Thursday, August 4, 2011

Inflation: the Last Bazooka

We seem to have had a little queasiness in the stock markets today, with the Dow Jones Industrial Average dropping over 50o points (more than 4%). Money is fleeing Europe, where investors have suddenly focused on the fact that the EU is dealing with its debt crisis by increasing, rather than paying down, its debt. That's like reaching for ever larger amounts of the hair of the dog that bit you. You may feel better for a little while. But a hangover is coming, and plenty of investors don't want to stay around to find out how bad it will be.

Meanwhile, back in the States, rumor has it that the economy is fluttering toward another recession. If not, then stagnation is clearly indicated by the economic data.

Because the government is expected to solve all problems that everyone has, the question now arises what can and will the federal government do. In terms of fiscal policy, the answer is nada. Tea Partiers and other conservatives in Congress now hold fiscal policy hostage. No significant stimulus, which would require one or more of increased federal spending, increased taxes and increased deficits, is politically possible. Hank Paulson's bazooka--TARP--is winding up, and there's no prospect of resupply.

That leaves only the Federal Reserve. It can't push rates any lower at the short end, because they're already at zero. It can (and probably will) do more quantitative easing, by buying longer term U.S. Treasuries and perhaps other debt instruments. The ostensible purpose of a third round of QE would be to lower already very low long term interest rates in the hope of stimulating growth. But QEII was done for that purpose, and its beneficial impact appears to be increasingly modest as statistics firm up. QEIII, in all likelihood, would offer even less benefit.

But QEIII might be inflationary. And that, dear reader, may be the point.

Debtors, like America, reduce their debt burdens by paying them down, refinancing them at better rates (and eventually paying them off), or, in the case of a nation, by inflating its currency. Inflation reduces the real cost of paying off old debt, with debtors using less valuable money to extinguish their obligations. Creditors, quite arbitrarily, take the hit from inflation. But in an overleveraged situation, losses are inevitable. The only question is how and where they will fall.

In many, and perhaps most debt crises, creditors take losses when debtors default. These losses appear as recoveries of cents on the dollar. But America cannot afford to default. That was the lesson of the recent debt ceiling debacle. The U.S. dollar is the foundation of the world's financial system, and a U.S. Treasury default simply cannot be allowed. But America's political system, paralyzed when it comes to raising taxes, cutting federal spending, and, most importantly, reaching reasonable compromises, can't figure out a way to pay off America's debt.

So the only way to reduce America's debt burdens is for the Fed to inflate the dollar. That's been done before. From 1945 to 1950, the Fed kept interest rates low and the price structure inflated by a third. Meanwhile, the economy grew briskly in real terms. The result was that the burden of paying off the war debt from the Second World War was significantly eased. In the 1970s, the U.S. was running large (for that time) deficits because of the Vietnam War. In addition, oil price hikes imposed by OPEC threatened an enormous transfer of real wealth from the industrialized West to the oil producing nations. The Fed responded by keeping money available on easy terms, allowing inflation to drive down the cost of debt repayment, and the amount of real wealth transferred overseas.

Today's Fed faces tremendous temptation to pull the same maneuver. No one else in the federal government will do anything. Ben Bernanke has made it clear that he'd rather do something controversial than nothing at all. The outcome is hardly clear. In the late 1940s and the 1950s, the Fed had a rapidly growing economy to leverage the debt reducing impact of inflation by providing more real wealth to pay creditors even as the value of the dollar shrank. In the 1970s, the economy grew hardly 1% a year. But personal income tended to keep up with inflation (in part because the work force was more heavily unionized in those days), insulating consumers from real sacrifice. Today, recession may return, reducing real wealth. And middle class Americans seem not to be able to keep up with inflation, cutting many expenses to have money for food and gasoline. But, rightly or wrongly, inflation may be the last bazooka for federal policy makers. And they could be taking aim even as we write.

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