Over on his blog Matthew Yglesias has a post lauding the idea of intentionally creating moderate inflation, based on a recent policy paper. The idea is that if you let inflation go up moderately for several years, you could alleviate the massive public and private debt burden substantially. For a nation like the U.S. plagued with debt, that sounds like a pretty nice result. The problem, however, are the other consequences that would follow.
First, here's a useful chart from that policy paper by Chris Hayes of New America:
As you can see, we've created a lot of debt, but little inflation. Yglesias thinks that inflation could help:
The idea is basically that if we could sustain a five or six percent inflation rate for a period of years, that would make it much easier to work off the debt overhangs--both in the public and private sectors--that otherwise threaten to hobble the economy for years.
Let's assume that all lenders, including banks who lent to consumers and foreign investors who bought U.S. Treasuries, are evil. You'd basically have to, because you'd be intentionally eating into their real return and in some cases turning it negative. Even if these parties really would all be getting just what they deserve, there are other outcomes to worry about.
Foreign Investors
The most obvious is the reaction of foreign investors. Just yesterday I wrote about how investors around the world aren't likely to soon forget the losses that U.S. banks caused them during the crisis. The same logic would apply towards U.S. policymakers that allow higher levels of inflation.
Why, in their right minds, would the Chinese be willing to invest in vast quantities of U.S. debt going forward? After all, the real return on that debt might end up being negative if Americans just decide to inflate their way out of it again. Certainly, the Chinese and others would learn from such a mistake.
That means, in a time of crisis, the U.S. would have a lot harder time doing any deficit spending to ease the economy. This should be an especially worrisome prospect for any Keynesians.
Damaging To Fragile Banking Industry
The world looks quite a bit better for banks than it did a year ago. But that isn't to say that it's business as usual. That will take years to happen. By allowing inflation to increase for the next several years, you make matters more difficult for that banking recovery. They will lose money on existing debt, which will be worth much less. I know there isn't a lot of sympathy out there these days for banks, but I can't imagine most Americans want to live in a country where the financial industry cannot regain its footing for several more years.
More Bubbles
Finally, inflation has the potential to create bubbles. One bubble might be in lending. By easing money supply over an extended period, lending might get out of control. Another potential bubble could occur in stock and commodity prices. People will be looking for ways to protect the value of the wealth, so will be turning to sources other than cash to do so. That will drive up demand for stocks and commodities, potentially overheating those markets as well.
Rich Benefit; Poor Suffer
It might seem like inflation would hurt the rich, as they have accumulated the most wealth. But they also have the most investment sophistication to avoid inflation's bite, because they have the cash to hire private brokers and money managers. Poorer individuals who have the little savings they've got in a money market or savings account will be the real losers.
I also noted this week that the rich often have even more debt than the other classes. Again, they would benefit more if their debt became easier to pay off.
The debt situation we're in is a serious one. It might result in lower growth until it's under control, but I think that's a bitter pill we'll have to swallow given the lifestyle we've led as a nation and individuals. The only good solution is to spend more responsibly on national and personal levels. A supposed easy way out like inflation will just result in other negative consequences.
in all scenarios the rich benefit.
I don't think inflation will be something that will willingly be induced so much as something that will inevitably happen when you consider the ballooning of the deficit with the costs of the various bailouts.
Martin,
Then you do you explain the Yen? They'd kill for some inflation - but all the deficit spending and bailouts in the world haven't been able to trigger any.
Inflation results from an increase in the money supply. Fiscal deficits don't directly cause inflation — inflation occurs when the central bank monetizes the debt.
Japan's central bank hasn't done that.
Over the last twelve months (ending August 2009), the US Federal Reserve has increased the money supply (M1) by a seasonally adjusted rate of 18.5%. Up until now, most of that increase has only been used to rebuild bank balance sheets — but if the increase continues, inflation will result.
Keynes has been so rehabilitated that Friedman seems to have been forgotten...
since you mention the Japanese, the reason inflation is so low in Japan and America in the 1980's as evidenced in the chart is that...the Japanese are sitting on a hoard of US dollars, just like the Chinese and their 2 trillion.
When you convert Yen to Dollars and then just sit on it, that restricts the supply of Yen and Dollars.
This was also why Reagan's deficits didn't result in runaway inflation. The asians have been giving America a free ride for the past 30 years or so.
It looks like their industrial interests want continue it, but effectively these policies have resulted in the enslavement of asian workers.
Another question is whether it would even be legal for the Federal Reserve to do what Yglesias and Hayes suggest.
The Fed is required by its legislation "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Reducing the burden of government debt by destabilizing prices is not, as far as I can tell, a legal objective for the Fed to pursue.
Someone would have to make the argument that any non-accelerating inflation is "stable", though I think it'd be a stretch to claim 5% inflation is consistent with stability, and claim that the only reason they're doing it is because if they don't "inflate away the deficit" then interest rates will get too high... I think that's another stretch.
No one who lived through the 1970's would ever suggest intentionally creating inflation. Yglesias continues to demonstrate his naïveté.
The idea that "moderate" inflation could even be managed is more fantasy. Once lit, inflation burns like kindling. Monetary stability can only be reestablished in conjunction with a crushing recession.
Maybe the Fed should stop its contractionary fiscal policy?
That would be the Fed's monetary policy — NOT the federal government's fiscal policy.
Breaking news: Overpaid philosophy-major blogger stumbles upon an Economics 101 strategy that failed miserably and thinks it's a groundbreaking idea! Film at eleven!
Better send that over to Yglesias's publicist ASAP — now he can get a job in the Obama Administration!
He's got all of the qualifications, right?
I have great sympathy for the idea floated by Yglesias, despite the derison leveled at him by defenders of the standard, and now largely discredited economic orthodoxy.
Especially in that it goes against the grain of the accepted wisdom of the current predominantly monetarist economic priesthood, which has of course performed so brilliantly as of late.
Intentional inflation is of course the great heresy.
Unlike 99.9% of the devotees of Chicago, I lived through not just the mild monetary swoon of the 1970's, but the real McCoy of hyperinflation (Russia early 90's) up close, and I have felt many of the effects of really serious inflation on my own hide.
There are indeed many ills (first socially the impoverishment of small monetary asset-holders and those on fixed incomes, and economically the inability to raise funds for large-scale private long-term investments for a certain period of time), but there are also definite benefits: in Russia the artificial financing of state enterprises helped to avoid the shock of immediate economic dislocation in a period of intense social, economic and political upheaval, and perhaps avoided an early retrenchment back to Communism.
The structural problems of the US naturally differ. Not grotesque over-militarization (just unsustainably high military expenses), but overconsumption, excess debt, weak exports and a far too anemic manufacturing sector.
But then, so the Chinese don't buy our debt: good! We'll have to raise taxes at last - a long overdue necessity, for many reasons. The Republicans' starvation strategy proved a sham, and to refashion the phrase: we need to stop feeding the sacred cow with junk, and give her proper food before we put her into fitness training.
Debt will be restructured, and the struggle of debtors vs creditors (not necessarily poor vs rich) could be intense. Still, creditors may not be evil, but given the exquisite, subtle, but ultimately nefarious way they, or rather their systems, have entrapped their "customers," the debtors, there need be no tears for these. They should not expect to escape the general social pain. Just look at the overdraft racket described so exquisitely in the New York Times this week.
And don't forget: inflation will devalue the dollar and breathe new life into our exports in general and manufacturing in particular. Having seen the miraculous, nearly instantaneous curative effect of a deep devaluation in Russia in 1998, I believe this would be very salutary for the structural problems in the US, indeed.
A short, sharp double-dip recession may indeed be the only way to restore normality later (although Russia managed to tame hyperinflation without this in 1994-95), and that is still a quite reasonable price to pay for the benefits to be reaped from solving our long-term structural imbalances.
I offer these very incomplete thoughts hoping that they may provoke ideas. I would love to see an elaboration of Yglesias' topic by a hard-core neo-Keynsian professional economist.
""And don't forget: inflation will devalue the dollar and breathe new life into our exports in general and manufacturing in particular""
Youre totally incorrect. This is a typical misconception that weaker currencies improve global competitiveness. If this was true, UK would be the world's economic powerhouse and Japan an exporting basketcase. Productivity not debasing one's currency is the key to exporting. Secondly, a weaker dollar means more expensive energy prices negating any positive temporary impact from a weaker dollar..
The argument put forth by Matt Ygelisas and the poster above assumes that somehow 6% inflation is sustainable and wont accelerate. It also assumes that the wizards of smart will be so able to fine tune the economy that no errors or unforseen consequences will occur. Once inflation expectations become widespread, they are impossible to stop without a deep recession ala 1981-82.
The 1980s and 1990s experienced a strong long lasting economic expansion. Both decades had a strong USD, rising standards of living and steady or falling commodity prices. The short expansions of 1971-73 and 1976-80 were characterized by exactly the opposite. Weak dollar = falling living standards, rising commodities, falling competitiveness.
Very good points.
Productivity is indeed the key to exporting, and we can certainly take a cue from the most productive countries [Euro-zone], but if the currency is misvalued (as the dollar is due to post-war subsidy from acting as the reserve currency), a disadvantage can also occur.
Long-term "managed" currency valuation is useless, but that does not hold true for a short-term currency shock, which can indeed have a stunning effect to right real structural imbalances. In 1998, 80% of Moscow's food was imported from Europe - within 3 to 6 months (!) afer the August crisis, that travesty was demolished.
Don't get me wrong, for a well structured economy, like Germany's, France's, Denmark or the Netherlands, I don't doubt the value of a firm currency. But for a country with so many basic structural imbalances (like the US [growth in the 80's and 90's notwithstanding] or Russia [growth in the 60's and 70's notwithstanding), the prescriptions which are very valid for healthy economies do not necessarily apply.