Archive

Tag Archives: inflation

Inflation as Insurance

December 2, 2013
the Economy: Home and the World
6 Comments

It is common to hear, in the best arguments against a higher inflation target, that the costs outweigh the benefits. For a representative example, Coibion, Gorodnichenko, and Wieland argue that within a New Keynesian model, the distortions higher steady-state inflation creates among the relative prices of goods and services are high – exceeding the benefit of avoiding a liquidity trap in the future. I don’t have much in the way of technical expertise to critique this model, though I am skeptical of the calibration – they assume that the frequency with which we will hit the zero bound in the future may be extrapolated from historical tendency. However, if the Wicksellian interest rate is on average lower now than in the past, this calibration would be optimistic.

But that is beside the point. Let’s assume that the costs of inflation outweigh the benefits.

How would you react if someone advised against purchasing health insurance because the cost outweighs the expected benefits. Many people pay heavy monthly premiums to avoid calamity in the event of a worst-case event. There are many models you can use to justify this insurance. Maybe costs are not linear. That is, the closer one gets to the bottom of his bank account, the more utility the marginal dollar brings. So long as the premium itself is not forcing him to dissave, it is not hard to imagine the value of insurance. Perhaps uncertainty itself is costly. This is a well-established behavioral phenomenon. Go ask a stranger whether he wants $500 in cash or $1,500 if he wins a coin flip.

A liquidity trap is not perfectly analogous, but it’s not hard to see its similarity with a heart attack. While there is debate among some as to whether the zero bound binds – Bernanke in his academic research is a great example – the performance of Western economies in wake of the crisis, not to mention Japan over the past decade, suggests monetary policymakers either lack the will, knowhow, or confidence to implement such policies.

Instead we get risky and untested asset purchase programs as well as forward guidance which suffers from time inconsistency and relies heavily on the credibility of a decentralized institution. We get political dysfunction and immobility. The Tea Party and Occupy Movements are at least second cousins of the liquidity trap – enough political science research suggests a bad economy engenders extremism.

My point here is that including political and social costs of mass unemployment, it is not enough to say the costs of inflation outweigh the benefits. The Fed understands this, to some extent, considering its heroic effort to stimulate the economy with unconventional tools. But even assuming they worked perfectly, is the cost of removing high quality collateral from the financial system worth the benefit of a slightly lower inflation rate?

This whole post is a contingency. I don’t think the costs of inflation outweigh the benefits, but I can’t construct a fancy model to prove that. It is worth asking why we target a lowly 2% to begin with. Because New Zealand did it?

The Supply Constrained US Economy

November 13, 2013
the Economy: Home and the World
1 Comment

Not:

Image

I’ve read a lot of posts recently claiming that the Fed should throw in the towel, because “US growth is not what it used to be”. That could be true. It’s very difficult to suss out structural changes, but it’s unreasonable to be puritanical that our problems can be solved with, and only with, more aggregate demand. At least if you define “solve” as returning to the 1990s boom. However, it’s a bit aggravating when people insist that this has anything to do with what the Fed should or should not be doing.

The Fed’s not in the business of increasing productivity growth or managing real GDP. As far as I know, no model suggests that the economy is hitting its potential when inflation is unanchored well below its long-run trend. In fact, aggregate supply doesn’t even matter right now. When consumers are leveraged to the hilt a fall in prices from a productivity boom would just increase balance sheet constraints in the economy as the real-value of debt rises. 

The camp of economists that talks about monetary policy juicing up a dead economy – or whatever it is – likes model heuristics like NAIRU or the natural rate of unemployment, potential output, whatever:

Weak payroll growth, despite a speedy drop in joblessness, forced Bernanke in September to backtrack from a June statement in which he said the Fed expected to halt its bond-buying by mid-2014, when joblessness would be around 7 percent.

But some economists argue easier policy is not the answer given the economy’s shifting fortunes.

