Volcker: Inflation Can't Solve Our Problems

Let's imagine a country with excessive national debt. Its local governments also have borrowed way too much. And let's say its people also have a gigantic mound of consumer debt. In fact, many have mortgage balances higher than the value of their homes. And let's call this country the "United States of America" (the "U.S."). How do you fix the U.S.'s debt problems? One possible solution is to adopt higher levels of inflation.

The logic here is easy. As inflation rises, so do wages. That helps take care of the consumer debt problem faster: people begin making more in nominal dollars, some of which they can use to more quickly pay off their debt. Inflation also drives the nominal value of their homes higher to better match their mortgage balances.

And of course, the government debt problems fade too, since tax revenues would rise as wages are inflated. So federal and local governments can fix their budgets as well.

This all sounds great, which is why some progressives have suggested that the U.S. ought to just inflate away its debt problem. Unfortunately, there are some significant problems that higher inflation also creates. For one thing, it serves as a transfer from savers to borrowers. So it harms people who have sacrificed to have a more stable retirement, while helping people who have spent irresponsibly. But it also creates potential macroeconomic problems for a nation.

Who better to explain these to us than the former Federal Reserve Chairman responsible for ending the high-inflation era the U.S. experienced about three decades ago? Paul Volcker explained why intentionally raising inflation is so dangerous in a New York Times op-ed on Monday:

What we know, or should know, from the past is that once inflation becomes anticipated and ingrained -- as it eventually would -- then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with "stability," but invokes inflation as a policy, it becomes very difficult to eliminate.

It is precisely the common experience with this inflation dynamic that has led central banks around the world to place prime importance on price stability. They do so not at the expense of a strong productive economy. They do it because experience confirms that price stability -- and the expectation of that stability -- is a key element in keeping interest rates low and sustaining a strong, expanding, fully employed economy.

Read the full story at the New York Times.