Inflation Should Be Just Around the Corner

Last week’s stock market collapse—and the latest bailout round for Citigroup yesterday—makes it clear that America’s greatest banks are still in deep trouble. But the news is actually worse and much more global. The prices of securitized residential and commercial mortgages reached new all-time lows, and most commodity prices continued their rout. The same pattern was seen in European and Asian markets. The default risk priced into Irish, Greek, and Italian sovereign bonds continued to rise, raising questions about the viability of the eurozone. There is an even larger question mark hanging over Switzerland’s financial viability due to its highly leveraged large banks. The main star performer of last week was gold, while long bonds rallied as investors anticipated deflation.

This downward spiral of asset prices is creating potential insolvencies on a massive scale. The natural private-sector response is to cut spending and try to repay debts. Citigroup’s announcement that it will dismiss roughly 50,000 employees to contain costs is just one example; similar announcements are being made around the world, and piecemeal over-the-weekend “rescues” will do nothing to stop this.

Governments are trying to offset the private-sector contraction. They offer to backstop potentially insolvent banks, provide more benefits to the unemployed, raise expenditures, and increase budget deficits. In essence, governments are risking their good balance sheets to limit the damage from “bad” private balance sheets. For some nations, there are already signs that this strategy could backfire in a serious way. For example, Ireland—the first country to guarantee all liabilities of its banking sector—saw its market-implied risk of sovereign default (within five years) rise from 12 percent to 18 percent in just one week.

Last week’s events parallel the early pattern during the Great Depression. The main difference is, compared with the onset of the Depression, we have already embarked on enormous measures to prevent financial collapse, and, so far, these appear to be failing. In economics, ever since Milton Friedman’s and Anna Schwartz’s great A Monetary History of the United States, we have been taught that overly tight monetary policy was a major factor explaining the Depression—so much so that Ben Bernanke even once apologized on behalf of the Fed for that mismanagement. Now, we can’t help but feel a nagging concern that, perhaps, all that teaching was not quite right. Perhaps the events of 1929 produced an unstoppable whirlwind of deleveraging that no set of policy measures would truly have been able to prevent.

We can be sure that deflation will only make our situation worse. If prices actually fall around the world, the solvency problems of banks, households with mortgages, indebted corporates, and most sovereigns will continue to worsen. A falling price level would be associated with lower asset prices and reduced collateral value for loans, while the nominal liabilities would remain fixed. This would open greater holes in balance sheets and reinforce the downward spiral. Further, falling prices mean that both long and short interest rates are low—a flat yield curve. This would exacerbate the financial sector’s problems as its lending becomes less profitable.

It is now imperative that strong actions be taken to prevent deflation, and we should use monetary and fiscal policy to start our reinflation. There are some people who think this is not possible: In the midst of rising unemployment and large excess capacity around the world, how can we get prices to rise?

In a brilliant speech in November 2002, Ben Bernanke outlined a game plan to prevent deflation, and it is far more relevant now than it was then. We are already well down his proposed road. He called for open-market operations to lower interest rates, and suggested the Federal Reserve could directly lend to corporates and other nonbanks if needed. None of this, so far, has worked. His next suggestion was to finance new tax cuts and spending increases with money printed by the Federal Reserve. If the money is spent, the economy should start to recover, and the added spending along with easy money just might be enough to raise prices. We have not tried that in earnest yet, but we should and likely will. Over the weekend we heard confirmation of Larry Summers’ earlier hints regarding a $500–700 billion spending plan under Obama—this makes sense if it is accompanied with aggressive monetary expansion. The goal should be to aim too big, not too small.

Unlike fiscal policy, which encourages other countries to “free ride” on any US expansion, the attraction of US monetary expansion is that it will force a global response. When the United States expands its money supply, thus putting pressure on the dollar to weaken, Asia and the United Kingdom will quickly follow suit to prevent their currencies from strengthening.

Already, the Bank of England is rapidly reducing rates and talking down the pound. They understand that the only way out of their crisis, which is arguably worse than in the United States, is to cheapen the price of money quickly and encourage depreciation relative to trading partners. Most Asian nations continue to manage exchange-rate policy so their currencies weaken, or at least stay stable, relative to the dollar. While the eurozone will lag, its deep economic and institutional problems mean they cannot afford a strong euro. The European Central Bank must soon cut interest rates sharply and follow along.

If President Obama’s team and Mr. Bernanke do manage to instigate a strong global monetary expansion, with newly rising prices, we might just arrest the downward spiral of asset prices and solvency. The collateral value underlying loans and mortgages will rise, or at least stop falling, and the yield curve will steepen, making banks more profitable. This would change the fundamental solvency of our entire financial system, households, and the government. We need to have significant inflation: 2 percent is not enough to improve solvency significantly, and we may experience 5–10 percent for a year or two. Inflation has major drawbacks and creates its own risks, but compared to the alternatives, it would be a relief.

And it would also make the latest round of bailouts more justifiable. Tim Geithner, the incoming Secretary of the Treasury, was at the table with Citigroup this weekend, and he knows better than anyone the actual and contingent liabilities taken on by the government over the past year. This approach to financial-sector bailouts will prove very expensive to taxpayers and may not work unless we have significant inflation. The early signs all suggest the Obama team is confident that enough inflation will produce recovery and ultimately protect the government’s balance sheet.

But let us be honest. Attempting to increase inflation may not work, particularly if private-sector spending does not respond. The policy response that is in the works is likely to be massive. But what we have already seen over the past 12 months is unprecedented and, to date, not very effective.

So what do markets think? Last week they weren’t sure. At the close on Friday, inflation-linked bonds priced in only 0.2 percent average inflation for the next ten years; this sounds like a deflationary spiral. However, the world’s oldest inflation hedge, gold, rose sharply, suggesting that some investors think we will soon be successfully inflating. Let’s hope the gold market is right.

Originally published at the Wall Street Journal Real Time Economics and reproduced at the Peterson Institute website, the Baseline Scenario and here with the author’s permission.

14 Responses to "Inflation Should Be Just Around the Corner"

  1.   November 25, 2008 at 3:00 pm

    I thought competitive devaluation was one of the lessons learned from the GD to be avoided. Reflation/inflation through rapid monetary expansion supports irrational price levels agreed; but doesn’t evicerating savings and requiring ‘backed by the full faith and credit’ appended by footnote have a downside for rational expectations going forward?? Please explain.

  2. Guest   November 25, 2008 at 9:56 pm

    So we induce people to borrow more money for a couple more years, then what? A legitimate recovery takes place in this utterly polluted financial system? Citigroup is magically made whole again? American manufacturing springs back to life for the first time in decades? Unicorns flock out of the woods and nuzzle lovingly with all of us? Please. A reinflation will mean nothing more than additional ludicrous borrowing with the bulk of the benefits being directed to China and the petro-states. In two years we’ll be right back here in an even worse (imagine that) state than we are today. We all need to accept the fact that global debt needs to be repaid or destroyed through default. Those are the ONLY options. The notion that we should hope Ben & Hank can induce more borrowing that allows us to keep driving Hummers ’til 2012 is beyond stupid. In fact, it’s the precise logic that has led us to the current crisis.

  3. mmcfarland   November 25, 2008 at 11:29 pm

    ‘The world’s oldest inflation hedge, gold, rose sharply, suggesting that some investors think we will soon be successfully inflating. Let’s hope the gold market is right.”Wrong. Gold didn’t rise because of an increase in expected inflation. Look at bond yields – where is the pricing of inflation? Gold rose because the market is now beginning to price in the debasement of the USD assets.

  4. Anonymous   November 25, 2008 at 11:56 pm

    Guest at 21:56 – F’ing brilliant! If only more Americans could arrive at that same undeniable conclusion.

  5. Little Saver   November 26, 2008 at 1:26 am

    Please move to Zimbabwe and be happy there.Don’t steal my savings, or I quit.

    • Little Saver   November 26, 2008 at 1:29 am

      You’ll have to live on taxpayer money, not on mine.

  6. Mick Rolland   November 26, 2008 at 5:22 am

    I read this article with dismay, especially its economic policy recommendations. It is permeated with the whole notion that spending drives the economy (spending drives production). I believe that sound economic thinking is the other way round: production drives spending. (Otherwise, the road to prosperity would be infinitely easy. Notoriously spendthrift nations and governments would be the richest in the world! Inflation would solve problems of “lack of demand”. It makes me think of the success of Latin America in these endeavours the XXth century…)The article is also deeply imbibed with the postulate that inflation is necessary for growth. If the US problem was “excess savings”, that could be correct. But if the problem was excess debt and lack of savings, with inflation we will wipe out the little savings that remain.Messrs. Boone and Johnson, forgive me if I think you are advocating the third-worldization of the US. However, at least you recognize that most of the inflationist measures already taken haven’t worked and I respect your spirit of self-doubt.

    • Ed   November 28, 2008 at 7:08 pm

      Mick Rolland,Marvelous comment, especially “… the third-worldization of the US.”. You will likely agree with much of this Letter “Mispricing and misbehaving” at has long seemed to me that IF ONLY real asset price histories, which well-show bubbles, were ongoingly well-apparent to the people, then bubbles would be well-deterred. And I reckon that rational behavior generally will be abetted by NOT counting air in asset prices as collective wealth.Talking to myself so far,Ed

      • Ed   November 29, 2008 at 12:24 pm


  7. Guest   November 28, 2008 at 11:26 am

    Inflation transfers wealth from borrowers to savers. Given that we are a nation of borrowers, this seems to be exactly what needs to happen to the US. The dollar needs to fall so as to make the US more competitive internationally and to drive up consumption among the savers of the world.

  8. Guest   November 28, 2008 at 11:28 am

    Sorry meant to say, transfer of wealth from savers to borrowers.

  9. Guest   November 30, 2008 at 10:38 pm

    Why is it that economists never learn from history? The lesson this time, as so many times before, is that a pyramid/ponzi scheme is destined to collapse and that no solution is possible except letting markets work it out. If anything else were possible then it would constitute free value which, like its overunity energy and perpetual motion brethren, is impossible. Anything the governments do at this point will simply make things worse. THAT is the lesson of history. Once the mania is bust it does not correct sideways.

  10. Anonymous   December 9, 2008 at 7:59 am

    Can someone please simplify these discussions? My little pea brain tells me that when government prints more money (ie billions in bail outs ) there is inflation, so where is the deflation coming from? I know the economy is a complicated machine…and I dont understand all its machinations…but I even heard dick Morris say on Fox that there was inflation around the corner.Makes it difficult to know how to manage assets and debt. Necessary to ride out this monster economy. If the economy were not over managed, things would be easier, granted, and common sense would prevail, ie savings good, debt bad, but we are not facing that situation.Thanks for any enlightenment…