The Return of the Inflation Narrative

I mentioned a few weeks ago that "financial repression" was making a comeback. It's being discussed at the highest level to determine whether it can be engineered in today's more sophisticated and more complex financial markets. Not only, inflation has to "fool" people in order for its dirty little magic to work; otherwise interest rates would just go up to eliminate the advantage that the effect of higher inflation has on real interest payments and on the level of debt. But it has also to act as a mild tsunami and pretty much affect everyone equally, or at least be perceived as fair, to be deemed a successful operation.

After WW II, it seems that it was easier to fool people with inflation and force them into accepting that mild inflation was a remedy to over indebtedness. First, financial markets were not as sophisticated as they are today; there were no bond vigilantes yet. Second, back then, inflation probably affected negatively much fewer people than it would today; the post war population was young, if anything indebted and not going to be retiring soon. Recall that financial repression lowers real returns and mainly favours those who have debts at the expense of those who have assets. Today, the importance and the political power of retiring baby boomers and pension funds make inflation engineering a much less attractive political solution.

But finally, and most importantly, had the current government debt been acquired as a result of a war and collective post-war reconstructing efforts as it was the case after WW II, an inflation tax might be socially more acceptable. But today, we find ourselves in a very different context. Those who have acquired debts are deemed to be irresponsible consumers, over-leveraged banks and discredited governments. The latter have promised more than we can afford and are perceived to protect crony capitalists and crony capitalism. And who would want to save such people? Certainly not the Tea Party and certainly not the Occupy Wall Street movement!

Some people would say that the problem is that by denying our government (i.e. our collective selves) an easy exit from its excessive debt burden, we maybe denying ourselves a future. But engineering financial repression might help reduce the current debt level but it won't solve the real problem of future pension and health care costs. Having lower real interest rates will worsen the deficits of defined-benefits pension funds as their asset growth will not keep up with inflation and their exploding liabilities. Public pension liabilities in particular will be governed by pretty nasty dynamics as public pension benefits are usually indexed for inflation. Until we accept that public pension plans need to be converted from defined benefit to defined contribution schemes (at least for all future contributions) and we understand that the practice of fully indexing pension benefits needs to disappear (the sooner the better and for all workers and retirees), government deficits are only going to worsen. Successfully engineering money illusion won't change anything to this outcome.

There is one important lesson to remember here: As much as inflation can reduce the current debt burden of a society, it can't do much to reduce actuarial deficits (i.e. debts incurred into the future). The problem today is not so much the current level of debt in the U.S. and in Europe but the dynamics of that debt in the future as most developed countries have promised their citizens a future that they can't afford. The remedy for this illness is not inflation. The solution lies in cutting benefits to realistically meet our means of providing them.

Postponing the retirement age gradually to fund social security would help tremendously. Let's propose that, starting today, for every year below the age of 65, individuals have to accept to work two more months in their life up to a maximum of five extra years. For instance, an individual who is 64 today, would retire two months after his 65th birthday; someone who is 60, ten months after his 65th birthday; and someone who is 53 today would have to retire when he would turn 67 years old; 2 months x (65-53) = 24 months or 2 years. Everyone who is younger than 35 today, would see their retirement age be raised to 70 years old; meaning that they would have to work 5 years (60 months = 2 x (65-35)) longer than today's retirees before collecting their pension and social security. Such a measure would save the government $100 of billions of dollars in the future and help bring back America on a more sustainable debt path.

The same perverse dynamics holds true for government health care costs if we stick with our current entitlements. Inflation today is not going to reduce the future costs of providing health care to an aging population who is seeing its life expectancy increase. If anything inflation is going to blur market signals and reduce investments and R&D expenditures which could reduce health care costs. The solution lies in accepting lower benefits in the future and sharing the burden of prohibitive costs for instance by imposing larger deductibles.

