Political Economy)
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IV.: The Inflation Trap - Geoffrey Brennan, The Collected Works of James M. Buchanan, Vol. 10 (The Reason of Rules: Constitutional Political Economy) 
The Collected Works of James M. Buchanan, Vol. 10 (The Reason of Rules: Constitutional Political Economy) Foreword by Robert D. Tollison (Indianapolis: Liberty Fund, 1999).
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The Inflation Trap
There are many similarities between the high-tax trap and the inflation trap, which we shall analyze in this section. The similarities are readily explained once it is recognized that both traps have essentially the same behavioral basis, which we have summarized as the disparity between the discount rate embodied in the choices made by individuals in their separate roles as public and private decision makers.
The United States, along with other Western countries, found itself caught up in an inflation in the 1970s that seemed to be continuing unabated. The inflation persisted despite the widespread recognition that a national economy operates less efficiently under an inflationary than a noninflationary regime. In a long-term perspective, inflation is clearly not in the interest of any group. But the short-term perspective that informs the decision calculus of those who participate in politics seemed to prevent them from initiating the action that would have been required to restore effective monetary stability.
How did we get into the dilemma? Is there a way out that can be other than temporary? An answer to the first question, which is perhaps essential to any attempt to answer the second, requires that we summarize the history of ideas in economics, at least since the impact of Lord Keynes. We shall do nothing more than sketch the bare outlines.
Keynes was successful in imposing on the mind-set of economists of the middle years of this century an abstract model of a high-unemployment, underutilized economy. And Keynes was surely correct when he noted that the ideas of academicians ultimately influence the actions of politicians. In the initial Keynesian model, demand brings forth supply, and increases in demand sop up underutilized manpower and capital, without creating increases in costs and prices. There are no supply-side constraints in the model, and quite literally, public spending is costless in terms of effectively displaced alternatives. This simple model appeared in the textbooks of all economics students after World War II, including all of those who later became the political leaders and opinion molders of the 1960s and 1970s. And surprisingly, the simple Keynesian model remains in many of the textbooks of the 1980s.
As early as the 1950s, however, there were indications that the Keynesian model is wrong in a critical respect. Supply schedules are not flat, to revert to familiar geometrical reference. Supply curves slope upward. Increases in demand, even in an economy with some or even considerable unused capacity, generate pressures on costs and hence on prices, at least in some sectors, especially if monetary policy is accommodating. This newly found post-Keynesian relationship between inflation and the rate of unemployment was accepted as an empirical reality of the late 1950s and 1960s. Its definitive version was presented by A. W. Phillips in 1958.5
The “Phillips curve” dominated macroeconomic policy discussion during the 1960s. This curve, or relationship, depicts the trade-off between unemployment, on the one hand, and the rate of inflation, on the other. The central idea is that a positive rate of inflation generates a reduction in the rate of unemployment (or an increase in employment). Once the existence of such a trade-off was accepted by economists, they began to temper their earlier enthusiasm for continued increases in aggregate demand to stimulate the economy, but they stayed within the broadly defined Keynesian model by talking about an “optimal” rate of inflation, based on the notion that optimality is attained when the trade-off between inflation and unemployment in the utility function of the political decision maker matches that dictated by the Phillips relationship. A little inflation seemed to be but a small price to pay for increased employment and output.
Things did not quite work out as the economists of the 1960s had foreseen. What the Phillips curve macroeconomists failed to reckon with was the time dimension of the inflation-unemployment trade-off. To be sure, there was empirical evidence that an increase in the rate of unanticipated inflation could generate a temporary increase in employment (a reduction in unemployment). But after a time, employment (and unemployment) seemed to settle back to a natural rate, a rate that was not basically affected by the now anticipated rate of inflation but that was, instead, dependent on structural characteristics of the economy, on such things as the flexibility of labor markets, the spatial location of employment, the skill level of particular employee groups, minimum wage and union restrictions, levels of unemployment, disability, retirement compensation, and a host of like factors. Economists came slowly to learn that no permanent and continuing increase in employment could be sustained by some optimally chosen and maintained rate of inflation.
At this point in our potted macroeconomic history, however, public-choice economists had something to contribute. Once those who participated in the making of governmental decisions had been led to think that a little inflation was the route to higher employment, even if such stimulus proved to be temporary, the same individuals were tempted to repeat the exercise, generating a second round of inflation in exchange for a second short-term, or temporary, increase in employment and output in the economy. The simple logic of short-run response built into the political mechanism seemed to suggest that politically induced inflation would accelerate, at least for many rounds of adjustment.
Such was the state of the macroeconomic game, so to speak, until the mid-1970s. Since the late 1970s, however, more sophisticated models of political-economic interaction have been developed. These models indicate that there may emerge a political-economic equilibrium closely akin to that discussed earlier under the high-tax trap. Politically induced inflation need not continue to accelerate to levels of hyperinflation. A political equilibrium may be reached well short of such levels. An equilibrium of this sort will be attained when the internal trade-off of the participant in political decisions, which embodies the short-term perspective of modern democracy, matches the inflation-employment trade-off dictated by the short-term Phillips relationship, while at the same time the inflation rate is fully anticipated, ensuring that the solution satisfies the long-term Phillips relationship.6
Such a full political equilibrium necessarily satisfies the conditions of the Phillips relationship for both the short and the long term. That is to say, unemployment is at its “natural rate,” but there is also a continuing and fully anticipated inflation. In such an equilibrium, there is no longer any short-term incentive for the governmental decision maker to generate more inflation, and furthermore, individuals are fully adjusted to the rate of inflation that exists.
Unemployment at this full equilibrium is as high as, or possibly even higher than, it would be if there were no inflation at all. To the extent that inflation creates any inefficiency in the economy, the full equilibrium seems clearly to be nonoptimal. It would seem to be in the interests of all persons to reduce or to eliminate the rate of inflation.
A trap exists, however, because any reduction in the anticipated rate of inflation will, according to the short-term Phillips relationship, generate short-term increases in unemployment, as, indeed, the United States witnessed in serious fashion in 1981 and 1982. The participant in political decision making will not normally base decisions on a time horizon sufficiently long to make the reduction or elimination of inflation rational, even if the long-term benefits of such action are completely recognized.
In such a setting, the incentives of the participant in politics can be modified so as to ensure choices based on a long-term perspective only if the discretionary authority of the collectivity is restricted. The political decision maker can act with prudence in investing in long-term disinflation only if he can be assured that political coalitions, in subsequent periods, will not reinflate in response to short-term utility considerations. This general point was widely recognized in the macroeconomic policy discussions in the United States in the early 1980s. But there seemed to be a surprising failure to draw the proper inferences to the effect that constitutional limits on the monetary authority of the collectivity are necessary to resolve the dilemma.
[5. ]A. W. Phillips, “The Relation Between Unemployment and the Rate of Change in Money Wage Rates in the United Kingdom, 1861-1957,” Economica 25 (November 1958): 283-99.
[6. ]See Finn E. Kydland and Edward C. Prescott, “Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy 85 (June 1977): 473-91.