Inflation. There I’ve said it: the dirty word, that bad, bad thing all of us have been taught to fear. In his second lecture at LSE last night Paul Krugman was a bit circumspect—but, if you read just a tiny bit between the lines, The Professor was telling us that bad boy inflation is the one and only way out of our current economic crisis. Monetary policy won’t do it, increased exports won’t do it, inflation is the answer. Only problem, we’ve been trained to view inflation as the predicament, not the solution.
Let me back up. The lecture, entitled “The Eschatology of Lost Decades,” looked at the causes and cures to the financial crisis. His shtick on the causes was reasonably familiar. The collapse of a huge world housing bubble led to run on the shadow banking system while over-indebted households struggled to repair their personal balance sheets by spending and borrowing less. He told the tale well, but it is a tale that unfortunately we all now know.
The interesting part was his look at the endgame, his examination of how we get out of this mess. The essential problem is an oversupply of global savings relative to desired investment. The traditional solution—cutting interest rates to make savings less attractive and investment more—can’t work because interest rates are already close to zero. We can’t go below zero so monetary policy has no scope; it cannot be effective.
Krugman then looked at how countries slammed by financial crises have managed to grow out of recession in the past. The answer: increased exports. That’s how Thailand, South Korea et al rapidly exited the 1998 east Asian debt crisis. It’s how the US escaped the panic of 1873, and how Japan began to edge out of its lost decade. Unfortunately, since this is a worldwide disaster, unless the Earth can start exporting to Mars, exports won’t do the trick. The next solution Krugman proposed would be to repair household balance sheets. Right now, we are all spending less because we have such huge debts. If our debts relative to our assets decreased, we would be more likely to spend and thus tempt firms into investing.…