Nov 12th, 2008 at 9:52 am
Fight Recession By Causing Inflation?
If I’m reading him right, that’s what Arnold Kling is calling for here. Not just a shift in emphasis away from inflation-fighting and toward expansion, but specifically an effort to create inflation to allow real wages to fall in lieu of mass layoffs. I’ll file that under “provocative.”
33 Responses to “Fight Recession By Causing Inflation?”
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November 12th, 2008 at 9:58 am
Krugman sort of went there. He didn’t say it explicitly, but he acknowledged that would be the effect. We have plenty of dry monetary powder to fight inflation.
November 12th, 2008 at 10:06 am
If I’m not mistaken, that’s also what Tyler Cowen was suggesting as key to the end of the Great Depression, rather than massive fiscal stimulus.
November 12th, 2008 at 10:09 am
Inflation is also a way to reduce our debt load, domestically and externally.
After all, isn’t the new game fighting DEflation?
Just one more twist in the New Disorientation!
November 12th, 2008 at 10:10 am
That is exactly what FDR tried to do by going off the gold standard.
November 12th, 2008 at 10:17 am
His arguments seem to have merit. I will also say that deflation seems to be the bugaboo now, not inflation. Some economists were warning of deflation several months ago, saying that the run up of commodities was a bubble and when it pops the dollar will rise. Certainly this is a strike against the New Austrians. The bigger question is can we really fight deflation? Or, if some inflation is desirable, can it really be induced?
November 12th, 2008 at 10:19 am
I’m surprised he doesn’t mention housing market, as well– inflation would reduce the real value of the outstanding mortgages while stemming the slide in nominal housing values.
One legacy of the 70s and 80s is that we’re enormously skeptical of using inflation as a tool, because the risks of being unable to control it are great. However, in theory, I understand the justification.
November 12th, 2008 at 10:24 am
This is simply Keynes, you idiot.
In Hayek’s view, perhaps the only true insight in all of the Keynesian pseudo-science.
November 12th, 2008 at 10:28 am
I’ve read that Bernanke criticized Japan for not doing this once their interest rate was set to zero. The idea is that once interest is zero, the only tool you have left to make capital cheaper is to inflate. This can be seen in the famous Fischer equation, i=r+pi (i is the nominal interest rate, r the real interest rate, and pi the inflation rate). So if i is zero, you can turn r into a negative number by increasing pi. This effectively makes it cheaper to borrow.
November 12th, 2008 at 10:33 am
But aren’t falling incomes exacerbating this recession?
The data seems to indicate something different from what Kling is asserting. While economic mobility hasn’t been dead the last 28 years (the data does show workers passing through income groups), it doesn’t mean that the bottom isn’t getting lower for the new workers and immigrants who take their place, nor does it mean that the higher income tiers haven’t become less attainable. I also think he’s purposely ignoring the effect reduced real wages would have on household balance sheets. If debt as a percentage of income rises, then servicing that debt becomes more difficult. And, it would be irrational for people to continue servicing such debt with less real income when their household assets are depreciating. True, having no job is worse than having a job that pays less. But the effect on behavior would likely be the same– If one is certain there won’t be enough money to pay a debt, one wouldn’t pay any of it, electing rather to spend on more immediate needs. Having no money to pay a debt leads to the same conclusion.
I don’t think this idea is provocative at all. Reckless, perhaps.
November 12th, 2008 at 10:42 am
There are two standard drawbacks to inflation.
The less important one, which happens to be the most important tenet of Republicanism, is that it erodes established wealth. That is a problem for very few people, since most people with positive net wealth have it in assets that track in value roughly with inflation – homes, future earning power etc. The wealthier you are, the less true that is.
The real problem with inflation is deterrence of lending. People with assets want some vig above the inflation rate if they’re going to lend their money out. At first glance, you wouldn’t want to do anything to push interest rates up during a credit crunch, but it might actually work out. Lenders are not so much worried that borrowers are unprofitable, but rather that they’re insolvent. Increasing the nominal value of underlying assets might more than offset the deterring effect of high interest rates in the long run. You could see more money borrowed at higher rates.
November 12th, 2008 at 10:44 am
Jake,
The argument is actually fairly straightforward: Because of changing economic conditions, a large number(not all!) of workers are being over-paid.
In an ideal world, the firms would simply cut their wages. But because of game-theoretic quirks, this is impossible. So instead, companies do other less ideal things, such as cutting staff. And a good deal of the damage in a recession is caused by these less than ideal responses.
