Inflation and the Banks

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.

11 Responses to “Inflation and the Banks”

  1. 1 João Marcus Marinho Nunes August 5, 2011 at 12:00 pm

    The general principal is sound and well argued. I only quibble with the word inflation (actual or expected). That has become a Taboo word, not to be pronounced in “civilized conversation”. An alternative would be a Price Level Target (PLT). But that suffers from several problems, for example, which price index to choose. There´s also the “supplyshock” problem associated with PLT. A nominal spending target level would be “neutral” (does not say inflation explicitly) and also “proactive” in the sense that what you want is to get the economy going. The division of spending between prices and quantities would be determined by the “markets” as a function, among other things, of the degree slack and wage rigidity .


  2. 2 Benjamin Cole August 5, 2011 at 12:01 pm

    Excellent, excellent blogging.

    I also argue (from experience) that if any small business wants a loan, the banks will ask you “on what collateral?”

    Your employees and yourself are worthless. There is factoring, but that is limited and expensive, Your equipment is nearly worthless (usually) in terms of getting a loan. Even a great hairdo won;t get you anything.

    Your real estate?

    Yes, if your factory or house or shop is yours and has appreciated, then you can get a loan.

    In addition, most households’ biggest asset is real estate: their home.

    Crickey-Almighty, we need to get real estate above water to help the banks, small businesses and households.

    The current obsession–fetish–for minute rates of inflation is dearly misplaced, and setting back the American recovery. Give us 5 percent annual inflation and five percent annual real growth for five years, and we will rule the world again.

    Call it the Triple Nickel. We want 5-5-5. Five years of five percent real growth at five percent inflation.


  3. 3 Luis H Arroyo August 5, 2011 at 12:44 pm

    Excellent, true, I agree totally. I don´t fear the word “inflation”. True inflation (and devaluation) for us european would be an excelent medecine.
    But the dogma is the dogma. I know well, since I worked in a central bank for 30 years.
    The dogma is that money have “no real effects”: only inflationary (never deflationary), and financial stability depens on prices stability (I never understood why).
    The assets prices “don´t worry”. Liquidity adjust always to demand for it. That´s all.
    We can not know if all the 17 national members parcitipating in the ECB´s executive council think so, because all the decisions are by “unanimity”.
    I suppose, as Simmon Johnson ( that we are on the verge of asisting to a profound division in the Council.


  4. 4 Lorenzo from Oz August 5, 2011 at 4:18 pm

    The dogma is that money have “no real effects” Do they ever stop to ask what is money for? What does money do? If money had perfect transparent neutrality (i.e. we could see “straight through it” to the “real economy” of goods and services), then we wouldn’t need it.

    I also find some discussions of “money illusion” unsatisfactory, since they seem to ignore the simplification and (particularly) existing-obligations role of money. So, of course people resist downward shifts in nominal wages, since they have existing obligations which are liable in units of money: if they are paid less money units, they are less able to meet those obligations–there is no “illusion” or irrationality in that.


  5. 5 JP Koning August 5, 2011 at 5:18 pm

    I recently read Robert Lucas’s 1995 Nobel lecture.

    Click to access lucas-lecture.pdf

    He asks: “If everyone understands that prices will ultimately increase in proportion to the increase in money, what force stops this from happening right away?”

    You say that an advance announcement by the Fed to promote inflation will encourage businesses to expand output and employment. But Lucas would probably say that they’ll just raise prices.

    What sort of friction(s) do you think exist such that an announced policy of inflation will have effects on not just prices but output?


  6. 6 Luis H Arroyo August 6, 2011 at 1:27 am

    whithin certain limits, statistically real growth and inflation have gone hand in hand. I remember a paper of Barro that fund that inflation lower than 10% doesn´t ave negative effects in growth (more or less).
    Investors need to know that their profits will rise, and that assets prices will rise. Asset prices rise increase the wealth effect in consumption.
    Obviusly, its is not a permanent way ; there is a risk of derailing and goin over the limits.
    But this type of process had worked in the past, for example, the “represion” of debt war in the forties was based on an high inflation and a real interest rate very low.
    It is the less painning form of transfering rents to productive sector and of acelerate the tranfer of wealth from deptors to be capable of paying their debt.
    It is not just:but it is just the less injust that to fall in deflation.
    In any case I think a big misconception that Central Banks have only a mandate to stabilise prices, without regard what is happening in financial markets.


  7. 7 David Pearson August 6, 2011 at 7:00 am

    “…in the expectation that prices would rise sufficiently to allow them to sell the added output at a profit.”

    The statement does not take into account vast sectoral differences that are likely due to structural factors. “Corporate profits” have never been better; small business (“Proprietors'”) income is in the tank; wages are also in the tank.

    Ten percent inflation would doubtless increase tradeables prices more than non-tradeables (I hope we can at least agree on that). The increase in tradeables prices means a deteriorating terms of trade for small businesses, a trend that has been in place since the recovery began. It also means that households will likely cut back on discretionary services spend. For the first time in history, the services sector has accounted for the majority of job losses in this recession. The health of that sector is therefore paramount in restoring employment growth.

