As a special mention before getting this post started, Rao Aiyagari, a research economist at the Minneapolis Fed, died in 1997 at the age of 45 after experiencing a heart attack. I wanted to start this post with that information because when I found the paper he wrote challenging common cost/benefit analysis of a zero inflation policy I wondered why I had never heard anything about him given the economic devastation we have experienced since abject hawkishness came to dominate the Fed after the retirement of Alan Greenspan. This detail about his life is saddening, almost in the same way I’ve felt after reading the writings of Abraham Lincoln. The world experienced a great loss with the 16th President’s assassination; and it seems also true in the case of Rao Aiyagari who brought rational scholarship to an irrational policy proposal that would later haunt the globe over. Having lost him in 1997 is certainly a cause for grief today.

I seem some similarities in the body of Aiyagari’s work with the current debate about inequality, his main interest appears to have been dynamic macro analysis, and those interested in the topic (and discussions about Piketty) may be interested in some of his papers. Here is a summary of Aiyagari’s lifetime scholarship that can serve as a reference in order to find relevant papers.

Of course this post is not about inequality. Somewhere in the back of my mind it appears to be a debate in which I *should* have some interest as I might later regret not having contributed. But there are only so many calamities which I have the attention span to consider with the regard to detail that they deserve. And so, having prioritized the calamities in order of importance, inequality (which seems a rather nebulous term) ranks pretty well down the list compared to what I have recently learned is called “the sacrifice ratio,” or the calculation of how much unemployment will be encountered in order to reduce the trend inflation rate by certain degree. Nonetheless, I found this blurb in the summary referenced above that speaks to my general opinion in the “inequality” debate (and I also notice that it appears to overlap with the arguments against a zero inflation policy – interesting twist):

In his most influential paper, (Aiyagari (1994)), Rao investigates the implications of precautionary saving due to individual earning risks and borrowing constraints for aggregate savings. He found that the contribution of uninsured idiosyncratic risks to aggregate saving is modest for plausible values of risk aversion, variability and persistence of earnings, (at most 3%), but can be significantly larger with higher variability and persistence parameters of the earning stochastic process. Access to asset markets in that model enables agents to cut consumption volatility by half, and enjoy welfare gain of 14% of per-capita consumption, compared to the equilibrium with no access to assets markets. The model generates a wealth distribution that is positively skewed, more dispersed than income distribution, and inequality is significantly higher for wealth than for income.

Precautionary savings generated by uninsured idiosyncratic shocks and borrowing constraints motivated Rao to examine the recommendation to eliminate tax on capital income (Lucas, 1990). Aiyagari (1995) shows that for the Aiyagari-Bewley economies this dictum may be wrong because the frictions in these models result in agents’ behavior that is closer to that in overlapping generations (OLG) models. Precautionary saving can lead to over-accumulation of capital in equilibrium, so that positive taxes on capital are needed to bring the pre-tax return on capital to equality with the rate of time preferences, at any point in time as well as in the long run. In contrast to OLG models, where government debt can also be used to reduce excessive saving, in Aiyagari-Bewley economies the demand for such assets becomes infinite when the interest rates approaches the rate of time preferences.

The bolded text in the quote I believe is key to the inequality debate. Certainly, 14% per-capita consumption welfare gain is nothing to sneeze at with access to asset markets, as I have argued in at least one previous post. In looking at these two paragraphs together, however, I see a symmetry between this research and the rebuttal of the zero inflation proposal, as the zero inflation proposal purported one benefit of lowering taxes on capital among other things.

Aiyagari’s rebuttal to the zero inflation policy (Deflating the Case for Zero Inflation, 1997) brought some new (at least new to me) arguments to the table and can be summarized thus:

The proposed benefits:

  • Reduction in transaction costs
  • Reduction in capital income tax
  • Reduction in uncertainty

Aiyagari’s Rebuttal:

Reduction in transaction costs:

Reduction in transaction costs is small, between 0.04-0.22 percent of GNP absent unrelated costs of reducing the inflation rate to zero, and can be achieved in other ways – allowing interest to be paid on demand deposits and paying IoR to back the deposits.

Other ways the transaction cost reduction benefit would not be realized is the impact on tax distribution from a zero inflation policy given that about 12-14% of the base is held/utilized in the United States itself. A zero inflation policy would reduce tax via inflation on the underground economy and other holders of US monetary items, and place the burden on people who are within reach of the IRS. In other words, a zero inflation policy is not revenue neutral and those who cannot be taxed by regular means would no longer be taxed at all. So much for the rhetoric of everyone “paying their fair share.”

