WHY WE CANNOT INFLATE OUR WAY OUT OF DEBT / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

August 15, 2011 10:27 pm

Why we cannot inflate our way out of debt

By Raghuram Rajan


We are experiencing financial panic. A downgrade of US debt has triggered a flight to liquidity towards the very assets downgraded. Ultimately, the cure for market paranoia is strong economic growth. Several commentators propose a sharp, contained bout of inflation as a way to reenergise growth in the US and the industrial world. Are they right?


To understand the prescription, we must understand the diagnosis. Recoveries from crises that result in over-leveraged balance sheets are slow, and are typically resistant to traditional macroeconomic stimulus. Over-leveraged, households cannot spend, banks cannot lend and governments cannot stimulate. So why not generate higher inflation for a while? This will surprise fixed income lenders who agreed to lend long term at low rates; bring down the real values of debt; eliminate debt “overhang”; and spur growth. Yet there are concerns. Can central banks with anti-inflation credibility generate sharply higher inflation in an environment of low rates? Will it work as intended? What could be the unintended consequences? And are there better alternatives?


Japan’s central bank tried and failed to generate higher inflation. Banks were too willing to hold the reserves that the central bank put out as it bought back bonds. Perhaps if a central bank announced a higher inflation target, and an asset purchase programme financed with unremunerated reserves, to continue until the target were met, it could have some effect. More likely though, any target would lose credibility once it became changeable. Market participants might conjecture that the programme would be abandoned once it reached an alarming size, and well before the target is reached.


Moreover, the central bank needs a rapid, sizeable inflation to reduce real debt values quickly. A slow increase will have very limited effect because lenders will demand both higher nominal rates and an inflation risk premium to roll over claims. But a sizeable inflation may be hard to contain: if a central bank abandons its inflation target for growth, will markets believe it has the stomach for high, growth-killing interest rates to reduce inflation?


Turn next to whether it will work. Inflation will do little for entities with floating rate liabilities (many households that borrowed near the peak of the boom) or relatively short term liabilities (banks). The US government, with debt duration of about 4 years, is unlikely to benefit much from a surprise inflation unless it is huge; and the bulk of its promises are social security and healthcare that cannot be inflated away. Even distressed households that have borrowed long term could be worse off – with unemployment likely to subdue nominal wage growth, and higher food and fuel prices cutting disposable income.


Moreover, inflation will clearly make debt holders worse off. Who are they? Rich people, but also pensioners who moved into bonds as the stock market scared them away, banks that will have to be recapitalised, state pension funds that are already deeply underwater, and some insurance companies that will have to default on their claims. Will inflation just shift the problem, ensuring the malaise persists? In the best of worlds, it would be foreigners with ample reserves who suffer the losses, but they may be needed to finance future deficits. Of course, if central banks regain credibility for being anti-inflation hawks soon after subjecting investors to a punishing inflation, there is no problem, but...


This does not mean nothing can be done. The US experienced periodic debt crises during the 19th century and Great Depression. Its response was to offer targeted, expedited debt relief – often by enacting temporary bankruptcy legislation. In this vein, a recent proposal* to facilitate mortgage debt renegotiation could help reduce the household debt overhang and avoid value-destroying foreclosures without government subsidies. It is less clear that shifting the burden of bank and government debt to others will help the economy.


Too many of our problems come from impatience with the pace of past recoveries and overconfidence in adventurous macro-policy responses. Rather than grand macroeconomic plans, we need many microeconomic actions. Unfortunately, they are disregarded because, as Daniel Burnham said, they have little ability to stir people’s blood.


* A Loan Modification Approach to the Housing Crisis, Eric Posner and Luigi Zingales, University of Chicago
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The writer is professor of finance at the University of Chicago and author of ‘Fault Lines: How Hidden Fractures Still Threaten the World Economy’
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Copyright The Financial Times Limited 2011.