Rogoff: Embracing Inflation

Kenneth Rogoff says inflation is the answer:

Embracing inflation, by Kenneth Rogoff, guardian.co.uk/Project Syndicate: It is time for the world's major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today's epic debt morass.

Yes, inflation is an unfair way of effectively writing down all non-indexed debts... Price inflation forces creditors to accept repayment in debased currency. ... Unfortunately, the closer one examines the alternatives, including capital injections for banks and direct help for home mortgage holders, the clearer it becomes that inflation would be a help, not a hindrance.

Modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts. Securitisation, structured finance and other innovations have so interwoven the financial system's various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed.

Moderate inflation in the short run – say, 6% for two years – would not clear the books. But it would significantly ameliorate the problems...

No one wants to relive the anti-inflation fights of the 1980s and 1990s. But right now, the global economy is teetering on the precipice of disaster. ... Unless governments get ahead of the problem, we risk a severe worldwide downturn unlike anything we have seen since the 1930s.

The necessary policy actions involve aggressive macroeconomic stimulus. Fiscal policy should ideally focus on tax cuts and infrastructure spending. Central banks are already cutting interest rates left and right. Policy interest rates around the world are likely to head toward zero; the United States and Japan are already there. ... Steps must also be taken to recapitalise and re-regulate the financial system. ...

Most of the world's largest banks are essentially insolvent, and depend on continuing government aid and loans to keep them afloat. ... As the recession deepens,... bank balance sheets will be hammered further...

When one looks across the landscape of remaining problems, including the multi-trillion-dollar credit default swap market, it is clear that the hole in the financial system is too big to be filled entirely by taxpayer dollars. ...

That brings us back to the inflation option. In addition to tempering debt problems, a short burst of moderate inflation would reduce the real (inflation-adjusted) value of residential real estate, making it easier for that market to stabilise. Absent significant inflation, nominal house prices probably need to fall another 15%... If inflation rises, nominal house prices don't need to fall as much.

Of course, given the ongoing recession, it may not be so easy for central banks to achieve any inflation at all right now. Indeed, it seems like avoiding sustained deflation, or falling prices, is all they can manage.

Fortunately, creating inflation is not rocket science. All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20% or 30% instead of 5-6%. Indeed, fear of overshooting paralysed the Bank of Japan for a decade. But... With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary.

It will take every tool in the box to fix today's once-in-a-century financial crisis. Fear of inflation, when viewed in the context of a possible global depression, is like worrying about getting the measles when one is in danger of getting the plague.