Thus I cautious against article such as How to Save the Global Economy: Whip Up Inflation. Now. However seductive the arguments made in the piece, which was published in Foreign Policy recently, the strategy carries enormous risks and it does nothing to solve the deeper problem of our future liabilities.

Here is the piece written by Menzie Chinn and Jeffry Frieden:

The American and European debt crises have dragged on for years now. Yet none of the heavily indebted countries -- not the United States, not the peripheral eurozone borrowers -- has been able to use a traditional weapon to fight the debt crisis: inflation. This has been the crucial difference between the current crisis and similar ones in the past.

Recovery from a debt crisis is always painfully slow, for reasons both economic and political. Creditors need to rebuild their balance sheets and are unwilling to make potentially risky loans. Debtors need to boost savings to cover their debts and are unwilling to resume spending. At the same time, debt-ridden countries collapse into political conflict over the question of who will pay to get them out of the red: Should it be taxpayers, bankers, public workers, or investors?

A bit of inflation can help on all these fronts. So long as the debts are denominated in national currency and interest rates are kept low by monetary policy, inflation reduces the real debt burden. This is, to be sure, a forced restructuring that puts some of the onus on creditors -- but that is almost always the outcome of more explicit negotiations in any case. When most of the debts are household debts, as they are in the United States and parts of the eurozone, it is not really feasible to renegotiate millions of mortgages and consumer loans; inflation takes care of that for the whole economy. It mitigates some of the political conflict and lessens some of the economic burden.

So far, though, none of the major debtors has been able to make this option work. The most troubled eurozone debtors -- Greece, Ireland, Italy, Portugal, and Spain -- don't make their own monetary policy, so they cannot inflate away a share of their debt. Indeed, two-thirds to three-quarters of the foreign debts of Greece, Portugal, and Spain are owed to eurozone creditors, primarily in Germany and France. Even Ireland, which has strong financial ties to Britain and the United States, owes about half its debts to other eurozone countries. This means that if the European Central Bank decided to pursue inflation, it would be taking money out of the pockets of creditors that are also members of the eurozone -- and powerful members, too. As politically daunting as this might be, however, some such redistribution would almost certainly be part of any durable settlement of the eurozone debt crisis anyway -- and the apparent inability of Europe's leaders to arrive at such a settlement in anything near a timely fashion has only further confirmed that inflation may be the only politically feasible way forward.

For its part, the U.S. Federal Reserve has run a monetary policy appropriately focused on stimulating the economy, keeping interest rates extremely low, and engaging in "quantitative easing," whereby it twice increased purchases of long-term Treasury securities and mortgage-backed securities. This effort has not, however, been enough to raise prices by more than trivial amounts. The Fed policy should theoretically lead to an export-boosting depreciation of the dollar, but every attempt to moderate the dollar's value so far has been met by countervailing efforts on the part of the big surplus countries, especially China. These policies have also been countered by the dollar's continuing strength as a perceived safe haven in the midst of crisis: Domestic and international investors still think of Treasury securities as the most reliable place to park their money in uncertain times, a view that has maintained the dollar's value in spite of the Fed's interventions.

We're not proposing a lot of inflation -- just enough to reduce the debt burden to more manageable levels, which probably means in the 4 to 6 percent range for several years. The Fed could accomplish this by adopting a flexible inflation target, one pegged to the rate of unemployment. Chicago Fed President Charles Evans has proposed something very similar, a policy that would keep 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. Making the unemployment target explicit would also serve to constrain inflationary expectations: As the unemployment rate fell, the inflation target would fall with it.

Today our highest priority should be to stimulate investment, growth, and employment. Raising the expected inflation rate will lower real interest rates and spur investment and consumption. It will also make it difficult for the de facto dollar peggers, such as China, to sustain their policies. The resulting real depreciation of the dollar would stimulate production of U.S. exports and domestic goods that compete with imports, boosting American production. The United States would get faster growth, an accelerated process of deleveraging, a quicker recovery, and a firmer foundation upon which to address long-term fiscal problems.