But if there is large inflation, the firms will simply decline to give their employees a raise, and their wage will stabilize at market levels fairly quickly.
Meanwhile, for the workers who were not being over-paid, market competition will, for the most part, keep their wages increasing.
As for the other idea you brought up about debt: Inflation decreases the effective cost of servicing debt, since wages usually go up with inflation(unless you were one of the people getting paid too much), while debt doesn’t.
November 12th, 2008 at 11:02 am
Not a new idea… Go back and read William Jennings Bryan “Cross of Gold” speech. The Democrats in 1896 wanted to boost inflation to make it easier for people to pay back debt.
I’ve been saying for several years now that the solution to our federal debt, as well as mortgage debt is likely to be high inflation. If that is coupled with fiscal discipline on the spending side… the $10 trillion won’t look like so much money.
November 12th, 2008 at 11:04 am
It’s not that it can’t be brought under control, it’s that doing so involves pain. At least having Volker hanging around the White House makes me think that an inflationary course would eventually be brought under control.
November 12th, 2008 at 11:05 am
Possibly. However, inflation combined with higher interest rates is actually beneficial to those who save. Higher interest rates on CDs and savings accounts is better for retirees than high returns in high risk stocks.
November 12th, 2008 at 11:07 am
Really? So how is this deflation doing for your 401K and home equity?
November 12th, 2008 at 11:14 am
duBois:
As a similarly debt-averse person (albeit younger and thus I concede more tolerant of volatility in asset values), I have to say I’m not super-worried about this. It sounds like you have, as I do, a large percentage of your net worth tied up in your house. The value of your house will, depending somewhat on where you live, track inflation pretty closely. So while your existing equity is being devalued in a sense, you will be gaining equity at basically the same rate.
It’s true that homeowners carrying more debt will be helped more by inflation than you will, but this amounts more to a subsidy of debtors than a penalty to the prudent.
As for your retirement portfolio, inflation is obviously a concern, but the much bigger concern is the fact that the value of the assets in that portfolio is getting hammered by fears of a deep, prolonged recession. The worst of all worlds is a deep recession WITH big inflation problems, but inflation-plus-recovery is going to be a lot better for your portfolio than price-stability-plus-recession.
That’s the opinion of THIS low-debt homeowner, anyway.
November 12th, 2008 at 11:17 am
It occurred to me after I hit post that if you or I REALLY felt that these inflationary policies were going to make it more desirable to be a debtor than not, we could certainly leverage our net worth and start flipping or something.
But I don’t think either of us is really going to do that, which reveals that inflation or not, in personal finance it’s usually better to owe less money than more money.
APS
November 12th, 2008 at 11:19 am
David,
As for the other idea you brought up about debt: Inflation decreases the effective cost of servicing debt, since wages usually go up with inflation(unless you were one of the people getting paid too much), while debt doesn’t.
I agree with this up to a point. Debt as a stand-alone figure is one thing, but compared with leveraged assets is another. Debt with fixed interest rates would decline at a real rate, but debt with variable interest rates would increase with the level of inflation in the form of higher interest rates. Cost associated with fixed mortgage debt would largely depreciate with inflation, but costs for credit card debt, variable mortgage debt and revolving lines of credits used by people and businesses alike would, in the long run, rise with the change in the price level (lest we all forget about the early 1980s). If wages rise at the rate of inflation, the effect on variable debt would be insignificant. Further, the associated increase in deposit rates would drive up the national savings rate, leading to a further deterioration in consumer spending.
We can’t forget about asset depreciation in the housing market. Nominal wage growth would have to keep up with 20-30% declines in household assets. Wages would rise in an inflationary environment but the aggregate rate of inflation necessary to compensate for the deflation in household assets would be extremely high and thus unsustainable.
November 12th, 2008 at 12:33 pm
So wait, we are taking anything Arnold “ding a ling” Kling has to say seriously? Really? The man is a mainstream, neoclassical economist – that is to say, a moron. Seriously, just ignore him. Nothing in his models predicted what is happening now, and all of his solutions are from a world where the General Theory was never written.
What needs to happen is this: governments need to increase deficits, by spending more and taxing less, until aggregate demand is high enough for full employment. That’s pretty much it. You might get a bit of inflation as we approach full employment, but a progressive tax structure makes that difficult, since taxes will rise as the economy expands.
How much of a deficit will this take? Maybe 750B, maybe 1T. Who cares? There are no financial constraints to how much a soveriegn currency issuer can spend in it’s own currency. The only constraints are monetary – that is, inflation, if the government increases aggregate demand past the point where it is mobilizing unused resources and is competing with the private sector and bidding up prices.
