Arnold Kling  

Inflation as Generic Debt Forgiveness

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Ken Rogoff writes,


Price inflation forces creditors to accept repayment in debased currency. Yes, in principle, there should be a way to fix the ills of the financial system without resorting to inflation. Unfortunately, the closer one examines the alternatives, including capital injections for banks and direct help for home mortgage holders, the clearer it becomes that inflation would be a help, not a hindrance.

Modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts.

I agree that the rescue plans are confounded by the complexity of the contemporary financial system. But I worry about trying to achieve 6 percent inflation as a way of easing credit risk. Maybe you do manage to reduce credit risk. But then at some point you kill some institutions with interest rate risk, because eventually nominal interest rates will rise and folks will be stuck with long-term bonds that lose value. In fact, high nominal interest rates tend to hurt the economy, even if real interest rates are low. They make house payments high relative to incomes, and they seem to depress stock prices (see the 1970's).

Actually, the more I think about the inflation idea, the less I like it. I give Rogoff credit for thinking outside of the box of rescue plans, but I'm not a fan of the inflation strategy.

Thanks to Mark Thoma for the pointer.


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COMMENTS (15 to date)
Todd writes:

I'm not sure I've ever heard promoting inflation referred to as thinking outside the box; isn't debasing the currency basically the oldest trick in the government book?

Mercutio.Mont writes:

This time last year, I was positive that the US would engage the inflationary gears to quell pain from home price declines.

Good thing I didn't put any money on it.

Also, agree with Todd - this seems far from thinking outside the box.

Ironman writes:

For the Fed in this go-round, it would seen that their first choice has always been inflation.

Todd: Debasing the currency is far from the oldest trick in the government book. That would be either using force or the threat of force to get the leader's way.

Walt French writes:

One has to presume that Messrs Paulson & Bernanke reviewed the inflation required to work out our multi-trillion-dollar mess and decided (perhaps with a depraved laugh about the anti-Volckerian legacy with which they would smear themselves and the Prexy) that they would try every other alternative first.

Including a State takeover of all financial institutions, which is slowly happening, to rather little effect.

Including targeting every possible place to target money where it might do more good than a general inflation, even as it gave the appearance of a discombobulated, ad hoc "program of the week."

Patience! We'll get there!

My greater concern is that by not acting more decisively, we seem to be encouraging looting and go-for-broke strategies at lenders, insurers, brokers, et al.

Akerlof & Romer's 1993 "Looting..." paper estimates that "forbearance" during the S&L crisis doubled the damage to the economy -- useless "investments" that took place, simple theft, fraudulent Ponzi and fake developer schemes; subsidized junk bond fraud from S&L malfeasance -- by nearly a hundred billion of 1980's dollars. I finally understand the emphasis on capping manager "earnings" and bonuses. But it seems that the more targeted solution would be to simply fire anybody who took such obscene risks that there was almost no conceivable scenario in which shareholders' interests would survive. (The exception: an infinite continuation of the Ponzi-like housing market, and China's lending us the grubstakes to play.)

El Presidente writes:

Would you prefer increasing the progressivity of our income taxes rates in a revenue neutral fashion?

MattYoung writes:

OK, what is doing well today?

Cell phones and on line sales, both up around 6%, from random news reports.

This is not an endorsement of Amazon, who gets it wrong, an endorsement of UPS.

If government invests in favorites, invest in giving pachage delivery separating rights from personal transportation. Organize around edge distribution, minimize inteference between personal transportation and freights.

Then, give me my two seat electric roadster, 300 kilo empty weight, including battery, good for 40 miles. I have raced these as remote control, I want one.


Felix writes:

I'm lost. The cash for these multi-national bailouts has to come from somewhere, right? Plunder, borrowing, huge government layoffs? Or the printing press.

But where are the numbers? Printing the cash for bailouts isn't necessarily inflationary, is it? That is, if there was, in effect, a gob of fiat money in the form of "leveraged" money before the latest financial crisis, and if that money has fluttered away in winds of distrust, then replacing that money with newly printed cash seems like it would not cause inflation.

Or, put another way, it seems to make no difference whether we like or dislike using inflation as a tool. The question preceding a question of (dis)likes is, is inflation even on the table?

GU writes:

As someone who is young, with few assets and a lot of educational debt, inflation sounds like a reasonable plan!

Kidding (kind of).

Steve Sailer writes:

The domestic alternatives are:

- inflation to take from the savers

- borrowing and then raising taxes

In any case, we're talking about huge transfers of wealth from the productive and prudent to the spendthrift and imprudent.

The foreign alternative is, what, privateering? After all, we have 80% of the world's aircraft carrier battle capacity and most of the world's nuclear missiles.

TA writes:

Rogoff says the financial hole is too big to fill with taxpayer dollars. This proposal says, fill it with saver dollars. Should this happen, I think savers then owe nothing to society at large, and are morally free to cheat on their taxes, etc.

Larry writes:

Printing money to stave off deflation and the liquidity trap seems quite reasonable. The trick is how you reverse course when the situation changes. Overshooting seems to be an unavoidable consequence of our poor understanding of the economy and the politicization of economic policy. Thus, it seems like betting on inflation over the next 5 years is pretty safe. So, probably are the high interest rates and resulting secondary recession that will likely follow the inflation.

I do wish somebody could lay out a roadmap for how all this plays out, including the easing, the stimulus, the financial system deleveraging, the consumer deleveraging, etc. Everyone seems to focused on doing some one thing, as if there is no bigger picture.

Evelyn Guzman writes:

For awhile there, I thought I was the only one who would not agree with Ken Rogoff. My simple reason is because I don't like inflation; it plays havoc to my retirement nest egg. So I was glad when I read further on that the author is not a fan if inflation either. That gave me a sigh of relief because otherwise, I won't understand the whole thing.

Evelyn Guzman
Debt Challenger

Jeff Hallman writes:

Inflation only helps debtors if it is unanticipated. Anticipated inflation not only doesn't help, it actually makes it much harder to borrow long-term. Inflation drives up nominal rates and shortens the effective maturity of nominal long-term bonds. In a world where debt is generally not indexed, this means the market for long-term borrowing disappears. Any way you look at it, that's a deadweight loss.

aaron writes:

That's only true if inflation is evenly distributed. If inflation lands disproportionately on consumables and not on wages, it does not decrease the debt for the wage earner and increases his risk.

Nathan Smith writes:

Here is my advice for how to create temporary inflation, as generic debt forgiveness, without driving up inflationary expectations.

Create an alternative price index which includes (a) housing prices (not just rents), (b) stocks, (c) foreign currencies (i.e., exchange rates).

Show the time path of this alternative price index retrospectively. What I expect you would find is: (a) there was a lot more inflation in the fifteen years to 2006 than was thought at the time, and (b) there has been considerable deflation in the past two years.

Next, state that you want to engineer a gradual shift from the old CPI to the new price index. Target a price level somewhere between inflated 2006 and deflated 2008, and price stability thereafter. Assuming the drop in asset prices is relatively permanent, that means you can push for consumer price inflation in the short run. At the same time, you can probably convince markets you have a sincere intention of making prices *less* inflationary in the long run (than they were in the Greenspan years, for example).

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