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A default dynamic of stupefying complexity

Sunday, December 14, 2008

The deflationists of the world might want to have a look at what is, without a doubt, quickly becoming conventional wisdom amongst the dismal set these days in light of what has transpired over the last year or so and the gloom that now appears to be descending upon 2009, just two-and-a-half weeks away.

In a nutshell, inflation is far, far better than the alternative.

Moreover, governments and central banks know how to create the stuff.

But most importantly, given the predicament we find ourselves in today, it is far better to err on the side of too much inflation than to deal with not having created enough. A minimum of six percent CPI-inflation sustained over the next couple of years ought to do the trick, but if consumer prices rise as fast as 20 or 30 percent per year, this too would be preferable to the alternative.

Harvard University Economics Professor Kenneth Rogoff, the former chief economist at the IMF, provides all the details in this piece at Project Syndicate:

It is time for the world’s major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic debt morass.

Yes, inflation is an unfair way of effectively writing down all non-indexed debts in the economy. Price inflation forces creditors to accept repayment in debased currency. Yes, in principle, there should be a way to fix the ills of the financial system without resort to inflation. Unfortunately, the closer one examines the alternatives, including capital injections for banks and direct help for home mortgage holders, the clearer it becomes that inflation would be a help, not a hindrance.

Modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts. Securitization, structured finance, and other innovations have so interwoven the financial system’s various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed.

Moderate inflation in the short run – say, 6% for two years – would not clear the books. But it would significantly ameliorate the problems, making other steps less costly and more effective.

True, once the inflation genie is let out of the bottle, it could take several years to put it back in. No one wants to relive the anti-inflation fights of the 1980’s and 1990’s. But right now, the global economy is teetering on the precipice of disaster. We already have a full-blown global recession. Unless governments get ahead of the problem, we risk a severe worldwide downturn unlike anything we have seen since the 1930’s.
Fortunately, creating inflation is not rocket science. All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20 or 30% instead of 5-6%. Indeed, fear of overshooting paralyzed the Bank of Japan for a decade. But this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary.

It will take every tool in the box to fix today’s once-in-a-century financial crisis. Fear of inflation, when viewed in the context of a possible global depression, is like worrying about getting the measles when one is in danger of getting the plague.
Economists all around the world are probably thinking to themselves, "Just do it".

Except, of course, the German economists.


This week's cartoon from The Economist:


Anonymous said...

Professor Rogoff's article has a confident clinical tone.
I'd say he's over confident...
Ordering up 5% inflation is harder than he describes.

Target a 5% inflation rate and
America's creditors will demand higher interest rates.

Higher interest rates require the US Treasury to print more money.
Print more money and creditors demand higher interest rates....

20-30% inflation is easy.
The Central bankers could create deflation.
Buy back the gold they've sold. Then create inflation.

Anonymous said...

you can't make banks lend it and you can't make people spend it ---- thats why we are going to have de---flation for the next ten years, not in---flation

dearieme said...

Inflation is like the cane toads in Australia: easy to introduce, not so easy to contain, and not guaranteed to do the job anyway.

oc bear said...

They've got a big debt hole to fill up before they build a bubble on top of it. Where do you put your money if you know 20% inflation? If you really want to piss people off, make them buy real estate from formerly failed flippers.

fat_tail_rider said...

The professor may be onto something. In real terms, the market crash in the mid-70s was as severe as the market crash in the '30s. Main Street in the '70s wasn't a pretty sight, but it was a lot more palatable than Main Street in the '30s. What we actually ended up with was a massive transfer of wealth from bond and blue-chip stock holders to middle class homeowners. Of course, the rich didn't take this lying down. They spent the next three decades deploying a lethal mix of Reaganomics, Rovian politics and global wage arbitrage to get it all back.

J6P said...

If I'm reading this toolshed right, he's essentially saying that the global financial system is too complicated a thing to try and fix with approaches that are logical and moral. Instead, let's do something that is guaranteed to be unfair, illogical and corrupting.

Coincidentally, Bernie Madoff used the 'too complicated' excuse as well:

Maybe now that the super-rich themselves are starting to get burned by their own corrupt policies and frameworks things will start to change for the better.

Mathlete said...

How the hell do you put inflation back in the bottle without causing another crash? Or do they just inflate for two years, but let everyone know that after those two years, we're going to deflate this sucker and if you're still in the hole, auf wiedersehn, hasta la vista baby.

Let's face it, if they inflate, it will create the mother of all commodity bubbles, and in 2011 we'll be wondering why we wasted 2 years of our lives on a stupid plan.

Mathlete said...

I think the proposal of a one-off devaluation makes the most sense. But it's still a bad idea.

Vespucian said...

I think the key is Tim's last sentence: "Except, of course, the German economists".

And WHY is that? The usual answer is that they saw the tragic inflation of 1923. But so what? The "so what" is that a hyperinflationary contraction wipes out good money along with the bad leaving a less promising foundation upon which to base a recovery (conversely, a deflationary contraction wipes out more bad than good, all other things being equal).

But more to the point the Germans learned -- inflation hurts creditors, and creditors tend to overlap with the Powers-That-Be in a society.

It also hurts savers, such as middle class Germans. Therefore, both the financially powerful and the middle class lose faith in the status quo, which could lead them to yearn for a new order, such as a "Thousand Year Reich". You get the picture. Those German economists certainly do.

However,in America's case c. 2008, many of the creditors are foreigners, and the middle class are debtors, not savers. This could change the calculus.

Regardless, I am counting on printing press inflation and going with gold, come what may.

Nick said...

Geniuses, those economists. I mean, what could possibly go wrong with printing another few trillion dollars and causing inflation? I mean, I guess there's an outside chance that:

- People will flee the US dollar and long term fixed-rate US Treasuries like the plague, causing the most monumental currency collapse in recorded history

- Long-term fixed rate credit will evaporate entirely due to uncertainty, making sure that the credit crunch is a permanent fixture of the American economy

- Anyone with any savings and means will look to flee the US before their wealth is absorbed by the invisible pervasive tax of inflation, causing a massive out-flow of wealth and skill

- Foreign investors will be loath to put money into the US or buy up US debt

- The CPI will be revealed to be the meaningless sham that it is

- As problems compound, the US government will respond by trying to print their way out of the mess, causing hyperinflation

Of course, the chances of those things happening are probably pretty remote: look at all the good inflation has brought all the other countries with lots of it. I like this plan, just give us a couple years warning, so we can GTFO before you try your "40 metric tonnes of TNT" solution to the growing leak in the ship we call the US economy.

Vespucian said...


The one thing we have in our favor is it looks like a lot other countries will print too. What would happen if ALL the major currencies become worthless simultaneously?

Goldbug wet dream, yet still a "stupefying" nightmare.

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