Sunday, December 20, 2009

Using Inflation: Economists now Chime In

In a posting on Vox by Aizenman and Marion, the two economists, one from my favorite strongholds of intellectual fortitude, Dartmouth, remember who comes from there folks. The article states( see also NBER Working Paper 15562) :

"As the US debt-to-GDP ratio rises towards 100%, policymakers will be tempted to inflate away the debt. This column examines that option and suggests that it is not far-fetched. US inflation of 6% for four years would reduce the debt-to-GDP ratio by 20%, a scenario similar to what happened following WWII."

It then continues:

"Many observers worry that the debt-to-GDP ratios projected over the next ten years are unsustainable. Assuming deficits can be reined in, how might the debt/GDP ratio be reduced? There are four basic mechanisms:

  1. GDP can grow rapidly enough to reduce the ratio. This scenario requires a robust economic recovery from the financial crisis.
  2. Inflation can rise, eroding the real value of the debt held by creditors and the effective debt ratio. With foreign creditors holding a significant share of the dollar-denominated US federal debt, they will share the burden of any higher US inflation along with domestic creditors.
  3. The government can use tax revenue to redeem some of the debt.
  4. The government can default on some of its debt obligations.

Over its history, the US has relied on each of these mechanisms to reduce its debt/GDP ratio. In a recent paper (Aizenman and Marion 2009), we examine the role of inflation in reducing the Federal government’s debt burden. We conclude that an inflation of 6% over four years could reduce the debt/GDP ratio by a significant 20%."

They then look at the statistics we have looked at over the past year. The debt of the Government falls into three categories. Namely:

1. Debt held by public, like China. This is $7 trillion and growing.

2. Debt held by itself, like the Medicare funds it purloined. This is $6 trillion and growing.

3. Contingent debt it most likely may have to incur due to guarantees. Nomi Prins in her work It Takes a Pillage has provided fantastic documentation on this issue. There is about $12 trillion or more! See Prins web site.

Thus we are at $25 trillion and growing at about $1.5 trilion a year! The GDP is about $14 trillion so just right now we are at 179%. We beat Greece!

So when these wizards of academe present their scheme from the days of Jimmy Carter, they are clueless as to the consequences. It will cause a collapse on all those retiring on fixed incomes, and with the Baby Boomers at that stage, it will destroy a whole generation. Fortunately I am older and planned a bit better but these characters just seem not to understand the problem of inflation. It is destructive in ways which can never be recovered. It would destroy the US as a power.

They conclude:

"The current period shares two features with the immediate post-World War II period. It starts with a large debt overhang and low inflation. Both factors increase the temptation to erode the debt burden through inflation. Even so, there are two important differences between the periods. Today, a much greater share of the public debt is held by foreign creditors – 48% instead of zero. This large foreign share increases the temptation to inflate away some of the debt. Another important difference is that today’s debt maturity is less than half what it was in 1946 –3.9 years instead of 9. Shorter maturities reduce the temptation to inflate. These two competing factors appear to offset each other, and the net result in a simple optimising model is a projected inflation rate slightly higher than that experienced after World War II, but for a shorter duration.

The temptation to inflate is frankly reduced by the holding of foreign debt. Mainly due to the fact that one will not have future borrowers if they feel you are diluting their investment. Or they will drive the interest rates well above inflation. The short term nature is in and of itself a hedge again any longer term inflation. Finally all borrowers of note are anticipating a substantial inflation and are positioning themselves. As we noted two days ago the CPI and PPI rates were at 5.6% and when you adjusted for the increases in productivity and reduction in hourly wages ten at the employee level they were already seeing a 7-9% inflation now!

In the simulations, we raise a concern about the stability of some model parameters across periods, particularly the parameters that capture the cost of inflation. It may be that the cost of inflation is higher today because globalisation and the greater ease of foreign direct investment provide new options for producers to move activities away from countries with greater uncertainty. Inflation above some threshold could generate this uncertainty, reducing further the attractiveness of using inflation to erode the debt.

Again this is somewhat of an understatement. If we were to start an inflationary trend, and frankly the current Administration has done just that, then we would see loss of our markets abroad and imports being the last stand of low prices would then inflate. China would drop the dollar so quickly that it would shatter the US economy.

Moreover, history suggests that modest inflation may increase the risk of an unintended inflation acceleration to double-digit levels, as happened in 1947 and in 1979-1981. Such an outcome often results in an abrupt and costly adjustment down the road. Accelerating inflation had limited global implications at a time when the public debt was held domestically and the US was the undisputed global economic leader. In contrast, unintended acceleration of inflation to double-digit levels in the future may have unintended adverse effects, including growing tensions with global creditors and less reliance on the dollar."

Yes, the unintended consequences would be catastrophic. But, they have already begun!