Here’s a quote from the paper:

This surprising fact affects the studies (on the benefit of transaction cost reduction) estimates in two ways. One is directly. The estimates implicitly assume that more or less all U.S. currency is held by adult U.S. residents; these are the people they assume would benefit from inflation’s elimination. According to a Federal Reserve study, however, adult U.S. residents instead hold only about 12-14 percent of it (Avery et al. 1987). Thus, the estimates of a transaction cost benefit from a zero inflation policy must be reduced accordingly.

But these estimates must also be reduced because of an indirect welfare effect, one that comes from inflation’s effect on those who do hold most of the U.S. currency. For the Fed study also implies that over 80 percent of it is held by people who are residents of other countries and people who are engaged in illegal activities (in the underground economy). These are people for whom U.S. policymakers may not want to eliminate the inflation tax.

If the inflation tax were eliminated, resources would implicitly be transferred from U.S. citizens, who don’t use U.S. currency much, to citizens of other countries, who do. This clearly imples some welfare loss to U.S. citizens

Capital income tax reduction from zero inflation:

Aiyagari addresses the purported capital income tax rate reduction in similar fashion, by first estimating that the overall benefit would range between 0.06-0.12 percent of GNP, then suggest that a better way to get to a reduction in the capital income tax is to simply reduce the tax directly and provides some suggestions such as indexing for inflation among others. He goes a bit farther to suggest that if there is some benefit to reducing inflation on the incidence of taxes, then the entire federal tax code could be indexed.

Reducing Uncertainty:

Even if the theory were right, though, reducing the average rate of inflation to zero may not have any effect on welfare. People who favor the zero inflation policy suggest that lowering inflation on average would necessarily make inflation less variable. Simple U.S. data support that idea. According to the data for the1960s and the1970s, the higher inflation is on average, the more it varies. But these data may be misleading. A study of them (Taylor1981) finds that the observed relationship between level and variability is due merely to monetary policy responses to supply shocks that had lifted the inflation rate. Government attempts to decrease fluctuations in output increased fluctuations in inflation. Thus, intentionally reducing the average money growth rate (to reduce inflation’s level) wouldn’t automatically reduce inflation’s variability. All of this may be only marginally relevant for economic welfare, anyway. What matters for welfare is not the variability of inflation, but the variability of personal consumption of goods and services, and that is already pretty low. Two studies (Fischer 1981b, Lucas1985) say that, per person, consumption in the United States doesn’t vary much. Thus, reducing the variability of consumption won’t improve welfare much.

Additional costs of a zero inflation policy:

After destroying the purported benefits of a zero inflation policy, Aiyagari then proceeds to talk about the tradeoffs, or other costs involved (things the zero inflation proponents don’t like to discuss) that include the following:

Sitcky money contracts/sticky wages (huge cost – he estimated about $2T in one year using Keynesian models. He also discusses rational expectations in which he examines how credibility could impact this cost).

The need for cooperation from fiscal authorities to control budgets, supposing it is an unlikely event (and how!)


If I could contribute to this in the vein of the credibility argument, one thing that has bothered me from the beginning of all of this is that the machinations toward this end were never transparent, and were never given the opportunity for public debate it deserves. If the rational expectations studies on credibility were ever given any weight at all, the public debate prior to attempted implementation of the policy and public visibility into the planning processes would have be absolutely critical to avoiding and/or mitigating what has been dubbed “the sacrifice ratio,” the amount of unemployment needed to create a reduction in the inflation rate in a compressed amount of time. It is absolutely unconscionable to allow naked sacrifice of the financial welfare of innocent victims when it could have been prevented. And in this regard anger regarding the opacity of policy intentions that results in completely uncivil and inhumane treatment of such victims is entirely justified.

Overall, I see plenty of echoes here of the central bankers’ anti-inflation rhetoric of recent years and I have at least a coherent response as to the supposed benefits of microscopic levels of inflation and some new arguments against it to add to my arsenal in fighting rhetoric with rhetoric. The very plus side of this find is that it’s all from a well-respected and well-researched point of view. It really is too bad that none of these things that show any rationality at all were ever delivered by the inflationophobes themselves, as it would have made them seem far more rational than I understood them to be.