The Economist recommends taking the easy path to inflation. But what if it’s closed?

Larry Kummer, Editor

12 years ago

Summary: If the great monetary experiments underway in Japan and America succeed, then the world will change. Aggressive fiscal and monetary stimulus will become routine, even normal. For better or worse. Already the normalization process has begun by people unaware that in this new century the easy path to inflation has been closed, with as yet unknown consequences.

Christian Science Monitor, 8 November 2010

Contents

The world has changed, yet they still dream of monetary magic
About inflation
The Boomers’ secret lust for inflation
For more information

(1) The world has changed, yet they still dream of monetary magic

QE3 will raise the Federal Reserve’s assets by almost 40% in its first year. Japan has adopted an even bolder strategy. One of the two arrows of the three arrows to Abenomics is doubling the money supply in two years in order to raise inflation to 2%. If these monetary experiments work, then the world will change. Already the yearnings for inflation, simmering since the crash (but expressed in euphemisms), are now expressed openly.

“Secular stagnation: The second best solution“, The Economist, 21 January 2014 — Excerpt:

WITH a string of talks and op-ed columns, Larry Summers has revived discussion in the “secular stagnation” hypothesis. Income has become concentrated in the hands of groups, like reserve-accumulating foreign governments and the rich, with low propensities to consume, the thinking goes. That has generated excess saving and pushed down real interest rates until they are substantially negative at many durations. That, in turn, has made life very difficult for central banks, which have struggled to stoke up adequate demand with nominal interest rates wedged up against zero.

Mr Summers identifies three broad solutions to the problem.

One is to do nothing, or not much anyway, on the demand side. This is not a particularly attractive solution, as it implies a very long slump in which incomes are lower than they need to be, unemployment is higher, and the economy’s potential is eroding.

Another is to raise inflation expectations in order to reduce real, or inflation-adjusted, interest rates until demand is where we’d like it to be. This policy is not without its downsides …

The last option to address stagnation is to have the government soak up excess savings and boost demand through deficit-financed public investment.

The third option is quite clearly Mr Summers’ preferred course of action. And it is a very attractive option. It is a rare rich country that doesn’t have a list of infrastructure needs that could justifiably be addressed in the best of times. Pulling those off the shelf and taking them on amid rock-bottom interest rates and weak demand is a no-brainer. Unfortunately, governments are discinclined to seize these opportunities. That makes it very important to sort out the relative attractiveness of alternative solutions to stagnation.

… My sense is that Mr Summers reckons the inflation strategy is not as easy to deploy successfully as I make it out to be. QE purchases focused on safe assets might have an ambiguous effect on the economy: boosting asset prices through portfolio balance effects but limiting lending growth by sucking up the supply of good collateral. And as Brad DeLong notes, high inflation could conceivably undermine the safe-asset status of some government securities. Meanwhile, central banks might not be comfortable mustering the bluster to convince markets that higher inflation is ahead. And if they did, increases in long nominal rates could create their own financial difficulties.

So there we are. I’m not convinced of the seriousness of some of these challenges. A fiscal stimulus that succeeded in creating adequate demand would also generate big increases in long-run nominal rates, for instance. If higher inflation primarily works as a solution to stagnation because it redistributes purchasing power from savers to spenders, then financial stability concerns are almost certainly overstated. I think we make a mistake in worrying about the technical difficulty of using either fiscal or monetary policy to whip stagnation.

But I should also acknowledge a weakness in my own argument. I often return to higher inflation as a strategy because something like Mr Summers’ five-year programme of deficit-financed public investment looks politically unachievable to me. Higher inflation, by contrast, is something the technocratic Fed could deliver without the support of a divided Congress.

(2) The Boomers’ secret lust for inflation

Why such eagerness for inflation?

Inflation hurts creditors. Such as people living on the interest from their bonds, and retirees living on fixed pensions. But most Americans are debtors, most of whom have fixed rate loans (such as mortgages). They benefit from inflation, as it erodes the weight of their debt.
The rich tend to have investments in assets whose values increase with inflation (such as land and business equity). They benefit from inflation.
Some Americans have little debt and few assets. Most of them are poor, and collectively have near-zero power in our economic and political systems.

Most Boomers would benefit from inflation, at least in terms of their balance sheets. But even more important: the Boomers know how to manage inflation.

The great inflation of the 1970′s was the Boomer’s formative economic event, the backdrop to their early adulthood — imprinting them, like new born ducks on their mother. Most missed that opportunity to get rich, either having no assets or ignorant of the game. A new inflation would be the Boomers’ last opportunity to get rich. For example by buying real assets (e.g., homes, gold, art) with fixed rate loans.

They can taste the opportunity. Read conservative and investment websites and you can feel the excitement. They’re lusting for it.

(3) About inflation

Unexpected inflation provides the magic sauce for profligate governments, diminishing the burden of their debts. But expected inflation makes things worse, not better. When people see inflation, they take protective action.

Shorten the maturity of their loans (inflation has less effect on short loans)
Shift investment preferences from government bonds to inflation-protected bonds (e.g., TIPS) and hard assets.
Move money into harder currencies, or even physically move funds out of the country.

Consider our situation a year after inflation become visible. Everybody (including elderly widows in Smallville) will own nothing but hard assets, inflation protected securities, and short-term debt. The average maturity of the Federal debt will be 2 weeks. {Correct: Tony notes in the comments that this is a silly exaggeration. Which it is. But the underlying point is correct.}

Under those circumstances the government would have to avoid inflation at any cost, as the resulting increase in its interest cost would be lethal.

(4) For More Information

(a) Posts about Inflation: