"It is time for the world's major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful"

Here's a post I delayed from yesterday, because it's my position, which is a paradoxical position: I believe that we should print money and cause inflation, and that is also our main worry. But my position is that it's a worry that we can handle. First, Kenneth Rogoff in the Guardian:

"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 in the economy. Price inflation forces creditors to accept repayment in debased currency. Yes, in principle, there should be a way to fix the ills of the financial system without resorting to inflation. 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."

Yep, that's been my position. It fulfills my number one criterion: I can understand it, and how to battle it. I've always assumed that the Fed would not allow Deflation. Period. So that the only problem is inflation. Now, it's a problem. I don't deny that. Strictly speaking, anything that we do will be unfair to someone. We must simply choose the least objectionable alternative.

"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."

This is true, although if we'd nationalized the banks and some other financial concerns, temporarily, we might have been able to, in essence, force through an unpleasant but effective unwinding on these complex investments. If nothing else, we could have structured an unwinding that, if it needed time to work out, would end with the taxpayers more certainly coming out ahead. TARP, a dreaded Hybrid, added unnecessary complexity to an already mind numbing complexity. It's like wrapping a riddle inside a mystery...well, you remember.

"Moderate inflation in the short run – say, 6% for two years – would not clear the books. But it would significantly ameliorate the problems, making other steps less costly and more effective."

I'd go up to 8%. Why? 10% is my "uh oh" rate.

"True, once the inflation genie is let out of the bottle, it could take several years to put it back in. 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. We already have a full-blown global recession. Unless governments get ahead of the problem, we risk a severe worldwide downturn unlike anything we have seen since the 1930s."

I'd rather go back to 80s and 90s than the 30s, for lots of reasons.

"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. The United Kingdom and the euro zone will eventually decide to go most of the way. "

I agree. I've already argued for tax cuts and a stimulus.

"Steps must also be taken to recapitalise and re-regulate the financial system. Huge risks will remain as long as the financial system remains on government respirators, as is effectively the case in the US, UK, the euro zone and many other countries today."

Now, I agree in theory, but there is a mess with TARP. This mess is going to lengthen, I repeat, lengthen, government involvement in the financial sector, unless we, in essence, really bail them out by eating their losses. As for regulation, I like supervision, rather than regulation, because regulation connotes to me rules which can easily and effectively be gotten around, and regulators who are too cozy with the industries that they regulate. It might well turn out to semantics. Humor me for now.

"Most of the world's largest banks are essentially insolvent, and depend on continuing government aid and loans to keep them afloat. Many banks have already acknowledged their open-ended losses in residential mortgages. As the recession deepens, however, bank balance sheets will be hammered further by a wave of defaults in commercial real estate, credit cards, private equity and hedge funds. As governments try to avoid outright nationalisation of banks, they will find themselves being forced to carry out second and third recapitalisations."

That's why nationalization would be preferable, but I've posted on this so much now it's beginning to sound like a condition even Cervantes couldn't describe. As for the wave of defaults, surf's up! But there are ways that we can more easily ride the waves. They're tedious to negotiate now, however, because everyone's waiting for the best deal that they can get from the government. From my perspective, we should be telling these supplicants "Wipeout!".

"Even the extravagant bail-out of financial giant Citigroup, in which the US government has poured in $45bn of capital and backstopped losses on over $300bn in bad loans, may ultimately prove inadequate. 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."

Why should it be? The financial world is not devoid of assets. Frankly, neither is the Federal Government.

"Certainly, a key part of the solution is to allow more banks to fail, ensuring that depositors are paid off in full, but not necessarily debt holders. But this route is going to be costly and painful."

Can't we choose between costly and painful? Why does it have to be both? Is it a merism?

"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% in the US, and more in Spain, the UK and many other countries. If inflation rises, nominal house prices don't need to fall as much."

Let's get this over with, one way or another.

"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."

I think that Buiter and Rowe disagree with this, but they get ticked off if I speak for them.

"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 this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary."

Spot on. It's a risk, but so is getting out bed in...now, is it really? Maybe a bunk bed.

"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."

Kenneth, if I can call you that, I've decided to ban the use of the tool box metaphor. I'll let the measles and plague thing pass, but it borders on disgusting to someone of my sensibilities and fear of disease.

I just noticed his picture, and he's also part of the bald with glasses brotherhood, signifying that he's terribly bright.

Here's the take on Rogoff's post on Free Exchange:

"And indeed, he's right. Not only would inflation reduce the value of non-indexed debts, it would also help housing markets clear and prices stabilise, and it would encourage households and financial institutions to stop sitting on their money. As Mr Rogoff mentions, we're also on the way to adopting the necessary policies—benchmark interest rates are moving toward zero, fiscal stimulus is in the cards, and the Federal Reserve is buying securities. As Mr Rogoff also mentions, the fact that all these actions have barely held off deflation, so far, suggests that a much more aggressive approach may be necessary.

There is a risk to such a policy, namely, that inflation will get out of hand, requiring a painful disinflationary recession at some point in the future. But frankly, at this point, the odds of inflation getting out of hand look slim, and the prospect of a disinflationary recession at some date in the future, non-threatening.

Still, I would wager that conditions would have to worsen significantly for Ben Bernanke to make the kind of commitment Mr Rogoff recommends. Helicopter Ben has, as yet, seemed reluctant to pull out all the available stops."

It's well reasoned, I must say. Helicopter Money. After struggling through that Buiter post about it, I've gone off it somewhat. I need time to recover from puzzling that paper out. I don't mean the money, I mean the phrase.

Here was my comment:

Don the libertarian Democrat wrote:

We can handle inflation. We've done it before. Always shift the battle to the terrain you're familiar with. Print away!

12/3/2008 10:21 PM GST