Since I started blogging exactly a month ago, I have been arguing that what our weak and faltering recovery needs is a good strong dose of inflation announced in advance by the Fed/Treasury. The reasoning behind that prescription is that inflation and the expectation of inflation would induce businesses sitting on hoards of cash and households trying to shore up their balance sheets to start spending some of their cash on investments and consumer durables rather than watch the cash depreciate. Additionally, rising prices, and the expectation of rising prices, would encourage businesses, afraid to expand output and employment because of insufficient demand, to do just that in the expectation that prices would rise sufficiently to allow them to sell the added output at a profit. Because increased output and employment would, by virtue of Say’s Law, simultaneously create the increased demand to purchase the increased output, there is a very good chance that the leap of entrepreneurial faith encouraged by expected inflation would be self-fulfilling and self-sustaining.
There is another argument for inflation, which I may have already mentioned in passing, but it deserves some further attention, especially after the events of this week. When the financial crisis turned into a panic in September 2008, it did not take long for Secretary of the Treasury Henry Paulson to propose a scheme whereby the government would buy the so-called toxic assets, largely mortgage backed securities and derivatives of those securities, held by the banks. Suspecting each other of holding large quantities of toxic assets and therefore of being potentially insolvent, banks stopped lending to each other in the overnight market, causing the entire payment and credit system to break down. Paulson decided that the only way to loosen up credit was to clear away the toxic assets from the banking system by having the government buy the assets, so that banks would no longer have to worry about lending to potentially insolvent banks in the overnight market.
In the end, the program could not be implemented as planned, because no mechanism could be found to price the toxic assets that the government would purchase from the banks. Banks, after all, could have sold off those assets at a loss, cleansing their balance sheets, except that doing so would have either precipitated insolvency or made it plain to shareholders how much of their wealth had been dissipated by management error or malfeasance. Banks insisted that the markets were grossly undervaluing the toxic assets, whose “true” worth was far more than the banks could realize if forced to unload them in a distress sale. Pleading their case to the sympathetic ears of Secretary Paulson and then Secretary Geithner, the banks succeeded in avoiding being forced to unload the toxic assets on their balance sheets to the government for anywhere near to their market value. The government, however, was unwilling to pay the banks what they were asking for the toxic assets, so most of the TARP money wound up being used to purchase preferred stock or warrants in banks judged to be at risk of insolvency. Banks received substantial infusions of government funds with which to recapitalize themselves, thereby avoiding having to book losses on the toxic assets still on their balance sheets. All in all not a bad outcome from the point of view of the banks. With a few exceptions like WAMU that were clearly and irretrievably insolvent, banks were not forced into receivership and were not forced to sell any assets at drastic write-downs.
That was not the only largesse directed towards the banks. In November 2008, the Fed began paying banks interest on their reserves, just as the Fed was reducing its target for the Federal Funds rate to 0.25%. The interest rate that banks have been receiving on reserves has actually exceeded the rate on 6-months and 1-year Treasury bills almost continuously since December 2008. Never before in history was holding reserves, which used to be the equivalent of a tax on banks, so attractive. The resulting expansion of the Fed balance sheet has not monetized the debt; it has merely exchanged Treasury debt previously held by the banking system for generally higher-yielding reserves, providing banks with increased interest income and increased liquidity.
Nevertheless, despite all the goodies showered on them, banks are still burdened with toxic assets on their balance sheets. Those assets are tied to the real estate market which remains severely depressed, and it now seems even more likely that their prices will fall even further. There is a good chance that the toxic assets will sooner or later be revealed to be worth close to what markets were offering for them in the darkest days of 2008. Instead of getting rid of the albatross, banks have held onto them in the hopes of a real-estate recovery that never came.
Why not? Because the real estate bubble was predicated on expectations of an economic boom with high employment that were not realized. That was not the only unfounded expectation responsible for the bubble, but it certainly was an important part of the story. Given that the assumptions on which borrowers and lenders entered into mortgage agreements, it would be reasonable for them to revise the original contracts to allow home owners capable of making reduced payments, perhaps over an extended period of time, to remain in their homes as an alternative to foreclosure. Mortgage renegotiation has been encouraged, but generally hasn’t worked, because too many separate parties would have to sign off on a renegotiation agreement.
Since renegotiation has not turned out to be practical, the only other method of accomplishing the goal of reducing the unsustainable burden of mortgage debt would be for an outside party to impose a reduction in the value of the debt and monthly payments obviating any agreement by the parties. One way to do that would be by legislation. That option has gone nowhere, and is no longer even discussed. An even simpler and more direct option is inflation. Increasing prices would increase cash flows and would reduce the burden of outstanding mortgage debt. Banks would be unhappy, but better off, because fewer foreclosures would mean fewer losses and less expense. Even if, as I suspect, prices initially rise faster than wages, mortgage payments are fixed, so homeowners would almost certainly come out ahead despite lagging wages.
People often assume that inflation is good for debtors and bad for creditors, while deflation is bad for debtors and good for creditors. But that holds only if there are no feedback effects from inflation and deflation. But when deflation increases the burden of real debt and reduces the cash flows available to service that debt, it harms creditors by making too much of debt they hold uncollectable. Similarly, inflation can make creditors better off by reducing the debt burden and increasing the cash flows available for debt service. At this moment, we may well be at a point where creditors, especially banks, have more to gain more from inflation than they would lose. Similarly, the European Union in general, and even Germany in particular, would likely gain far more from an inflation allowing Greece, Portugal, Ireland, Spain and Italy to pay off their bonds in somewhat depreciated euros than from insisting on ruinous austerity measures that can only lead to the self-destruction of the common currency and perhaps the European Union itself. Perhaps that is a topic for a future post.