The thing to avoid is what FDR did in the 30s and Japan did in the 90s – take some half measures, then attempt to balance the budget when things get a little better. My own recommendation would be a payroll tax holiday, staring immediately and continuing indefinitely. That would add about 20B+ a week to AD, directly to those most likely to spend it. You could add it back later if things overheat (although I personally would like to dump it entirely…)
November 12th, 2008 at 12:51 pm
You are missing the big point: If we have high inflation, in a few short years, many of the houses now under water will be worth more than is owed, BECAUSE THEY WILL BE REPAYING THE DEBT IN DEVALUED CURRENCY.
In fact, high inflation, something like 12-20% a year for 6-10 years, make all the credit crunch problems go away….Though, of course, you are stuck with a nasty bit of inflation.
November 12th, 2008 at 1:00 pm
Matt, I hate to be this way, but have you read an introduction to a macroeconomics textbook?
November 12th, 2008 at 3:05 pm
This is what keynesianism is all about and, at least on the short term, it works. Oh, and if you can broke the back of unions before the refletion, it is going to work even better. The left loves Keynes because they don´t understand him…
November 12th, 2008 at 3:07 pm
This is a good idea for reasons that several have mentioned, including Matt Saroff just above.
David Shor, though, is supporting the idea for idiotic reasons. Most people are overpaid? On what standard? What counts as fair pay, other than what the market will bear? And what does this have to do with the macroeconomic situation.
If most people are overpaid, doesn’t it follow that the owners of capital have been getting the shaft? That the wealthy should have been wealthier? What??
In the real world, a big part of what’s going on is that working families have compensated for falling real wages by borrowing more. You could argue that these families are unwise for living beyond their means (and maybe I’d agree with you in some cases), but the macroeconomic consequence of consumer prudence is falling consumption and, ultimately, slower economic growth.
Overpaid workers? Jesus.
November 12th, 2008 at 4:07 pm
Duh. That’s what’s going to happen. Savers like me are going to have the value of our savings debauched to pay for the all the borrowers and lenders.
What else could happen?
November 12th, 2008 at 8:45 pm
Certainly this is a strike against the New Austrians.
No, it isn’t. Austrian theory states that inflation (defined as an increase in the money supply) causes people to take on bad debts and to invest in too many projects that are unprofitable or that cannot be completed. The end result of this is that the bad debt will eventually have to be liquidated, resulting in massive deflation as bad investments go belly up, and as money created by creating credit out of thin air (as opposed to getting credit out of savings) disappears when the debtor defaults.
The government at the end of a boom tries mightily to prevent this, by inflating more rapidly. This puts off the day of reckoning and the destructive deflation, but it makes the bubbles generated worse and causes the eventual bust to be worse. As time goes on, it gets harder and harder to “stimulate the economy” to put off the day of reckoning. At some point, you reach a point where any further attempts to prevent the liquidation of bad debts will cause hyperinflation.
However, hyperinflation rarely occurs because the government usually backs off from trying to stimulate the economy enough to cause this to occur. The government eventually lets the deflation happen because the alternative is the Hungarian Pengo.
That we are facing deflation rather than hyperinflation does not make the Austrian economists wrong; it simply means that our leaders are choosing door number one instead of door number two.
His arguments seem to have merit. I will also say that deflation seems to be the bugaboo now, not inflation.
Deflation may be painful, but it is necessary in order to get ba debt off of the market.
The bigger question is can we really fight deflation? Or, if some inflation is desirable, can it really be induced?
Yes. The main reason why the lowered interest rates and the bailout have not been too inflationary yet is that the banks are afraid to make loans. If the government simply forced them to make loans, or attempted to pay off some of its debt or to increase spending simply by printing the money outright, it would have an inflationary effect.
The problem is not that we cannot fight deflation, it is that we shouldn’t. It is a necessary process to correct the monetary expansion of the past decade and a half. Fighting it is like fighting the urge to vomit when one has food poisoning. You’re just keeping the bad stuff in instead of getting rid of it.
November 13th, 2008 at 12:19 am
As an older guy who lived through the late 70’s and early 80’s, the “pain” of reining in an inflationary spiral isn’t an abstraction, it’s a very concrete memory. I was there trying to get my career started during the deep recession created by 20% interest rates as this same Paul Volker managed to finally put the brakes on the double-digit inflation of the 70’s. It was not fun.
Be careful you don’t create a cure worse than the disease.
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