Paul Krugman — surely the most (deliberately) provocative economist in the world — thinks we need more inflation.
From Paul Krugman:
Inflation hawks, including Paul Volcker in today’s NYT, often invoke the supposed lessons of history, to the effect that inflation is always harmful and always gets out of control.
But that’s a selective reading of history, and it skips the most relevant examples.
Early on in this crisis, I began wondering why the US didn’t relapse into the Great Depression after World War II. And there’s a good case that this had something to do with it:
The big rise in prices during and after WWII arguably did a lot to eliminate the debt overhang, making it possible for the economy to enter a sustained, non-inflationary boom.
So his reasoning is that inflation is necessary for debt elimination. And when it comes to debt elimination, (for once) I agree with him. But should that be done through inflation?
Absolutely not. If a debtor cannot afford its debts, there are two paths to debt-elimination:
- Admitting that the mountain of debt is immovable, and giving negotiated haircuts to creditors
- Inflating away the debt with money printing
The second option — which is effectively what Krugman is advocating — is incredibly risky. From the perspective of the consumer, inflation coupled with stagnant wages would be painful — and the potential for a hyper-inflationary spiral is downright dangerous. A far better option is giving consumers more options to default on or renegotiate their debts, including mortgages.
But from the perspective of the US Treasury, inflation would be far worse still. Why? Money printing is increasingly seen as a sign that foreign creditors need to get out of the dollar, and into harder assets. This would result in many foreign-held dollars flooding back to America, worsening the inflationary spiral.
The private Federal Reserve has been quite careful in maintaining a veil of secrecy over the full extent of dollar saturation in foreign markets in order to hide the sheer volume of greenback devaluation and inflation they have created. If for some reason the reserves of dollars held overseas by investors and creditors were to come flooding back into the U.S., we would see a hyperinflationary spiral more destructive than any in recorded history.
Conversely, a straight-forward haircut would be painful in the short term, but would do far less than money printing to undermine the dollar in the medium term — and cause far less of a flood of dollars back into America. Creditors, particularly China, would be happier to see a short-term default stopping the printing presses and safeguarding the long-term purchasing power of the dollar than they would see the dollar constantly undermined.
So, in conclusion, default achieves debt elimination in a clean and relatively one-dimensional manner, while safeguarding the value of the currency. Inflating away the debt achieves the same thing in a more dangerous fashion, because it endangers the quality of the currency. The international ramifications of such a policy are unpredictable, especially given the fact that so much of America’s economic might is built on its ability to acquire resources and energy with dollars.
As Ernest Hemingway put it:
The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.
No — we don’t need more inflation. We need to pay down our debts in a timely and honest fashion, and if we can’t do that we need to default.
Of course, there is another aspect to this:
Krugman thinks weak demand is eating the American economy, and that money printing and a little inflation will provide enough of a boost to juice the economy into a stronger position. But weak demand is not the problem. The biggest problem is imperial overstretch.
I had a hugely interesting, abeit brief, converation with a chap on the Indie forums at the start of the year. I was suggesting we should expect inflation to rise to inflate away the debt here in the UK. I hope he won’t mind me requoting. Here’s what he had to say:
“This from the IEA on a suggestion from David Blanchflower that inflation could be a way of reducing the value of our Debt
One fifth of government debt is index-linked. Index-linked debt cannot be inflated away. 35% of the government’s debt is made up of Treasury Bills, short-dated debt or ultra short-dated debt. There is little that the government can do to inflate this away. This will have to be refinanced within the next seven years (most of it much sooner) and, as inflation expectations will rise if the central bank pursues an explicitly inflationary policy, the cost of refinancing this debt will increase. Over the next five years, the UK government is also planning to borrow an amount not much less than the existing national debt in nominal terms. None of this can be inflated away: it will all have to be financed in the new environment of higher inflation if the Keynesians have their way. So what is the bottom line?
The only debt that can be inflated away with any significant effect is the existing long-dated or medium-dated conventional government debt that has already been issued. This is the debt which the government has promised to service with fixed (not inflation-linked) interest and capital payments. This is currently 43% of the existing national debt, but it makes up only about 20% of the debt that will exist by the end of the proposed policy of creating inflation. If inflation were 5% for a few years, as suggested by Professor Blanchflower, the real value of this debt might fall by about 2%-5% of the total projected debt in 2016: this is a drop in the ocean. This “gain” could easily be cancelled out by a higher inflation risk premium that would be demanded by investors on newly issued government debt.
On the issue of interest rate rises ,if the purpose is to reduce demand pull effect then this is arguably being achieved by fiscal consolidation, not just a one club solution of interest rates which are arguably delinked from base rate anyway(ask the portuguese paying near 7% when the ECB is nominally 1%)”
Index-linked debt can be inflated away by perverting the indices.
Is CPI really a valid measure of inflation? Why do you think house prices were never included in CPI when they were flying away during the 90s and early 00s. Gilts were hugely devalued during that period relative to the real rate of inflation.
Quite. If the 50+ brigade knew what the state had done to their public sector pensions by moving from RPI to CPI they would riot. They may still
Hemingway’s boss warned us before, when Ezra Pound was talking about Federal reserve nobody cared, so now swallow it !
His books were all burned out due to excuse of supporting fascism.
Default worked okay for Iceland! Cut the cancer out, I say.
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