“Easy money will likely lead to asset bubbles or higher inflation, because policy is miscalibrated relative to … the economy’s underlying potential,” said Joseph LaVorgna, chief U.S. economist at Deutsche Bank.

He said potential GDP growth had “meaningfully downshifted” and warned of “potentially serious negative long-run implications” of current monetary policy.

It’s not clear to me what monetary policy has to do with asset bubbles. We should either not care about those or, preferably, outsource that to the macroprudential regulators. Asset prices shouldn’t be a cornerstone of any monetary policy (which, incidentally, is why we should be skeptical of the wealth effect from quantitative easing). But let’s go back to what Deutsche Bank is saying. Quantitative easing and zero interest rates will cause inflation because potential GDP isn’t what it was. However, this would require accelerating inflation as “artificial” demand competes for a shrinking stock of free labor. We’ve got precisely the opposite phenomenon. Either demand is not high or the growth potential of the US economy has surged (and while that’s good for the future, it doesn’t do squat for us today).

More importantly, people obsessed with asset markets are confusing noise and signal. Yes, real estate and equity markets have picked up much quicker than the economy itself. This is a byproduct of their own demon – slowing population and productivity growth. Let’s go back to the simple and elegant Harrod-Domar-(Solow) model. The wealth-to-income ratio (which determines asset prices) is determined as:

b = s/g where s is the national savings rate and g is the growth rate. The lower the growth rate the higher the wealth to income ratio. This is important because it suggests all this whining about interest rates and asset prices has very little to do with monetary policy. Interest rates have been in secular decline since the ’80s:

Image

 

As Piketty and Zucman thoroughly confirm, the wealth-to-income ratio increases as would be expected under conventional models. Any observer notices that this trend in interest rates is completely independent of monetary policy in the past few years. Growth has been slowing down which means much more wealth is chasing much less capital, resulting in a falling labor share, and low interest rates.

It is a tautological position to suggest the Fed should change course because low growth will cause asset market bubbles and hyperinflation. However, with the long-run supply side costs of persistently low demand (hysteresis) it might just be self-fulfilling. Let’s hope it doesn’t get there.

High Inflation and the Supply Side

November 10, 2013
the Economy: Home and the World
2 Comments

A fantastic new paper from Dave Reifschneider, William L. Wascher, David Wilcox – all economists at the Federal Reserve – tries to put some numbers on something economists have been worried about for a while: hysteresis, or the gradual contraction of labor supply due to deficient demand. (John Cassidy has a good rundown). The upshot is that hysteresis over the past five years may halve growth potential. This is (or at least should be) the most urgent, if not important, issue for policymakers.

The standard story will tell you this is, keeping structural constraints constant, an irreversible trend. As price level increases with a higher aggregate demand, the cost of production rises contracting aggregate supply. This is almost certainly a fairy tale. Consider why workers exit the labor force. After a point, the monetary and psychological cost of searching for a job exceeds the expected benefit –  ∫(chance of being hired at a given wage rate * wage rate) over all wage differentials. Assuming the costs remain constant, the best way to expand the labor force is to increase the opportunity cost of remaining outside: that is either increase the chance of being hired or the nominal wage rate.

A naive analysis would suggest monetary policy can’t do much in the way of the former, and that the nominal above should be replaced with real. (To some extent, this would be correct, the best thing we can do right now is offer reemployment credits and a payroll tax holiday). Indeed, the opportunity cost of a certain wage rate shouldn’t really be measured in the dollars I could earn, but the purchasing power thereof. However, those who exit the labor force have some form of support system: savings, welfare, and help from friends among others. It would not be unreasonable to assume that except for the most basic needs (catastrophic healthcare, charity, and certain welfare programs) none of this support is, unlike the wage rate, inflation protected. The nominal wage rate is the price level * real wage rate. By definition, increasing the real wage rate increases the cost of remaining out of the labor force. But clearly increasing the price level does as well.

