A default dynamic of stupefying complexity

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.
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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.

ooo

This week's cartoon from The Economist: