The Inflation Solution – More Harm Than Good? : Raghuram Rajan

By: Raghuram Rajan   Date: 14 September 2011

About The Author

Raghuram Rajan

Eric J. Gleacher Distinguished Service Professor of Finance at the Booth School of Business at the

Raghuram Rajan, EconomyWatch Contributor

 

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The obvious solutions to economic stagnation have been tried and have failed. Clearly, more innovative ideas are needed to reinvigorate the economy. The latest proposed solution making its round have been to use a sharp, contained bout of inflation as a way to reduce debt. While it may seem like an attractive solution at first glance, there is cause for concern.

The Inflation Solution – More Harm Than Good? : Raghuram Rajan

An Injection to the World Economy is Needed, But is Inflation the Cure?
Photo Credit: doug88888

CHICAGO – Recently, a number of commentators have proposed a sharp, contained bout of inflation as a way to reduce debt and reenergize growth in the United States and the rest of the industrial world. Are they right?

See the Slide Show >>> Inflation Wrecked Countries of 2010

To understand this prescription, we have to comprehend the diagnosis. As Carmen Reinhart and Kenneth Rogoff argue, recoveries from crises that result from over-leveraged balance sheets are slow and typically resistant to traditional macroeconomic stimulus. Over-levered households cannot spend, over-levered banks cannot lend, and over-levered governments cannot stimulate.

So, the prescription goes, why not generate higher inflation for a while? This will surprise fixed-income investors who agreed in the past to lend long term at low rates, bring down the real value of debt, and eliminate debt “overhang,” thereby re-starting growth.

It is an attractive solution at first glance, but a closer look suggests cause for serious concern. Start with the question of whether central banks that have spent decades establishing and maintaining anti-inflation credibility can generate faster price growth in an environment of low interest rates. Japan tried – and failed: banks were too willing to hold the reserves that the central bank released as it bought back bonds.

Perhaps if a central bank announced a higher inflation target, and implemented a financial-asset purchase program (financed with unremunerated reserves) until the target were achieved, it could have some effect. But it is more likely that the concept of a target would lose credibility once it became changeable. Market participants might conjecture that the program would be abandoned once it reached an alarming size – and well before the target was achieved.

Moreover, the central bank needs rapid, sizeable inflation to bring down real debt values quickly – a slow increase in inflation (especially if well signaled by the central bank) would have limited effect, because maturing debt would demand not only higher nominal rates, but also an inflation-risk premium to roll over claims. Significant inflation might be hard to contain, however, especially if the central bank loses credibility: Would the public really believe that the central bank is willing to push interest rates sky high and kill growth in order to contain inflation, after it abandoned its earlier inflation target in order to foster growth?

Consider, next, whether the inflationary cure would work as advertised. Inflation would do little for entities with floating-rate liabilities (including the many households that borrowed towards the peak of the boom and are most underwater) or relatively short-term liabilities (banks). Even the US government, with debt duration of about four years, would be unlikely to benefit much from an inflation surprise, unless it were huge. Meanwhile, the bulk of its obligations are social security and health care, which cannot be inflated away.

Even for distressed households that have borrowed long term, the effects of higher inflation are uncertain. What would help is if their nominal disposable income rose relative to their (fixed) debt service. Yet, with high levels of unemployment likely to keep nominal wage growth relatively subdued, typical troubled households could be worse off – with higher food and fuel prices cutting into disposable income.

 

Inflation Wrecked Countries of 2010
View the Slide Show

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