The Path Not Taken … Thus Far: Debt Deleveraging by Inflation

From the latest issue of the Milken Institute Review, “Trends: Better Living Through Inflation” (co-authored with Jeffry Frieden):

If the aftermath of the Great Recession doesn’t feel like the recovery from a normal cyclical downturn, that’s because it wasn’t a normal cyclical downturn. We’re living through the consequences of a massive global debt crisis, and debt-driven crises produce an especially malign form of recession. …

The politics of debt is, if anything, more daunting than the economics. A debt crisis typically degenerates into bitter political conflict over who will bear the burden of the adjustment. Some of the conflict may be among countries, with creditor nations trying to force debtors to pay off in full and debtor nations rebelling against measures that could conceivably make that possible. Other political battles take place within countries, as taxpayers, bankers, government employees, pensioners and investors jockey to avoid being saddled with the costs of working off the accumulated debts.

If we simply choose to wait for the world to find acceptable formulas for sharing sacrifice, we may be in for nearly a decade of snail’s pace growth — a truly global lost decade. …

Our recommendation: Conditional inflation targeting now, by keeping the Fed funds rate near zero and supplemented with other quantitative measures as long as unemployment remained above 7 percent or inflation stayed below 3 percent:

When nominal interest rates are kept below the rate of general price increases, inflation reduces the real burden of debts denominated in local currency. To put it another way, as prices rise and wages follow, debtors (households, businesses and governments) find it easier to service their debts and can more readily resume regular economic behavior.

The idea may seem radical, but it’s hardly unprecedented. After World War II, the United States inflated away a portion of the debt that it had accumulated in the war years — and did so even though the economy wasn’t facing an actual debt crisis. An analysis by Joshua Aizenman (University of California at Santa Cruz) and Nancy Marion (Dartmouth) points out that the federal government came out of the war with a debt equal to 109 percent of GDP, substantially more than the debt-to-GDP ratio the country faces today. But all it took to (nearly) halve the ratio between 1946 and 1955 was a mix of reasonable economic growth turbocharged by relatively mild (on average, 4 percent) inflation.

This is not a new observation. In Lost Decades (W.W. Norton), Jeffry Frieden and I wrote:

Government revenues keep up with inflation, but the debt doesn’t — and so its real weight declines. This is why countries with heavy foreign debts typically run inflation rates double those without. Many countries with foreign debts in their own currency reduce their real debt burden by allowing their currency to drop in value, so that foreigners get repaid in less-valuable currency. (p. 188)

The typical counter-argument is that any move toward a higher target inflation rate raises a possibility of a hyper-inflationary spiral. To place things in perspective, consider current inflation in the US and the Eurozone:

Figure 1: Annual inflation, measured by CPI for US (blue), for eurozone (red). Latter is HICP. Source: BLS via FRED, ECB, and author’s calculations.Not only are current inflation rates quite muted in the US and the Eurozone; inflationary expectations are well-anchored [0], and can stay anchored if the target is conditioned. In his discussion of our article, Ben Casselman in the WSJ’s RTE blog noted:

In a speech last fall, Chicago Fed President Charles Evans laid out the argument this way: The Fed’s implicit inflation target is 2%. The Fed doesn’t have a widely cited numerical target for unemployment, but a conservative estimate of the “natural,” or underlying, rate of unemployment is 6%.

“So, if 5% inflation would have our hair on fire,” Mr. Evans said in September, “so should 9% unemployment.”

Unemployment has come down some since last fall, but it’s still at 8.2%, nowhere close to the Fed’s “maximum employment” mandate. By Mr. Evans’s logic (which he explains more fully in his speech), the current rate of joblessness is equivalent to inflation running at 4.2% — more than double the Fed’s target rate.

Mr. Evans has argued the Fed should consider allowing inflation to run above its target until unemployment falls to some pre-determined — and pre-announced — level.

Casselman illustrates Evans’s point, assuming the Fed’s target unemployment rate equals the natural rate of unemployment:

Figure from Ben Casselman, “Number of the Week: Could Inflation Revive the Recovery?” WSJ RTE (July 21, 2012).Note that our argument here focuses only on the balance sheet and government debt aspects. As discussed elsewhere, a higher general inflation rate facilitates the relative price adjustments which are of particular importance in the Eurozone [1] [2], and would also help revive the moribund housing sector in many countries.

One particular challenge in the Eurozone, where arguably the benefits of higher inflation would be the greatest, is that the definition of “price stability” would have to be altered.

Update: The repeated reference to (allegedly) already high inflation spurred me to refer readers to this post by Ed Dolan on the psychology of price perceptions.

This post originally appeared at Econbrowser and is posted with permission.

4 Responses to "The Path Not Taken … Thus Far: Debt Deleveraging by Inflation"

  1. Matt Dubuque   July 25, 2012 at 10:58 pm

    "AND IF THIS DOESN"T WORK, are you just going to raise the inflation target?"

    That was Paul Volcker's response to this proposal and this approach.

    You need to answer these concerns of Volcker's before you get anywhere with Fisher in Dallas Fed and Angell at the Kansas City Fed.

  2. TWest   July 26, 2012 at 2:28 am

    You assume that Policy Makers can operate such a scheme with a feather light touch, Do you really expect this scheme to be manageable with a simple lifting of inflation targets? As the policy/communication moves get more complicated, the system is prone to larger skews, both positive and negative. More volatility,…..anyone???. Beyond the probability that such a scheme will be difficult to manage, IMHO, by folks who have proven to be faulty managers. Without significant banking reform, aren't you assuring that todays, unchecked, unbalanced systems/structures will continue to drive the value to mostly the wrong people, and insure that we repeat this entire scenario on our historically ptrdictable time frames. Stop the train, I would prefer walking. I do understand, thats just what may happen.

  3. R. Coutinho   July 31, 2012 at 5:17 am

    Given that none of the (admittedly anemic) recovery has gone to anyone in the 99%, I believe that inflation would be an insidious tax if done in the manner of QE and low interest rates. The working class has not seen pay raises while they have seen at least some inflation in the past four years. Inflation will only help if wages rise along with prices. That is not currently happening.