The Keynesian blogosphere is up in arms at Ben Bernanke’s response to Krugman’s view that he should pursue a higher inflation target as a debt erasure mechanism.
According to Chairman Bernanke:
We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been able to take strong accommodative actions in the last four, five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.
This is not at all the tone of Bernanke’s Japan analysis; remember, Japan had nowhere near as high unemployment as we do, and his analysis back then was not simply focused on ending deflation.
The basic Keynesian logic is as follows:
The economy is performing far below its potential, due to an ongoing slump in aggregate demand caused by a contraction of confidence. Simply, there is plenty of money, but far too many people are risk averse and thus are not spending (and thus creating economic activity) but instead just holding onto their money. The Fed should ease some more, so as to create inflation that turns holding cash into a risk, and so encourage investment and consumption. What’s more, residual debt overhang is a burden on the economy, and additional inflation would decrease the relative value of debts, giving some relief to debtors.
Matthew O’Brien presented this chart to make the case that output is far below its potential:
I am deeply sceptical that GDP is a sufficient measure of output, and I am even more sceptical that the algorithmic jiggerypokery involved in calculating what the Federal Reserve calls “Potential Nominal GDP” has anything whatever to do with the economy’s real potential output. But I will accept that — based on the heightened unemployment, as well as industrial output being roughly where it was ten years ago — that potential output is far below where it could be, and that the total debt overhang at above 300% of GDP is excessive.
The presupposition I really have a problem with, though, is the notion that this is a problem with hoarding:
Simply, the United States is a consumption-driven economy. And that isn’t so much of a fact as it is a problem. More and more money is going toward consumption, and less and less is going toward investment in companies, in ideas and in businesses. Exemplifying this, less and less money — even in spite of the Fed’s “pro-risk” policies (QE, QE2, ZIRP, etc) is going into domestic equities:
The fundamental problem at the heart of this is that the Fed is trying to encourage risk taking by making it difficult to allow small-scale market participants from amassing the capital necessary to take risk. That’s why we’re seeing domestic equity outflows. And so the only people with the apparatus to invest and create jobs are large institutions, banks and corporations, which they are patently not doing.
Would more easing convince them to do that? Probably not. If you’re a multinational corporation with access to foreign markets where input costs are significantly cheaper, why would you invest in the expensive, over-regulated American market other than to offload the products you’ve manufactured abroad?
As Zero Hedge noted:
In the period 2009-2011, America’s largest multinational companies: those who benefit the most from the public sector increasing its debt/GDP to the most since WWII, or just over 100% and rapidly rising, and thus those who should return the favor by hiring American workers, have instead hired three times as many foreigners as they have hired US workers.
So will (even deeper) negative real rates cause money to start flowing? Probably — but probably mostly abroad — so probably without the benefits of domestic investment and job creation.
Then there is the notion that inflation will effect debt erasure. This chart tends to suggest that at least for government debt it may not make much difference:
There’s no real correlation between government debt erasure and high inflation.
Paul Donovan of UBS explains:
The fundamental obstacle to governments eroding their debt through inflation is the duration of the government debt portfolio. If all outstanding debt had ten years before it matured, then governments could inflate their way out of the debt burden. Inflation would ravage bond holders, and governments (with no need to roll over existing debt for a decade) could create inflation with impunity, secure in the knowledge that existing bond holders could do nothing to punish them. In the real world, of course, governments roll over their debt on a very frequent basis.
Consumer debt may also not experience significant erasure.
From Naked Capitalism:
Inflation only reduces debt overhang in a significant way for households who are fortunate enough to see their nominal wages rise along with the general rise in prices. In today’s economy, workers are frequently not so fortunate.
The deeper reality though, is that even if my concerns are unfounded and Krugman is correct, and that a higher inflation target would achieve precisely what Krugman desires, I don’t think it would solve the broader problems in the economy.
As I wrote in November:
The problem is that most of the problems inherent in America and the West are non-monetary. For a start, America is dependent on oil, much of which is imported — oil necessary for agriculture, industry, transport, etc, and America is therefore highly vulnerable to oil shocks and oil price fluctuations. Second, America destroys huge chunks of its productive capital policing the world, and engaging in war and “liberal interventionism”. Third, America ships even more capital overseas, into the dollar hoards of Arab oil-mongers, and Chinese manufacturers who supply America with a heck of a lot. Fourth, as Krugman and DeLong would readily admit, American infrastructure, education, and basic research has been weakened by decades of under-investment (in my view, the capital lost to military adventurism, etc, has had a lot to do with this).
In light of these real world problems, at best all that monetary policy can do is kick the can, in the hope of giving society and governments more time to address the underlying challenges of the 21st Century. When a central bank pumps, metrics (e.g. GDP and unemployment) can recover, but with the huge underlying challenges like the ones we face, a transitory money-printing-driven spike will in no way be enough to address the structural and systemic problems, which most likely will soon rear their ugly heads again, triggering yet more monetary and financial woe.
On the other hand, it would be interesting to see Bernanke go the whole hog and adopt a fully-blown Krugmanite monetary policy, just to see Krugman’s ideas get blown out of the water by the cold, dark hand of falsification.
Of course, there was an opportunity to achieve debt erasure in 2008, when the world faced a default cascade and a credit collapse. Had economists and planners let the system liquidate, a huge portion of bad debt and bad companies and systems would have been erased, and — after a period of pain — we might well be well into a new phase of organic self-sustaining growth. But we live in a different world; where zombie systems, companies and their assets are preserved by government bailouts and interference, and very serious people like Paul Krugman earnestly push dubious solutions to problems that their very interventionist worldview created.