There’s another, possibly deeper, reason: the money illusion (not the blog). People think in nominal terms. If you don’t believe this consider the fact that people across the world are simultaneously worried about both inflation and wage stagnation, even though my raise is your inflation. Increasing the nominal wage rate would give workers the perception that they are actually earning more in real terms. That’s all that matters as far as the decision to reenter the labor force goes. Anyone who believes in nominal wage rigidities for behavioral reasons (and, seriously, why wouldn’t you) should accept this as a natural extension of that irrationality.

And directly capitalizing on this, monetary policy can increase the chance that a given worker is hired. I touched on this earlier, but in brief downward wage rigidities are an important concern at all times, not just during a recession:

Firms that want to expand employment don’t have perfect information about the quality of potential workers. There’s the chance they may be way better than expected, in which case raising relevant wages to keep the worker is quite easy. But what if they’re not as productive as the firm wished? Heaps of empirical evidence shows that firms just don’t like cutting nominal wages. Inflation, then, is an insurance policy against imperfect information. Conversely, a firm that is downsizing because of changing (microeconomic) demand can choose to inflate away a workers’ wage rather than laying off employees en masse.  This is more relevant to the poor and casually employed where large-scale employers face more informational uncertainty.

These two effects – both derivative of higher inflation – are self-reinforcing. As the chance of being hired increases, the stock of free labor will fall increasing real wages further. As these together increase aggregate supply and aggregate demand at the same time, real wages will increase without a substantial increase in the price level (above that which is dictated by a expansionary central bank). This encourages more entry into the labor force, and the process fulfills itself until a wage-price spiral forces the central bank to increase interest rates. And farewell to the liquidity trap.

In the short run – and only in the short run – there is a risk of overshooting. That is, in the period where all savers adjust to a higher inflation rate, those who left the labor force for life cycle reasons may feel compelled to return as their savings are eroded. However this is, to a large extent, stemmed because most seniors at risk rely primarily on Social Security, which is inflation protected. More importantly  this – like anything else – requires a judgement call on behalf of policymakers about the composition of labor force exit – between retirees and discouraged workers. It would be smart to use the employment to working population rate, rather than U3 unemployment, as a key indicator of labor market health. 

This gets to the final point. If we’re going to stick to the current, state-contingent forward guidance, it makes little sense to consider the unemployment rate at all – doing so presumes knowledge of the natural rate of unemployment, which may have changed. Rather, the central bank should determine a rate of inflation with which it is comfortable – even something stupidly low like 2% – and focus. This doesn’t make monetary policy “easier” or “tighter” per se, only more accurate. For example, a concern some economists (see this interview with Barclay’s Michael Gapen) have with a lower unemployment threshold, signaling a longer period of low interest rates, is that if the natural rate of unemployment has increased, then the economy will overheat before the threshold is reached, forcing the Fed to increase interest rates and compromising its credibility:

That said, we emphasize that the benefit of this action is linked to the assumption that NAIRU is within the FOMC’s central tendency. Our own view is that NAIRU is higher, which would imply higher potential inflationary costs from lowering the unemployment threshold and a worse cost-benefit trade-off. San Francisco Fed President Williams has made similar arguments, saying that uncertainty around any NAIRU estimate is high and that policymakers may be better served by keeping the 6.5% threshold in place and conducting policy in a more discretionary manner once the threshold has been reached. Other center-leaning FOMC participants may also share this view and we read staff conclusions in this regard as providing justification for a lower unemployment rate threshold, but that view need not be binding on policymakers.

That’s curious, because it seems like they cite NAIRU either without realizing what it is and what it means, or without realizing that the Evans Rule has a clause for inflation and is constructed disjunctively. If the unemployment rate falls below the NAIRU, and inflation doesn’t pick up, THEN IT’S NOT THE NAIRU. If unemployment falls below the NAIRU, and inflation does pick up, the Fed has every right to increase the interest rate given the Evans Rule without compromising credibility.

