Could the U.S. fix its economic problems by devaluing the dollar?
The recent recession wasn't just a deeper version of other cyclical downturns. It was fundamentally different, which is why the stimulative measures taken by the government and Federal Reserve have done so little to improve the situation. This is the assertion of Harvard economist Ken Rogoff. Instead, he says that too much debt is the problem, which makes the solution easy: high inflation. Even though he says that inflation might have some negative consequences, the benefit of swifter economic recovery would be worth the associated costs. But would it really be so easy to inflate our way to prosperity?
In my December 2008 column, I argued that the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years. Of course, inflation is an unfair and arbitrary transfer of income from savers to debtors. But, at the end of the day, such a transfer is the most direct approach to faster recovery.
Eventually, it will take place one way or another, anyway, as Europe is painfully learning.
Some observers regard any suggestion of even modestly elevated inflation as a form of heresy. But Great Contractions, as opposed to recessions, are very infrequent events, occurring perhaps once every 70 or 80 years. These are times when central banks need to spend some of the credibility that they accumulate in normal times.
Or in short, high inflation is bad, but the consequences of allowing economic stagnation to drag on for a decade or more would be worse. Let's assume he's right. Could the U.S. simply inflate its way out of this mess?
How We'd Do It
John Carney at NetNet rightly notes that logistics could be a challenge here. Uncle Sam can't just point his finger and prices rise. He imagines that government spending, using newly printed money instead of debt, is one way this could occur. But he believes that the recent debt ceiling debacle shows that such an option isn't politically palatable. He's right, and other ways to inflate the U.S. currency look equally as problematic.
Free Money for Everybody!
Instead of spending the money it prints itself, what if the government sent this money directly to the people? Let's say each American got a check the mail for $10,000. That would cost about $3.1 trillion. And let's say that it was taxable income -- so some of that would also go to deficit reduction. The rest could be spent freely. If this doesn't raise inflation by enough to cure the problem, do it again next year, and so on.
Even if Congress somehow agreed to do this, would it necessarily result in consumers' loan burden declining? Some Americans might spend that money right away. But others might use it towards a down payment on a home or car. Maybe they buy more expensive stuff that require more expensive accessories, causing them to increase their credit card balances. Just because people have more money to spend doesn't mean that their appetite for credit would disappear. Indeed, they might want even more.
Fed Sets a High Inflation Target
Another option could be for the Fed to step in. It could establish an inflation target, but set that target quite high, at say 6%. This wouldn't necessarily cause inflation to rise, but it could have severely negative consequences for the U.S. The market would come to view the Federal Reserve's price level control as an exercise in convenience. The market would come to believe that as soon as it becomes advantageous for inflation to be higher, the Fed will just raise its inflation target.
As a result, investors will be very wary when it comes to U.S. dollars and U.S. public and private debt. It will begin to distrust the U.S. central bank. Even if the Fed eventually restates its goal to keep inflation at a low, stable rate, the market can point to this episode as an example of the central bank's whimsical attitude towards inflation. It may take several decades for the Fed to rebuild its reputation, and by then the U.S. might soon be faced with yet another "Great Contraction," which renew investors' concern about high inflation.
And in the case of the U.S., in particular, a tarnished reputation would be particularly harmful. Currently, the U.S. dollar is the global reserve currency of choice, and Treasuries are considered the safest among debt securities out there. If the U.S. consciously calls for higher inflation to get out of its current mess, then global investors might decide that there's nothing special about the U.S. dollar after all. The loss of this global competitive advantage would be worse than even a lost decade.
How would the market react if a higher inflation target was announced? Defensively: investors in debt securities would immediately attempt to protect themselves. They would pay for derivatives to guard against losses or dump assets that would lose value while fleeing to safer options. Credit markets in the U.S. would shrink and interest rates would soar. Of course, this would make the already struggling housing market have even more trouble recovering. If credit becomes more expensive and less available, then firms will also have a tough time growing and hiring once the economy picks up.
So whether the government or the central bank seeks to raise inflation, problems will arise. Either the cost will cause possibly irreparable damage to the reputation of the U.S. or the tactics won't work at all but will cause the recession to deepen further. While higher inflation might sound good in theory, in practice it won't work out so well.
Image Credit: REUTERS/Jim Young