There Are Only 2 Ways to Save the Economy: Innovation or Inflation

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It all comes down to this: We have to match growth to debt. If we can't create miracles from growth, we have to consider inflation to reduce the value of our debt

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We have only two ways out of our current global economic mess: innovation and inflation. And as the saying goes, we should hope for the best (more innovation) and prepare for the worst (higher inflation).

Looking across the world, the underlying problem is that borrowers--households and governments--have taken on debt that they can't afford to pay back, given the current rate of income and economic growth. In the U.S, too many homeowners are struggling with mortgages that far exceed the value of their homes and cannot be repaid from their current incomes. In Europe, Greece and perhaps other countries have issued bonds that they cannot pay back unless growth unexpectedly skyrockets.

Down the road the same principle of matching growth to debt allows us to perceive potential financial crises to come. Young male college graduates, for example, have seen their real earnings plunge by 19% since 2000, with young female college grads experiencing a similar decline. Meanwhile education borrowing has soared, suggesting that we are on the verge of a student loan crisis, where young grads simply cannot pay back their mountain of debt.

It's not easy to explain why lenders overestimated the ability of debtors to pay. Or, rather, there are too many explanations. Some believe that complicated financial instruments obscured the true amount of debt, as in the case of the U.S. financial crisis. Others think that greedy financiers expected to be bailed out, or worse, simply didn't care. In Greece, the official numbers understated the budget deficits for many years.

An alternative class of explanations points to excess optimism about future growth as the main culprit. In the case of student loans, the conventional wisdom is that education is always a good investment, suggesting to both students and lenders that borrowing for college is always a good idea. In the case of housing, many economists subscribed to the belief that national home prices never go down.

To be truly effective, reinflation would have to be followed by all of the world's major central banks

Another piece of the puzzle is the unexpected innovation shortfall of recent years, which I, Tyler Cowen, and others have documented. This shortfall, particularly in biosciences, has led to a slowing of growth in the developed countries. What's more, the true extent of the growth slowdown has been masked by flaws in the economic statistics.

But no matter which explanation you favor, the essential mismatch between growth and debt has only two possible solutions: Increase the growth rate or reduce the debt. For a country like the U.S., increasing the growth rate requires innovation, and innovation requires a devotion to investment: Investment in physical capital, investment in human capital, investment in knowledge capital. That increased investment, in turn, should result in higher rates of productivity growth and increased innovation.

In other words, we have to shift from a consumer economy to a production economy. This is partly about a change in spending patterns, but also about a change in attitude. For example, we need to boost R&D and other investment in knowledge capital, but we also need federal regulatory agencies to encourage rather than discourage innovation. We need more infrastructure spending and other investment in physical capital, but it should be directed towards supporting exports and production in the U.S., rather than clearing up bottlenecks of imported consumer goods. This profound shift in policy and behavior is essential over the long run, but it won't be easy or quick.

IF NOT MORE GROWTH, LESS DEBT

The alternative to increasing growth is reducing the outstanding debt. In theory governments can organize a orderly write-down for unpayable debt, getting lenders to accept a deal that acknowledges reality.

In practice, however, an orderly write-down is not so easy to organize in today's multi-layered financial system. Much of Greek debt, for example, is held by European banks, but those banks in turn fund themselves by borrowing abroad. Given that both the U.S. and the European Union are net borrowers, it's clear that the ultimate source of funds is likely to be the big creditor nations such as China and Saudi Arabia. It's difficult to see China--still a poor country--accepting a write-down in the value of its loans to richer countries.

That leaves inflation as an undesirable but feasible mechanism for reducing the burden of debt. By inflation I mean a sustained increase in both wages and prices. For example, an inflation rate of 4% would raise the nominal level of wages by 50% over ten years, making debt much less onerous.

Ben Bernanke addressed exactly this point in a 2000 paper, where he suggested that the Bank of Japan could have targeted an inflation rate of 3-4% to combat the Japanese stagnation of the 1990s. Just this week, Chicago Fed President Charles Evans suggested that the Federal Reserve should target 3% inflation.

The Federal Reserve has the authority to execute such a policy, although it would have a lot of critics. One way is for the Fed simply announce that it will keep rates near-zero until inflation expectations are above 3%. Another way is to target some level of nominal gross domestic product that rises over time. In either case, the expected results would be a reduction in the real value of dollar-denominated debts, a rise in long-term interest rates, and most likely a depreciation of the dollar.

However, to be truly effective, this policy of reinflation would have to be followed by all of the major central banks around the world. Such a synchronized monetary policy would not eliminate the debt overhang right away, but over time would have the effect of balancing the scales between borrowers and lenders.

In adopting a reflationary policy, central banks would have to be very wary of letting inflation get out of control. It's all too easy to keep pumping money into the economy, eventually leading to hyperinflation and a general loss of faith in the financial system. Investors can lose faith and be unwilling to lend.

There's no doubt that innovation is a far superior solution to our problems than inflation. Innovation creates new wealth, raises the living standard of future generations, and potentially solves some of the real problems of our time. Inflation creates no new wealth, but merely pares down the mountain of debt to reasonable levels. However, inflation is something we know how to achieve, while using public and private investment to deliver innovation is a complicated process.

We want innovation, we need innovation. But if we can't have innovation, we may have to accept inflation as the less-desirable but feasible way out.

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Michael Mandel is chief economic strategist at the Progressive Policy Institute.

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