If the Fed believes in any natural rate of unemployment – and, clearly, it does – the dual threshold of unemployment and inflation is completely tautological, as one implies the other. This presumes that the theory behind NAIRU holds. And if it doesn’t, having an unemployment threshold is completely useless because what the Fed really wants – for any given inflation rate – is maximum employment. 

Consider the uncertainty the unemployment threshold creates in financial markets. For one, it adds one more variable to be monitored whose interpretation by the central bank must be monitored. But there’s already so much talk that this threshold will be lowered that markets have no idea how to read the Fed’s reaction function. 

If the NAIRU is 0% and the Fed increases rates before we get there, then policy will be unnecessarily contractionary. If the NAIRU is 15% then by definition the Evans Rule will require an increase in rates until inflation falls to the target. All we know for certain is that inflation is well below target today, and so monetary policy is insufficiently aggressive. 

Feed the Beast

July 31, 2013
the Economy: Home and the World
13 Comments

Mark Thoma asks a question:

Why should government spending as a percentage of GDP stay constant as GDP grows? It seems that, as we grow wealthier as a society, we would want relatively more of the kinds of goods government provides, e.g. social insurance.

I think the answer is a whole lot simpler than that. Thoma’s speaking on the normative – that, as we become a richer society, we ought to spend more on social services for the poor. I agree with that. But in fact one doesn’t need to share my progressive views to see that G/GDP must rise unless we tempt a catastrophically – yes, catastrophically – amended social contract. In other words, the answer is positive.

Conservatives are right. Government sucks at providing most goods and services. Here’s a list of some things with which Uncle Sam should never involve himself:

These are all left better to the private sector. On the other hand, due to economies of scale, monopsony advantage, and network effects, the government has a comparative advantage in the provision of:

  • Medical care.
  • Retirement.
  • Defense.
  • Infrastructure.
  • Education.

Government’s comparative advantage above derives in part from standard economic analysis, but also a public, bipartisan conviction that these services should be provided by a robust public sector. This is not only a liberal consensus.

Now, the real gross domestic product is modified from its nominal counterpart with what economists call a “GDP deflator” from a given base year. It broadly tracks inflation. If price levels increase 10% in a given year, a 12% increase in nominal GDP isn’t too impressive. However, it is the broadest measure of inflation on the aggregate of (C + I + G). But take a look at individual price indices:

fredgraph

The above graph destroys any hope of a smaller government. Since 1988 education (purple) has increased almost seven fold. Healthcare (red) five fold. Food and beverage prices have only doubled, apparel costs have flatlined, while technology and entertainment prices have plummeted. Basically prices for everything the government is good for have a positive slope and everything it’s bad for have a negative slope. I don’t think any other graph could more clearly explode hopes for a smaller, or even flatlined, government.

The past thirty years has not been kind to the median worker. But all inflation isn’t created equal. It all comes down to relative prices. Items consumers spend on (C/GDP) benefit most from rapid globalization and technological change (Netflix… iTunes… Moore’s Law… etc.) and have experienced either incredibly slow inflation or even deflation. Things government can and should spend on (G/GDP) has experienced a disproportionately higher inflation. We can talk about “bending the cost curve” or whatever but a) nothing will bend it near consumer inflation and b) nothing will stop America from aging.

Fact of the matter is – as hard as evidence might be for the right-wing to swallow – so long as medical and educational price inflation outpaces the GDP deflator, G/GDP must rise to maintain the real value of government provision. That is to say that if we maintain a small government – forever at 20% of GDP – its real, inflation-adjusted value will continue to decline.

This is the level at which we must discuss the size of government. Once we fall into the realm of normative, conservatives will stress the inefficiencies of bureaucracy and ideals of free markets. But even at the positive, nothing can halt growth of government. This scares me because one of America’s flagship political parties is hell-bent not only on preventing growth of G/GDP, but also shrinking government despite hugely inflationary pressures to the contrary.

That scares me because I see no way to reconcile our current social contract with the demands of a smaller government. Needless to say, part of the inflation is secular and will ebb as the population ages into an equilibrium. It will ebb as technology moves from entertainment to medical care. It will ebb as online education revolutionizes the university. But it will ebb at a higher level than 1988 – and the size of government must reflect that fact of nature.

