One of the troubling issues that arise during a recession, especially when we have arbitrary central bank monetary policy makers casting about looking for solutions to new problems is that there is a strong tendency to see inflation bandied about as a possible tool of monetary policy. RationalTheorist has looked at possible indicators of coming price inflation.
There are a couple of key reasons that inflation is considered as a policy tool. First, whether government officials believe in the value of inflation as a monetary policy, there is an implicit temptation to use inflationary policy to deal with the problems of financing massive government spending programs, such as the recent TARP, Obama stimulus package, and the FED’s various credit facilities. Inflation rewards those who hold debt, since an inflating money supply in the face of fixed debt payments means that debt loads shrink. A key problem that the FED has today is how it is going to issue enough debt in the form of Treasury bills in order to fund the stimulus programs. In addition, because asset values are inflated, any effort by the government to buy so-called “toxic assets” at prices that are too high will be ameliorated as the values of those assets would artificially inflate.
This temptation alone should give one concern about what might happen in the future. However, the second reason should give one even more concern. There are those who explicitly believe that inflationary policy is actually beneficial for the economy during a recession. Two examples have popped up recently in the media; one from a report of a Fed governor’s remarks, “FED’s Bullard: U.S. Facing Risk of Sustained Deflation” and the other from a Financial Times op-ed “Coordinated Inflation Could Bail Us All Out.” (free registration may be required)
The basic argument here is that monetary inflation (i.e. inflation of the money supply) can be used to combat a “deflationary trap” or deflationary spiral. The argument for a deflationary spiral says that due to a contraction in spending at the outset of a recession demand, and thus price, drops. However this leads to cutbacks and layoffs in the private sector and as a result, average incomes drop, and average debt levels actually rise. This in turn forces even more saving, with resultant demand drops and further cutbacks. This process is said to continue on in a spiral, eventually destroying the economy. This effect does happen during a recession, but I question its severity, and whether or not monetary inflation is proper to combat it.
In an economy that has been over-stimulated as ours has, a correction in asset values must occur. If we’ve been improperly subsidized to build too many houses over the last decade, then the price of housing must come down. Part of what we’re seeing is the market’s natural response to reset these asset values. This will hurt those who’ve over-estimated their ability to absorb risk (and should be a strong reminder why we don’t government interfering and creating distortions in the economy in the first place); however, it must occur. But the existence of falling asset values is its own stabilizer to continued fall because falling prices stimulates demand. Not everyone in the economy sees their incomes and asset values fall, and for those who do not, falling prices create an incentive to consume, thereby stabilizing deflationary pressures.
But the secondary and even more important issue here is that one cannot combat demand deflation with monetary inflation. Yes, inflating the money supply will cause prices to rise, seemingly reversing falling prices; however the mechanism of price movements are completely different in each case and one is not an antidote to the other. In a time of recession such as this where market distortions have resulted in the destruction of investment capital, what is needed is recapitalization. We need to use our current productive capability to accumulate savings (which if deposited become investment capital). Those who have over-borrowed need to pay down debt or sell off assets and their concurrent liabilities. Those who are in the best shape risk-wise can afford to spend, and those who are in worse shape should save and get rid of debt.
However, inflation destroys this process. Inflation destroys real wage levels, i.e. productive capability. It favors those who have large debts, and it destroys the value of accumulated assets. It is unjust. Those who have over-borrowed see their debts effectively forgiven. Those who were prudent and have saved see their assets destroyed.
Those who think that this sort of policy can be a good thing suffer from a form of macro-economic rationalism. That is, they view the economy as an aggregate machine, a sort of “black box.” They have correlated increasing money supply with rising prices and recession with falling prices and simply see one as a way to combat the other. Faced with a condition of falling prices, they know they can make prices rise by printing money. It is as if they are pulling levers and turning knobs on this black box simply to keep the gauges reading what they were. They care little what the fundamental mechanisms of each are. The articles I referenced show this.
From the WSJ blog:
Bullard also said a more systematic approach to countering deflation would entail more communication about what the Fed is trying to accomplish. He suggested setting “quantitative targets for monetary policy, beginning with the growth rate of the monetary base.”
“By expanding the monetary base at an appropriate rate, the FOMC [the Fed’s policy-making Federal Open Market Committee] can signal that it intends to avoid the risk of further deflation and the possibility of a deflation trap,” Bullard said.
In his comments on the economy, Bullard said “macroeconomic expectations are very fluid and volatile.” He added “the current recession is a global phenomenon” and “it seems likely that output and employment will continue to shrink in the first half of 2009.”
“There is a risk that core prices may continue to stagnate or decline slightly for some time to come,” Bullard said.
The article is devoid of any reference to what market prices should be, or any mechanisms of operation of the market. Output and employment are falling, therefore the FED should act to increase prices. The “gauge” does not read correctly therefore we have to pull this “lever” to make it do so.
Even more brazen or bizarre is the Financial Times article, where the author clearly advocates for an inflationary policy, after explicitly and correctly articulating the various positive effects of such a policy, while all but ignoring the negative effects.
It [an inflationary policy] would help government finances by inflating away 10 per cent of total government debt. This lowers the interest burden for future taxpayers. Since taxes are levied primarily on income, this has both equity and efficiency benefits. It is (more) equitable as the cost of recession will be borne by wealth holders as well as income generators, and it is (more) efficient in that it reduces the extent of incentive-reducing tax rises on income in the future.
Companies will benefit in two ways. First, a portion of their debt will disappear, with the benefit being the largest for those companies that have debts with fixed interest, such as corporate bonds.
Second, while real wages seem to be downwardly flexible, nominal wages are less so. Higher inflation allows more companies and workers to agree to real wage cuts than would otherwise be the case. This is both useful for those firms that are currently uncompetitive, and preferable for society, because wage cuts are more equitable than unemployment.
A rise in inflation also means that declines in real house prices translate into less negative equity, freeing up the housing market. This is beneficial for labour mobility and helpful to the real economy because additional house sales spur economic activity.
Banks would gain in three ways. Inflation reduces future bad debts by making debt servicing easier. It makes defaults less costly because real collateral is more likely to exceed nominal debt. Finally, it makes existing bad debts less onerous on the balance sheet. This reduces the need for government recapitalisations and “bad banks” and increases the ability of governments to sell recently acquired banks. This, in turn, reduces the debt burden on future taxpayers.
An extra 2 points of inflation for five years is not a “get out of jail free card”. Bank shareholders, rightly, will still lose greatly from their managers’ decisions. Future taxpayers will, inevitably, still bear most of the cost of counter-cyclical government spending.
It is not costless. Regrettably, prudent savers will see their assets reduced. That might be the price society has to pay to keep the banking system afloat without crippling future taxpayers.
In terms of direct costs, the negative effects are equal and opposite to the claimed benefits. For every dollar that a debt holder’s obligation is lessened, the capital lender is punished by an equal amount. To call that a “cost” is to suggest that when a thief steals from you, that your loss is simply a “cost” of the benefit he gains. When the costs equal the benefit, there is no benefit. The indirect costs however are even greater because it is the asset holders that will restart the economy and it is they who are punished in an inflationary environment. Inflation destroys the very process of recapitalization that the recession will facilitate if left alone!
The rising debt levels that the United States is experiencing should concern those who see it as a temptation on the part of regulators to use inflation to “finance” their efforts. However, when inflation is explicitly advocated as a monetary policy by those in power, it is all but sure to rear its ugly head. It can only prolong the recession.