Friday, September 11, 2009

Inflation (Just This Once...)

Or, "you shall not crucify mankind on the cross of an informal 2% inflation target"

Christopher Hayes of the New America Foundation argues for more inflation as a way of reducing the real burden of Americans' debts, which has become quite massive. He writes:
While accessible credit fuels growth, too much debt kills it. The entire institution of bankruptcy exists because we recognize that otherwise functional economic entities can be paralyzed by debt, and that it ultimately benefits economic growth to allow some means of wiping out debt and starting fresh.

But even short of default, a vicious cycle can take hold. At a certain point households, firms, and even governments are forced to spend money on meeting short-term debt servicing obligations rather than on making long-term investments. What results is a form of debt serfdom. Farmers don't invest in new crops and land; businesses don't add needed productive capacity because every spare cent goes towards interest payments. Governments can't afford to provide basic services because they have to pay off onerous debts. Households can't send their children to college because credit card payments have eaten up their savings.

Avoiding the deadening effect of too much debt on the economy is the kernel of wisdom found in numerous ancient traditions and scriptural injunctions that require formalized periodic debt cancellation. Deuteronomy commands that every seven years (that is, during the sabbatical year) debts will be forgiven "because the Lord's time for cancelling debts has been proclaimed" (Deut. 15: 1-2). In the Judeo-Christian tradition, it is called Jubilee.

We don't have Jubilee in modern financial capitalism and for good reason: the understanding of moral hazard then wasn't quite what it is today. But if we are to emerge from the current crisis into an economic future of sustained growth and widespread prosperity, we are going to have to do something to lessen the burden that past debts now impose on investors, innovators, consumers, and the federal government. Failure to do so would likely lead to a Japanese-like lost decade of low or non-existent growth, or worse.

The surest way to avoid such a fate is to jettison a central, indeed the central axiom of post-1970s neoliberal global capitalism, and that is to embrace a period of moderate, sustained inflation.

That is, in essence, a modern version of the argument made by late 19th century populists who campaigned for monetizing silver, which would have caused an inflationary increase in the money supply. At the time, grinding deflation had raised the real value of debts, effectively redistributing wealth from midwestern farmers to eastern bankers (i.e., a farmer's mortgage payments, fixed in dollar terms, increased relative to his income from selling crops, which had fallen in price).

Hayes is correct that high levels of household debt could be a serious drag on the recovery, as people seek to improve their balance sheets by holding back on spending. A little extra inflation could help in that regard, but it would potentially create new problems.

Expectations matter. When firms and individuals make plans and enter into contracts, they do so based on their expectations of future inflation rates. From a lender's perspective, higher inflation means that interest rates must be higher to make up for the erosion in the real value (purchasing power) of the payments over time. In high-inflation environments, borrowers are willing to pay higher interest rates because they expect their nominal incomes to be rising. One reason that interest rates have been lower over the past two decades is that people have come to expect moderate inflation. An unexpected increase in inflation would reduce ex post real interest rates and redistribute wealth from creditors to debtors. That would be a short-term boost to the economy, but it would also change people's expectations of the future. An increase in expected future inflation would mean higher nominal interest rates now.

Hayes' solution to the problem of spiraling inflation expectations is to use inflation targeting - i.e., for the Fed to announce a target level of inflation (some argue that its long-term forecasts of 1.5-2.1% inflation act as de facto targets now) - but at a higher level. He says:

Historically, this approach has been favored by inflation hawks, who feel that it would serve as a control on the temptation for the Fed to cut rates to spur economic growth, or to allow recovery to go on too long raising prices too much. In the context of promoting inflation, it would be used as a kind of check against the fears of spiraling inflation that a sustained rise in the price level might bring about. If global investors come to credibly believe the target, even if the target is 5 percent, then it will reduce speculation in commodities and gold and avoid a rush away from bonds. For investors can price a predictable rate of inflation into the futures markets now, creating stable prices, rather than rushing to place bets that inflation will go to 10 or 12 percent. (Some of those bets are likely to be placed regardless.)
This would work fine if the target were credible - if people believed that the increase was really just a one-time only event. But is a Fed which shifts its target around going to have much credibility? I doubt it. Interest rates would likely incorporate a premium for the risk that, next downturn, the Fed would ratchet up its target again. The effect of that premium would be to redistribute wealth to creditors, and to inhibit investment by making it more costly to business to finance projects.

Furthermore, the inflation would be painful to reverse: disinflation can be very costly, as the experience of the early 1980's "Volcker recession" showed.

Hayes is right that some of the inflation fears resulting from the Fed's unconventional policies are misplaced; the Bernanke Fed is rightly trying very hard to avoid deflation. To that end, it may make sense for central banks to target a slightly higher rate, as this would give them more room to ease monetary policy before hitting the dread zero lower bound (Real Time Economics reports John Williams has similar thoughts; see also this earlier post). But that is very different from a policy of deliberately inflating away debt.

While the overall argument is interesting, I think Hayes oversells it a bit, offering a somewhat mono-causal view of the postwar economy:

The annual real growth rate from 1948-1980, the bad old days of high inflation, was 3.7 percent. From 1980-2009, the brave new era of low inflation, it was a mere 2.9 percent.

We are, in many ways, now reaping what decades of historically low inflation have sown: a massive upwards redistribution of wealth, an oversized financial sector, an eviscerated tradable goods sector, and a grotesquely large trade deficit. In other words, the imbalances and structural weaknesses of the post-Volcker economy, the ones that built up to create the crisis, were partly produced by the Great Disinflation that Volcker ushered in. Recovery will involve a fundamental restructuring of our economic engine, shifting from the supply-side nostrums of the past two decades that paradoxically led to an unhealthy pattern of asset bubbles and debt-financed consumption to policies that bolster global demand by investing in quality-of-life improvements and by raising incomes and wages worldwide. That means the seeding of a global middle class and recalibrating the share of profits captured by labor as opposed to capital. Such an economy will almost certainly be an economy with higher inflation than has been the case over the past two decades.

While the stabilization of inflation at low levels may have contributed to some bouts of irrational exuberance, it is a bit of a stretch to attribute so much of the economic pathology of the last 30 years to it. Though the beginning of the rise in inequality roughly coincides with the Volcker disinflation, it likely has more to do with Reagan-era policies (lest we forget, Volcker was a Carter appointee) which discouraged unionization and lowered tax rates on high incomes. The trade deficits of the 1980's had something to do with the strong dollar resulting form Fed policy, but other factors, like China's massive intervention in foreign exchange markets, are more important for the imbalances of the past decade.

Also, while 1980 is an important breakpoint in both monetary and other policies, comparing averages over 1948-80 with 1980-2009 obscures the fact that much of the growth came in the 1960's, while the inflation was (mostly) in the 1970's.

(red: output growth, blue: inflation)

While I believe Hayes' proposal would have more serious costs than he does, we are in times that call for rethinking some of our views. If the current slump turns out not only to be deep, but also persistent (along the lines of Japan's "lost decade"), it may be that a policy that creates some long term problems is nonetheless worthwhile. After all, "in the long run, we're all dead."

(Hayes' article came to my attention via Matt Yglesias' blog).

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