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.
Uneasy Money 
David
I just love the argument “Recoveries from crises that result in over-leveraged balance sheets are slow, and are typically resistant to traditional macroeconomic stimulus”.
It´s nothing but a big cop-out!
And John Taylor thinks there´s danger from the recent rise in M2!
http://johnbtaylorsblog.blogspot.com/2011/08/why-m2-growth-spurt.html
Given the recent rise in demand for money (from the “panics” and “uncertainties”) at least the Fed is not doing what it did in 2008 – decrease the rate of money supply growth in the face of the steep fall in velocity.
LikeLike
I can understand why the letter wasn’t printed.
LikeLike
By my calculations, getting GDP (nominal) back to the trend of the Great Moderation within one year would require it to grow 23%. So two years at 8% is a good bit less and two years at 10% is getting close to what would be needed.
The price level (as measured by the GDP deflator) only needs to increase 4.7% over the next year to return to the trend of the Great Moderation. And so, 10% over two years would leave it well above trend.
On the other hand, if the CBO estimate of potential output is correct, which is well below the trend of the Great Moderation, and GDP (nominal) was on the trend of the Great Moderation, with real GDP equal to potential, the price level two years from now would be 16% higher than its current value!
If GDP (nominal) had remained on trend and potential RGDP growth had slowed down as the CBO suggests, then we would have had several years of 3% inflation and a couple of years of 4% inflation. (The CBO estimates suggest productivity growth has been that bad.) That adds up and would require a couple of years of close to 8% inflation to make up for it at this point. (In other words, my best guess of what would happen if GDP (nominal) returned to the trend of the Great Moderation over 2 years is 8% inflation.)
Personally, I favor adjusting the growth path of GDP (nominal,) and propose 10% GDP (nominal) growth over the next year and then 3% per year after.
With nominal income targetting, if potential output remains on this lower growth path, then the price level would stay on the higher growth path. On the other hand, if potential output begins to grow faster in the future and catches back up, then inflation would be extra low for a time, and the price level would come back down.
LikeLike
Rajan’s premise is wrong: The market actions over the last months have not been triggered by the US downgrade. Market participants do not seriously fear US credit worthiness. If there indeed was a US debt scare then we would certainly not have seen a rally in US treasuries, but that is exactly what we have seen. Furthermore, if there had been any fears of US trouble then money would not have flooded into US banks, but that is exactly what we are seeing.
In many ways the situation is similar to 1931 (albeit on a much smaller scale). Fears of the economic and financial situation in EUROPE in 1931 led to a spike in gold demand (David, your Free Banking book covers this in excellent fashion). This time around, however, we do not have a gold standard, but rather a dollar standard and the dollar certainly is still the reserve currency of the world. But as in 1931 the problem originates in Europe – this time in the euro zone – but the result of the crisis has been the same: A sharp increase in dollar demand, which obviously is deflationary. So to me it is not a matter of inflating anything – it is a question of counteracting the deflationary forces coming from European dollar demand.
Paradoxically, the European debt crisis to a large extent has been exactly worsened by the fact that the individual euro countries cannot “inflate” their economies. David, you have rightly told of the that European crisis is not really a debt crisis, but rather a NGDP crisis.
While I certainly do agree that “inflation” will not increase long-run growth, I can’t see why “forced” deflation should be preferable either.
And Marcus, maybe somebody should tell John Taylor that the recent sharp increase in M2 is DEMAND driven and not supply driven therefore in fact is DEFLATIONARY rather than inflationary. The same thing by the way happened in the Autumn of 2008. Maybe he should just have a look M2 velocity to understand this…Milton Friedman in monetarist heaven will shake his head…
LikeLike
Bill, I agree – I think it would make a lot of sense to switch to a 3% NGDP target rather than 5%.