    The evidence from 1H01 is that the character of inflation matters: relative price movements that shock middle-income real wages and hurt small businesses also bring employment and real income growth to a halt.

    Here are some nice graphics representing the data in the first paragraph above:


  8. 8 David Glasner August 6, 2011 at 10:17 pm

    Marcus, I agree that inflation is a problematic term, but I guess that I have been too lazy to try to come up with and explain an alternative term. As you note, price level has problems and nominal spending is way too wonky. So I have settled on inflation by default.

    Benjamin, Thanks. I actually think 3 years would probably do it.

    Luis, I don’t think that there is any hope of maintaining the euro while imposing austerity on the debtor nations. At some point, countries will say enough already and will opt out of the euro and default on their debts. Argentina would provide a model.

    Lorenzo, The neutrality argument only works in a comparative statics framework, not in a real-time framework in which people are constantly reshuffling their asset portfolios based on the expected yields of real and financial assets.

    JP, I disagree with Lucas. He made some very important contributions in some of his early work, but I am not a big fan of his. David Laidler has written some excellent pieces on the misunderstanding entailed by his continuous market clearing rational expectations paradigm. I don’t have the references to Laidler handy, but I will try to come up with them later.

    Luis, I think one of the areas in which further research is necessary is to understand the conditions in which inflation may be growth-enhancing and when it may be growth-retarding. The implicit assumption of so much of previous theoretical discussions has been that the rate of inflation should be constant. But that is a mistake. Sometimes we may want higher inflation and other times, low or even negative inflation. We need to work out a model that gives us a way to derive the optimal inflation rate under different circumstances. It might turn out that you would get precisely the same answer that you get by stabilizing nominal gdp at a fixed rate of growth. That would be a really important result if it were true.

    David, Perhaps you are right that the statement you quoted does not take into account the sectoral differences you refer to. But I am sorry I need you to work out the reasoning for me more explicitly, because I don’t exactly see the connection. As for tradables vs. non-tradables. I am prepared to stipulate that tradables prices would increase faster than non-tradables. That would mean that US export and import-competing industries would become more competitive, so that job growth would increase in those sectors to make up for slower growth in the service sector. I think that a lot of people would argue that there has been too much shrinkage in the US tradables sector over the years so that such a shift would be appropriate.


  9. 9 David Pearson August 6, 2011 at 11:06 pm


    The services sector is far larger and has lost many more jobs in this recession. We have had a strong manufacturing recovery, and we have little to show for it in terms of overall employment gains.

    Keep in mind that, in the past, the services sector kept growing right through recessions. This recession, not only has services shrunk, but it has lost a great deal more jobs than manufacturing. Economists are used to thinking of manufacturing as the “swing” employment sector across a cycle; they seem slow to recognize that this small sector is not as important to the strength of this recovery as previous ones. Any policy that hurts the services sector and helps manufacturing is unlikely to result in robust employment growth.


  10. 10 Luis H Arroyo August 7, 2011 at 12:18 pm

    “Luis, I think one of the areas in which further research is necessary is to understand the conditions in which inflation may growth-enhancing and when it may be growth-retarding. The implicit assumption of so much of previous theoretical discussions has been that the rate of inflation should be constant. But that is a mistake. Sometimes we may want higher inflation and other times, low or even negative inflation. We need to work out a model that gives us a way to derive the optimal inflation rate under different circumstances. It might turn out that you would get precisely the same answer that you get by stabilizing nominal gdp at a fixed rate of growth. That would be a really important result if it were true.”

    Very good. I have always had this intuition, but it was so against orthodoxy!
    I call orthodoxy these beliefs that unconsciously impose invisible limits to introduce alternative in the debate.


  11. 11 David Glasner August 7, 2011 at 12:39 pm

    David, I agree that we need a recovery in all sectors. I was simply responding to your point about a faster increase in the prices of tradables than non-tradables. That doesn’t strike me as a bad thing given that the non-tradable sector has probably grown too much relative to the tradable sector. A relative adjustment between tradables and non-tradables does not preclude an absolute expansion of both sectors. Inflation may help tradables more than non-tradables; that doesn’t mean that it is not helping non-tradables, too.

    Luis, That result is already implicit in Hayek’s work in the early 1930s on neutral money as a policy objective. He concluded that the optimal policy was stabilizing MV. That implies that a falling price level in times of expanding output and a rising price level in times of falling output. For reasons he never adequately explained, his policy advice in the 1930s was not to stop deflation, but to use it as a means of breaking the control of monopolies (especially labor monopolies). He admitted his error late in his career, but unfortunately, the vulgar Austrian extremists who are happy to invoke his authority (as well as the authority of other Austrians like Robbins, Machlup and Haberler who repudiate their early policy recommendations) when it suits them to do so, never acknowledge that Hayek held that it was the duty of the monetary authority to do everything in its power to prevent a contraction of nominal income.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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