Inflation Isn't The Answer

Over on his blog Matthew Yglesias has a post lauding the idea of intentionally creating moderate inflation, based on a recent policy paper. The idea is that if you let inflation go up moderately for several years, you could alleviate the massive public and private debt burden substantially. For a nation like the U.S. plagued with debt, that sounds like a pretty nice result. The problem, however, are the other consequences that would follow.

First, here's a useful chart from that policy paper by Chris Hayes of New America:


As you can see, we've created a lot of debt, but little inflation. Yglesias thinks that inflation could help:

The idea is basically that if we could sustain a five or six percent inflation rate for a period of years, that would make it much easier to work off the debt overhangs--both in the public and private sectors--that otherwise threaten to hobble the economy for years.

Let's assume that all lenders, including banks who lent to consumers and foreign investors who bought U.S. Treasuries, are evil. You'd basically have to, because you'd be intentionally eating into their real return and in some cases turning it negative. Even if these parties really would all be getting just what they deserve, there are other outcomes to worry about.

Foreign Investors

The most obvious is the reaction of foreign investors. Just yesterday I wrote about how investors around the world aren't likely to soon forget the losses that U.S. banks caused them during the crisis. The same logic would apply towards U.S. policymakers that allow higher levels of inflation.

Why, in their right minds, would the Chinese be willing to invest in vast quantities of U.S. debt going forward? After all, the real return on that debt might end up being negative if Americans just decide to inflate their way out of it again. Certainly, the Chinese and others would learn from such a mistake.

That means, in a time of crisis, the U.S. would have a lot harder time doing any deficit spending to ease the economy. This should be an especially worrisome prospect for any Keynesians.

Damaging To Fragile Banking Industry

The world looks quite a bit better for banks than it did a year ago. But that isn't to say that it's business as usual. That will take years to happen. By allowing inflation to increase for the next several years, you make matters more difficult for that banking recovery. They will lose money on existing debt, which will be worth much less. I know there isn't a lot of sympathy out there these days for banks, but I can't imagine most Americans want to live in a country where the financial industry cannot regain its footing for several more years.

More Bubbles

Finally, inflation has the potential to create bubbles. One bubble might be in lending. By easing money supply over an extended period, lending might get out of control. Another potential bubble could occur in stock and commodity prices. People will be looking for ways to protect the value of the wealth, so will be turning to sources other than cash to do so. That will drive up demand for stocks and commodities, potentially overheating those markets as well.

Rich Benefit; Poor Suffer

It might seem like inflation would hurt the rich, as they have accumulated the most wealth. But they also have the most investment sophistication to avoid inflation's bite, because they have the cash to hire private brokers and money managers. Poorer individuals who have the little savings they've got in a money market or savings account will be the real losers.

I also noted this week that the rich often have even more debt than the other classes. Again, they would benefit more if their debt became easier to pay off.

The debt situation we're in is a serious one. It might result in lower growth until it's under control, but I think that's a bitter pill we'll have to swallow given the lifestyle we've led as a nation and individuals. The only good solution is to spend more responsibly on national and personal levels. A supposed easy way out like inflation will just result in other negative consequences.