In last Tuesday’s Financial Times, Raghuram Rajan wrote an op-ed piece entitled “Why we cannot inflate our way out of debt.” Here is how it starts:
We are experiencing financial panic. A downgrade of US debt has triggered a flight to liquidity towards the very assets downgraded. Ultimately, the cure for market paranoia is strong economic growth. Several commentators propose a sharp, contained bout of inflation as a way to reenergise growth in the US and the industrial world. Are they right?
To understand the prescription, we must understand the diagnosis. Recoveries from crises that result in over-leveraged balance sheets are slow, and are typically resistant to traditional macroeconomic stimulus. Over-leveraged, households cannot spend, banks cannot lend and governments cannot stimulate. So why not generate higher inflation for a while? This will surprise fixed income lenders who agreed to lend long term at low rates; bring down the real values of debt; eliminate debt “overhang”; and spur growth. Yet there are concerns. Can central banks with anti-inflation credibility generate sharply higher inflation in an environment of low rates? Will it work as intended? What could be the unintended consequences? And are there better alternatives?
In reply, I sent the following letter to Financial Times, which was not printed.
Sir, Raghuram Rajan (“Why we cannot inflate our way our of debt” August 16) argues that inflation is not the answer to the debt overhang weighing down the international economy and holding back its recovery. Professor Rajan offers four reasons for skepticism that inflation can solve our debt problem: 1) that it will squander dearly bought central bank credibility; 2) that it may fail to stimulate growth as promised; 3) that it will have unwanted side effects, e.g., reducing real wages and harming bondholders; and 4) narrowly targeted relief for debtors could be provided and would be more effective than inflation in relieving the debt burden.
Unfortunately, Prof. Rajan fails to grasp, or chooses to ignore, several important reasons why inflation is our best hope for escaping the depression in which we are now stuck.
First, rising prices and the expectation of rising prices instantly encourage production, enhancing incentives for businesses to increase output, hire additional workers, and undertake new investment instead of continuing to accumulate idle cash. The prospect of rising prices will would also encourage households to increase purchases of consumer durables instead of paying down their debt.
Second, any stimulus to output when an economy is beset with chronic unemployment and idle capacity tends to induce further increases in output. The yield on 5-year inflation-adjusted Treasuries is almost minus 1 percent. That is a measure of the extreme pessimism about future economic conditions now pervading the markets, discouraging real investment and growth in a vicious cycle of self-fulfilling gloomy expectations. Increasing inflation expectations and output would promote further improvements in expectations. initiating a virtuous cycle of self-fulfilling optimistic expectations and rising real interest rates, encouraging new investment and reducing desired holdings of cash. This is why an unusual positive correlation began to emerge in 2008 between changes in inflation expectations and changes in the S&P 500 stock index. The correlation, which continues to be observed even now, is documented in my paper “The Fisher Effect Under Deflationary Expectations” available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1749062.
Third, central bank credibility is worthless if it supports — even encourages — such expectations of stagnant or declining future output as now exist (otherwise the real yield on 5-year Treasury could not be negative). Central bank credibility would not be squandered if they announced an explicit price-level target at least 10 percent above the current level and pledged to reach that target within two years. Alternatively they could announce targets for nominal spending (NGDP) to grow by 8 to 10 percent for at least the next two years.
Finally, the tendency for rising prices to depress real wages is largely transitory, and, in any case, would be more than offset in the transition by falling unemployment. Similarly, the harm to bondholders and banks from the erosion of the real value of their assets would be offset by the increased likelihood that debtors would repay most of what they owed rather than default entirely, leaving creditors with nothing but worthless paper. Only by ignoring all this, can Prof. Rajan imagine that targeted debt relief could be a substitute for a stiff dose of inflation.