Without feeding the beast we will be starving ourselves. And it doesn’t take a progressive ideologue to see this. 

Abenomics Meet Mundell-Tobinomics

June 10, 2013
the Economy: Home and the World
1 Comment

In a 1963 paper Robert Mundell first argued that higher inflation had real effects. He challenged the classical dichotomy by suggesting that nominal interest rates would rise less than proportionally with inflation, because higher price levels would induce a fall in money demand, thereby increasing velocity and capital formation which, in turn, would bring real rates down. The most interesting part of my argument comes from a model designed by Eric Kam in 2000, which I’ll get to.

And as Japan emerges from a liquidity trap, the Mundell-Tobin effect (named, too, for James Tobin submitting a similar mechanism) should anchor our intellectual framework. I don’t see any of the best bloggers (I may be wrong but see the self-deprecation there via Google) arguing along these lines, though Krugman offers a more sophisticated explanation of the same thing through his 1998 model, this can only strengthen our priors.

Paul Krugman, Noah Smith, Brad DeLong, and Nick Rowe have each replied to a confused suggestion from Richard Koo about monetary stimulus. Smith, as Krugman points out, was restricting his analysis on purely nominal scope and notes that DeLong captures the risk better, so here’s DeLong:

But if Abenonomics turns that medium-run from a Keynesian unemployment régime in which r &ltl g to a classical full-employment régime in which r > g, Japan might suddenly switch to a fiscal-dominance high-inflation régime in which today’s real value of JGB is an unsustainable burden..

Moreover, to the extent Abenomics succeeds in boosting the economy’s risk tolerance, the wedge between the private and public real interest rates will fall. Thus Paul might be completely correct in his belief that Abenomics will lower the real interest rate–but which real interest rate? The real interest rate it lowers might be the private rate, and that could be accompanied by a collapse in spreads that would raise the JGB interest rate and make the debt unsustainable.

I’ll address the latter concern first. Let’s consider the premise “to the extent Abenomics succeeds in boosting the economy’s risk tolerance”. If the whole scare is about Japan’s ridiculously-high debt burden, and we’re talking about the cost of servicing that debt, as far as investors are concerned isn’t Japan’s solvency a “risk”. I don’t think it is, I certainly don’t see a sovereign default from Japan, but that’s the presumed premise DeLong sets out to answer. So with that clause, the question becomes self-defeating, as increased risk tolerance would convince investors to lend Japan more money. Note the implicit assumption I’m making here is that it’s possible for a sovereign currency to default. I make this because there are many cases where restructuring (“default”) would be preferable to hyperinflation.

Even ignoring the above caveat, the fall in interest rate spreads can come from both private and public yields falling, with the former falling more rapidly. A lot of things “might be”, and do we have any reason to believe it “might be” that inflation does nothing to real public yields?

Well, as it turns out, we have good reason beyond Krugman’s model suggesting that inflation increases only nominal yields:

  • Mundell-Tobin argue that the opportunity cost of holding money increases with inflation, resulting in capital creation and decreased real rates. This is a simple explanation as any, but would be rejected as its a “descriptive” (read: non-DSGE) model.
  • So comes along Eric Kam arguing that: The Mundell-Tobin effect, which describes the causality underlying monetary non-superneutrality, has previously been demonstrated only in descriptive, non-optimizing models (Begg 1980) or representative agent models based on unpalatable assumptions (Uzawa 1968). This paper provides a restatement of the Mundell-Tobin effect in an optimizing model where the rate of time preference is an increasing function of real financial assets. The critical outcome is that monetary superneutrality is not the inevitable result of optimizing agent models. Rather, it results from the assumption of exogenous time preference. Endogenous time preference generates monetary non-superneutrality, where the real interest rate is a decreasing function of monetary growth and can be targeted as a policy tool by the central monetary authority.