Furthermore, isn’t it a bit problematic from a purely “strategical” perspective to talk about “inflating” the economy? To me it is a question of “undoing” the mistaken tightening of monetary policy over the last 3 years to get the economy back to monetary equilibrium. (That was mostly to David…)
LikeLike
Lars I did a nice graphical representation of the “monetary mistake” of 2008:
http://thefaintofheart.wordpress.com/2011/08/21/%E2%80%9Cuncertainty%E2%80%9D/
LikeLike
Thanks Marcus. Excellent stuff as always.
I especially like the graph with velocity in 2007. As Robert Hetzel teaches us all the Great Recession started well before the collapse of Lehman – and the Fed should be blamed for allowing the collapse in velocity…
I, however, miss the European part of the story. European dollar demand spiked in 2007-8 and now again. As I noted above – it is 1931 all over again. Again – both David and Scott have written about this. Earl Thompson of course is the early source for the “gold demand explanation” for the Great Depression. The Hetzelian-Sumnerian explanation of the Great Recession would be even more “correct” and insightful if the European dollar demand story was part of the “storytelling” regarding the Great Depression…the market pricing of “basis swaps” is what should be tracked to tell that story “real-time” (See Natixis Research on that issue from 2009: http://cib.natixis.com/flushdoc.aspx?id=45725)
LikeLike
“European dollar demand spiked in 2007-8 and now again.”
If Euro dollar demand has spiked how come the USD/EUR exchange rate is even with a bias to weakening over the last 5 weeks?
LikeLike
JPK, it is of course right that EUR/USD has been more or less flat over the last month. However, as I suggest about – have a look at the the basis swap (3M Euribor vs. 3M USD libor). That have declined around 30bp to -50bp. This clearly reflects rising dollar funding costs for European banks as a result of rising dollar demand.
LikeLike
Excellent blogging. Please Mr. Bernanake-san, read this blog. And all gold-nuts.
BTW you have a typo in your headline.
LikeLike
Lars, thank you. All new for me, I must confess I have not looked at cross currency basis swaps before.
As you point out, the fall in the basis can only indicate higher funding costs for European banks. You say this is due to rising dollar demand on the part of European banks. If I understand these swaps properly, the basis may also be falling because US banks are unwilling to supply the USD leg of the swap due to a collapse in perceptions about European bank solvency.
In any case, I’m having difficulties getting my head around the idea that there could be some sort of repeat of Euro dollar demand (as in 2008) without a fall in the EUR/USD spot exchange rate.
LikeLike
You are welcome JPK. I agree that there surely also is an issue with US bank’s perception of European banks. It is however notable that everything in market pricing currencies, fixed income, stock markets and basis swaps are indicating a tightening of US monetary conditions. I will however also readily admit that the dollar hoarding was significantly more “aggressive” back in 2008/9 than now, but nonetheless the developments have been worrying.
It should however be noted that dollar swap lines are in place and the infrastructure and the coordination among global central banks is better developed today than in 2008.
LikeLike
David, I agree with your excellent post, however, I continue to think that Rajan´s “Fault Lines” is an excellent book. I don´t participate with his fears about inflation risk now, when asset prices are half that the previous of the crisis;
We are not in a normal situation now. We are before a risk of falling in a more severe crisis than that of 2008.
That, obviously, doesn´t explain the actitude of FT.
I think that both Bernanke and Trichet are “behind the curve”, and I´m affriad that they will react too late.
All that is a consequences of many years of ignorance on monetary economy, specially in Europe, where the only idea is that the ECB is good because it is a copy of the Bundesbank and that with the Euro we all will be like Germans.
LikeLike
Marcus, I agree that is just what it is. Thanks for the link to Taylor’s blog. Actually it is not as bad as I expected, because he does at least acknowledge that the recent increase in M2 may be demand driven. But the subtext clearly is that the increase in the monetary base is about to unleash the inflationary dragon at any moment, as if that were the chief danger facing us now.
Scott, That was a delphic comment.
Bill, Thanks for sharing your calculations here. As you could probably tell, my own suggestions for the price level and NGDP were more or less pulled out of my hat, so it is good to have them cross checked against some real numbers. I am somewhat skeptical of CBO’s estimates of real trend growth. The rapid real growth in the 1990s and the slowdown real growth in the oughts were both surprises, so I don’t know how much anyone should rely on what CBO is projecting.
