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. This of course is a slow process. It took Japan 10 years to return to pre-bubble debt ratios.
Fiscal policy of course will play a role. Krugman reminded us that the world exited the great depression with that massive deficit spending programme the History Channel likes to call the second world war. He insisted that those scholars (read Niall Ferguson) who fear high government deficits naively underestimate developed countries’ ability to service their debt. Nonetheless, he cautioned that even these massive government deficits do not begin to fill the hole left by private sector deleveraging. So far, fiscal policy will not solve the problem.
What’s left? Krugman ended his speech listing three possibilities: his first, a cheerful “Damned if I know,” the second, a surge in private investment, perhaps in green technology, and the third, the big one, the scary one, inflation. Inflation, of course, penalises lenders and rewards borrowers. It cleans up balance sheets by making debts diminish in real terms, but perhaps most important, it allows real interest rates to go negative, thus giving monetary policy the latitude it needs to be effective. A belief that prices are going up makes people spend now, makes investment cheaper, stimulates demand. We all know that deflation would make the recession even more hellish. Inflation, Krugman mildly suggests, could make it go away.
Keynes, remember, looked forward to “the euthanasia of the rentiers.” For the past 30 years we have instead had the lubrication of the financiers. Admittedly, inflation will hurt holders of capital, those that have profited from the boom and have caused its bust. But it would also solve my problems and yours, dissolve our enormous debts, restore our personal balance sheets, tempt us to start borrowing and spending again. Years of editorials have trained us to fear inflation, inured us to its benefits. After the speech, Krugman told me he would like to see prices rise 5 or 6 per cent per annum. He added, “Good luck trying to sell that”.
Tonight is what I suspect will be the best lecture of all: “The Night they Reread Minsky”—a look at the failure of orthodox economics. With the tube strike in full swing, LSE expects more seats will be available to the general public.