[Caution, be-warned that we can probably create a DSGE for anything under the sun, but I will go through the caveats here as well] Note that he’s not making any (further) remarkable constraints to prove his point, just relaxing a previous assumption that time preference is exogenous. A previous paper (Uzawa, 1968) followed a similar procedure, but made the strong, questionable, and unintuitive assumption that the “rate of time preference is an increasing function of instantaneous utility and consumption” which implies that savings are a positive function on wealth, which contradicts the Mundell-Tobin logic.

Kam, rather, endogenizes time preference as a positive function on real financial balances (capital + real balances). He shows non-neutrality with the more intuitive idea that savings are a negative function on wealth. (So unanticipated inflation would result in higher steady-state levels of capital).

Look, in the long-run even Keynesians like Krugman believe in money neutrality. By then, however, inflation should have sufficiently eroded Japan’s debt burden. DeLong’s worry about superneutrality in the medium-term, where debt levels are still elevated, seems unlikely even without purely Keynesian conditions. That is, no further assumptions other than an endogenous time preference are required to move from neutrality to non-neutrality. DSGEs are fishy creatures, but here’s why this confirms my prior vis-a-vis Abenomics:

  1. Lets say superneutrality is certain under exogenous time preference (like Samuelson’s discounted utility).
  2. Non-superneutrality is possible under endogenous time preference. Personally, I find a god-set discount rate/time preference rather crazy. You can assign a Bayesian prior to both possibilities in this scenario. But note, the models which support neutrality make many more assumptions.

Now we need a Bayesian prior for (1) vs. (2). My p for (1) is low for the following reasons:

  • It just seems darned crazy.
  • Gary Becker and Casey Mulligan (1997) – ungated here – quite convincingly discuss how “wealth, mortality, addictions, uncertainty, and other variables affect the degree of time preference”.

I’d add a few other points to DeLong’s comment – “the real interest rate it lowers might be the private rate, and that could be accompanied by a collapse in spreads that would raise the JGB interest rate and make the debt unsustainable” – if the idea of falling real yields is not plausible. A fall in private cost of capital should be associated with a significant increase in wages, capital incomes, and at least profits. This by itself increases more revenue, but likely a greater portion of the earned income will fall in the higher tax brackets, suggesting a more sustainable debt. Of course my belief is that both private and public debt will be eroded quicker, but even if that’s too strong an assumption, there’s no reason to believe that falling spreads per se are a bad thing for government debt so long as it maintains tax authority.

However, the Mundell-Tobin and similar effects derive from a one-time increase in anticipated inflation. It’s not even to be seen that Japan will achieve 2%, and that’s a problem of “too little” Abenomics. On the other hand, if Japan achieves 2%, and tries to erode even more debt by moving to 4% it will loose credibility. Therefore, Japan should – as soon as possible – commit to either a 6% nominal growth target or 4% inflation target.

This is preferable because it increases the oomph of the initial boost, but primarily it extends the duration of the short run where monetary base is expanding and inflation expectations are rising. A longer short-run, we minimizes DeLong’s tail risks of a debt-saddled long-run, even if you reject all the above logic to the contrary.

DeLong concludes:

Do I think that these are worries that should keep Japan from undertaking Abenomics? I say: Clearly and definitely not. Do I think that these are things that we should worry about and keep a weather eye out as we watch for them? I say: Clearly and definitely yes. Do I think these are things that might actually happen? I say: maybe.

 I agree with all of it except the last word. I’d say, “doubtful”.

Am I More Hawkish Than Ken Rogoff?

May 24, 2013
the Economy: Home and the World
8 Comments

Short answer is, no. Long answer is, well, maybe: depending on what you call “hawkish”.