Lars, I understand why you are reluctant to come out for inflation, but I think that it is actually important to specify a price level target that is well above the current price level. in the Great Depression, those who were calling for the price level to be raised back to the level it was at before the Great Depression said that they were for reflation. Since the price level is already above where it was in 2008, that verbal trick won’t work, so we might as well acknowledge that in the current circumstances we favor a substantially higher price level than we now have and not shrink for calling it inflation. In addition, I think that inflation is important for reducing the burden on homeowners and other debtors.
You are right that Rajan is wrong about the downgrade. I actually did a post on the downgrade a couple of weeks ago just as things started to go crazy. The analogy to 1931 is apt, but I still hope that it won’t get that bad. And thanks for your kind reference to my discussion of the 1931 crisis in my book on Free Banking. If there is an analogy between the 1931 crisis and the current situation it is that countries on the euro are stuck with the monetary policy of the ECB just as countries on the gold standard were stuck with an appreciating currency; The solution is for the ECB to inflate, but they won’t. You are being a bit too hard on Taylor, but only a bit.
Marcus, very nicely done. Your graphical representations are exceptionally informative.
Lars, Earl Thompson is indeed a source for the gold demand explanation, which is where I got it from. But I later discovered that Hawtrey and Cassel understood what was going on before it happened and while it was happening, but nobody listened to them. (Actually as you pointed out to me, the Swedes apparently did listen.)
JP and Lars, Isn’t the reason why the spike in European dollar demand has not caused the dollar to appreciate against the euro over the past few weeks precisely the increase in M2 that has John Taylor so worried? In 2008, the Fed was holding the money supply tight forcing the dollar to appreciate rapidly and causing a sharp but brief deflation. Now we aren’t getting deflation (at least not yet) but expected inflation is falling just as falling profit expectations would require a compensating increase in inflation expectations. Lars, your banking jargon went over my head, could you please translate for me.
Benjamin, Thanks twice.
Luis, Thanks. I haven’t read Rajan’s book, so I can’t comment. From the reviews that I recall reading when it came out, it has a lot of interesting ideas, but his monetary theory is all wrong. Compared to our Wall Street Journal, the Financial Times is a voice of reason. Martin Wolff, Sam Brittan and Clive Crook have all been more right than wrong in their comments on monetary policy, so I think that you may be overly critical of the FT.
LikeLike
David, I was to hard on John Taylor. I realise that and regret what I wrote to be frank. Taylor is an excellent economist. That said, I am frustrated as you that many “rightwing” economists fail to see how damaging the massive monetary tightening we have see is.
And of course Cassel and Hawtrey had the gold explanation before anybody else. You are right about that – I am just on a little PR show for Thompson;-)
Regarding my banking jargon – you more or less got it right. But let me return to you with deeper description later on…
And finally regarding inflation – why not formulate the discussion in NGDP terms? We can not really know the “split” between RGDP and prices if MV were to be increased back to the “old” trend. By the way the Swedish example shows that there do not have to be a lose of credibility if the central bank acts to counteract deflationary trends.
LikeLike
I’m really skeptical that the Fed can micro manage inflation and ngdp the way you wish. The lags are too long and variable.
I’m afraid those with extreme faith in monetary policy have been fooled by the fire fighter fallacy. Fire fighters always take credit for containing forest fires, but in reality the fire burned up all of the fuel in could and died a natural death. In the same way, monetary policy has little effect on ending depressions.
But for the sake of argument, let’s say the Fed is so good that it can set any target for a quarter and achieve it with 100% accuracy. Think about what you’re asking when you ask the Fed to inflate our way out of a depression: you’re asking savers to bear all of the cost. You’re rewarding profligate debtors and punishing savers.
At the same time, people probably won’t react to higher inflation in the way you think. They won’t necessarily borrow more and spend on durable goods, such as autos. If people want to repair their balance sheets, they’re more likely to save even more with higher inflation. That’s because they not only see their debt shrinking via inflation, they see their standard of living falling as their wages fail to keep up with price inflation and their cost of living increases.
Besides, if people are already deeply in debt, trying to reduce that debt and increase savings, few will think taking on more debt just to take advantage of price inflation is a good idea.
If people want to reduce debt and increase savings, maybe we should help them out by raising interest rates? Once they have their savings in place, they will begin to spend again.
LikeLike
Roger M–Why is raising interest rates any more or less artificial than lowering interest rates?
And what if a global glut of capital results in permanently “low” interest rates?
And are not job creators who borrow capital and risk equity to create jobs more important than the rentier class? Why punish those who run businesses?
And when you raise interest rates, do not you lessen existing bond values, thus hurting savers?
When you raise interest rates, are not you indirectly injuring those who save in the form of equities?
LikeLike
Lars, Well now I would say that you have gone from too hard to too soft. But there’s no point in pursuing this discussion, at least not in public. And it’s fine to give Earl a plug. You can do that any time you like. Don’t forget your promise to get back to me. On inflation and NGDP, please have a look at yesterday’s post on the perverse effects of inflation targeting. I suggested the possibility that NGDP targeting might provide less accommodation to a supply shock than targeting wage inflation. But I haven’t worked my way through the analysis, so I am open to other opinions.
Roger, That’s an interesting analogy. However, I think it is definitely not well-taken for the Great Depression, where I think it is absolutely clear that abandoning the gold standard was the most important step toward recovery for just about every country. In addition the few fortunate countries that were not on the gold standard largely escaped deflation and disaster.
Actually I am not asking savers to bear all the cost. Indeed, savers as a group may well do better under my policy than under a “pro-saver” policy because more debtors will be solvent and able to pay back most of what they owe rather than defaulting and leaving creditors with even less. Also every transaction has two parties. If borrowers were irresponsible to borrow, lenders were irresponsible to lend so I am not impressed by those who insist that justice be done though the heavens fall.
I don’t say that everyone will respond in the way that I suggested. But I think many will and that will provide a boost to economic activity. Household balance sheets will improve and as they do, there will be a pick-up in spending. Wages will lag prices, but that will provide an incentive for businesses to hire, so in the aggregate wage earnings will rise even if the real wage will fall at first. Over a longer time horizon, real wages will catch up. In addition, buying consumer durables is actually a kind of saving. If prices are expected to rise, there will be a greater incentive to save that way than to keep money in the bank at very low interest. I am all for raising interest rates, but the way to get interest rates to rise in this economy is to increase inflation expectations.
Benjamin, Good points.
LikeLike
Someone else is trying to puzzle out why the Euro is strong while basis swaps are not…. http://seekingalpha.com/article/288533-the-curious-case-of-the-strong-eur-usd
LikeLike
This piece from 2011 is pure nonsense. No nation has ever been successful in attempting to inflate it’s way out of debt and it’s not going to work for the US either.
Any advantage provided to the economy and its various sectors (most of all export) are temporary – and SO temporary that before the adverse effects of inflation set in – there would be no time for all this author says will be forthcoming by inflating/devaluing the dollar to develop.
The argument that inflation fear will “instantly” spur production is again pure nonsense! Production ALWAYS follows DEMAND – and inflated dollars buying fewer EXISTING goods and services will impinge on the incomes primarily of the Middle and certainly and absolutely on those trying to get by on less than level of income so they aren’t going to be spurring any demand for an uptick in production when their buying power for what is already on the shelf has been reduced by the inflation the author of this piece is so anxious (or was at the time of writing it in 2011) to foist on the nation.
Finally – and without trying to address every statement the author makes that is for the most part all contradicted by the lack of success in deploying inflation to reduce debt by every nation that has tried it before) – the “inflation” spoken of so glowingly in this article is an ARTIFICIAL inflation – not the result of VELOCITY outpacing supply – it is artificial in that it is ‘helicopter money’ – dropped from the sky as it were, straight from the printing presses of the Fed.
Bad idea. Always has been – always will be.
LikeLike