In a tour of essays since Excelgate, both Reinhart and Rogoff have been (finally) flaunting their dovish credentials: Reinhart telling us austerity is a disaster or Rogoff telling us that “austerity is not the only solution to a debt problem”. Or, perhaps most curiously, Rogoff calling for substantially more inflation:

One of us [Rogoff] attracted considerable fire for suggesting moderately elevated  inflation (say, 4-6 per cent for a few years) at the outset of the crisis.  However, a once-in-75-year crisis is precisely the time when central banks  should expend some credibility to take the edge off public and private debts,  and to accelerate the process bringing down the real price of housing and real  estate.

Structural reform always has to be part of the mix. In the US, for example, the bipartisan blueprint of the Simpson-Bowles commission had some very  promising ideas for simplifying the tax codes.

Now the second paragraph is obviously just fluff. It’s not vogue to write an op-ed without talking about “structural reform” and “simplifying the tax code”. It’s kinda like the chorus all Serious People must add to their argument to sound well-balanced.

And, quite successfully, Rogoff masks just how radical his original proposal is. It’s not the magnitude of “elevated [4-6 per cent] inflation” per se, rather the reason thereof. Left-leaning commenters, such as myself, have argued for more aggressive inflationary policies, but as a means to an end:

  • In a liquidity trap, cash hoarding can put us in a deflationary spiral (Keynesian).
  • Inflation, through the “hot potato effect”, increases money velocity and NGDP hence. (Market Monetarist).
  • Wages (and prices, to a lesser extent) are sticky in the downward-direction and inflation is required for readjustment (Keynesian and Market Monetarist).
  • Inflation will decrease the market-clearing interest rate and hence allow savers to substitute lending for money holding and increase investment (Mundell-Tobin effect).

We might call this inflation as a necessary means to an end. But Rogoff wants central bankers to consider “the option of trying to achieve some modest deleveraging through moderate inflation of, say, 4 to 6 percent for several years”.

We call that inflation as an end in and of itself. That is scary. And far more radical than anything I’ve ever proposed. For one, I don’t understand how more inflation by itself will bring down the “real price of housing and real estate”. It always seemed to me investment in land was a hedge against inflationary pressures. In fact, through the Mundell-Tobin effect, cheap mortgages should increase real estate demand – as we’re seeing today (albeit with substantially less inflation).

Scott Sumner puts this well in a fantastic argument for nominal income targeting:

Ben Bernanke does not really want higher inflation; it would be more accurate to say that he wants more aggregate demand and expects such higher demand to result in somewhat higher inflation rates. Unfortunately, however, the Fed has chosen a language to communicate its intentions that is both deeply unpopular and profoundly misleading. Inflation targeting gives the public the wrong impression, and the resulting political reaction impedes the Fed’s ability to carry out its work.

However, that’s only the tip of this dangerous iceberg. Inflation for the sake of inflation is a partial default on our obligations (aside from social security and TIPS, of course). I think debt forgiveness is a remarkably important component of the new international finance system. But it is a signal of fiscal irresponsibility and recklessness, neither of which afflict America today.

Our debt-to-GDP ratio is historically high, but nothing unsurmountable, especially at the low cost of capital today. The next decade is relatively stable as far as deficits are concerned, and there’s no reason to believe we won’t implement the necessary adjustments come what may after 2023. For this reason, inflation as a cop out of our obligations will send the wrong message:

  • The Federal Reserve will loose credibility – that is, investors will forever think that we will inflate our way out of even tolerable debt burdens.
  • The Federal Reserve will loose perceived independence – that is, investors will forever think that the FOMC will accommodate idiotic deficits and fiscal irresponsibility. (If they partially default today, imagine the expected reaction to real recklessness!)
  • We will send savers the wrong message; inflation will cease to be a noble and necessary means to an end, but a counterproductive end by itself.

I actually don’t mind the distributional effects of inflation, by itself. Very few Americans save, and those that do at high levels should probably be taxed more. But I dislike the idea of incentivizing dissaving, especially as it becomes ever-evident that the poor can and should save more. America’s tax burden is rather low, which makes our debt eminently more solvable, and I would rather the distribution explicitly handled through a more progressive code (preferably a neo-Ricardian land value tax coupled with nationalizing oil & gas companies).

Notably, as a global reserve currency and store of value, devaluing the dollar for deleveraging’s sake is a terrible idea. Once the Federal Reserve looses credibility, the phantom bond vigilantes might materialize (I would be willing to take this bet, at low odds). This would impugn our ability to run high deficits for countercyclical stimulus come the next recession.

But I told you the short answer to the titular question is no. And that’s absolutely true. In fact, the pith of my argument against inflation is from deeply dovish roots: that is I don’t think our deficits are near intolerable. I think because the nominal average premium on long-run bonds is unprecedentedly low, the market is begging America to borrow more. If not for stimulus, for infrastructure and education. The only relevant arguments against any sort of deficit spending today is moral hazard.

I also support inflationary policy after considering DeLong and Summers (2012). If hysteresis contracts labor force and aggregate supply during disinflationary periods, the logical conclusion would be positive supply side effects of mildly higher inflation, even out of recession. (Indeed, the logic used therein derives from work by Larry Summers with regard to female entrance into labor markets during inflationary times). To this end, I would support the central bank dictating policy around the employment-population ratio, rather than unemployment rate.

Perhaps most flabbergastingly, why inflate so much when we can just target nominal spending? Your guess is as good as mine.

Is Sovereign default a credible threat?

March 9, 2013
the Economy: Home and the World
2 Comments

Alex Jutca has this to say about a partial default via inflation:

One issue here is that Moody’s should change its own rules about what constitutes a default to include general inflation. Of course, any sovereign issuer could be immune from default by printing money to retire principal and interest owed, in nominal terms. In real terms, doing so would likely make that type of repayment extremely costly to investors. Consider the U.K. It has debt outstanding of approximately £1.4 trillion and £54 billion in currency in circulation, so you’d end up with inflation approaching Weimar Germany or Zimbabwe today.

Moreover, this sort of profligacy may work well for a one-shot end game, but, for a repeated game (in game theory parlance), the standard analysis leads to the conclusion that this would be horribly counterproductive. After seeing serial defaulter Argentina reenter capital markets, though, maybe not. The evidence of market discipline for defaulters is that the medium-term costs to sovereigns are either nonexistent or quite mild, after all.

First, as Alex acknowledges, inflation isn’t a problem right now. But this raises a very interesting question that might be particularly salient for Italy, especially given its primary surplus. The argument for Italian austerity is predicated on the need of future access to credit markets. Italy can default today, and would have quite a bit of money leftover to cut taxes or increase spending. Notably, the Monti government’s property tax is very unpopular, and increases in spending could jolt an economy that’s been stagnant for more or less twenty years.

As Alex notes, the IMF released a study which contradicts intuition: that in the long-run default has little if any economic costs, and debtors aren’t restricted from capital markets. This is to say, defaulting is a credible threat, in other words: profligacy is subgame perfect.

It’s not surprising that defaulter nations aren’t long-restricted from capital markets. As Adam Smith concluded, division of labor (and hence prosperity) is limited by the extent of a market. Capitalism is an inclusive game, and it doesn’t make sense to exclude millions because of profligate government.

For countries with high borrowing rates, this strongly raises the value of formal debt restructuring. If the market believes that the Italian government thinks it can credibly-threaten to default on its debt, one of two things can happen. Rates can soar, making default inevitable, or creditors can reach a preemptive restructuring agreement offering lower rates, lines of credit, with a promise to repay debts.

The lingering questionn, then, is how to ensure that debtors can’t credibly threaten to default on restructured loans to which it agreed? International agreements, perhaps, that formally disallow lending to violator nations.

The upshot of this, vis-a-vis the UK, is that (unlike interest rate hawks claim), Britain can credibly inflate its debt and follow easy money policies, without facing any risk of increased interest rates. Indeed, this conclusion is independent of the Keynesian argument that in a depressed economy borrowing won’t crowd-out the market for loanable funds.

Again, an indictment on the tight-money hawks.