Inflation as a solution for Europe

Earlier this year, IMF chief economist Olivier Blanchard suggested that countries should raise their inflation targets from a typical 2% per year to 4%. His suggestion was greeted with hoots of derision.

Yet in a world where there are no good solutions to the European debt crisis, inflation could be the best of bad alternatives.

Blanchard said that if 2% inflation was the norm, and interest rates were around the same level, central banks could not cut interest rates by more than 2% in a slump: they could not go below zero.

This greatly restricted the power of monetary policy as an anti-recession tool. Besides, it was politically difficult to cut wages in a highly indebted country requiring structural adjustment, but a wage freeze was easier. If 2% inflation was the norm, then a wage freeze would lower real wages by only 2%.

But if 4% inflation was the norm, a wage freeze would cut real wages very substantially and produce sizable structural adjustment. The Sukhamoy Chakravarty Committee in 1985 came out with the same 4% inflation target for India. Chakravarty did not worry that the RBI would not be able to cut interest rates below 0%.

But he did emphasise that 4% inflation was “acceptable”, providing flexibility for relative prices and wages to adjust without causing a backlash from voters or trade unions. Blanchard’s proposal to raise the western inflation target from 2% to 4% was regarded as brave by some.

Yet he funked highlighting one of the most important advantages of 4% inflation: it will slash the real debt of countries with excessive debt overhangs, and could help revive growth sustainably. Europe, Greece, Italy and Belgium already have national debts exceeding 100% of GDP, and so does Japan.

Ireland and Portugal are not far behind, and Britain’s debt is galloping upward. Their debt/GDP ratios look like rising much higher, given the grim outlook for European growth (and hence government revenues), and the huge welfare entitlements they are politically committed to.

The interest rate on their debt is also rising fast. Markets have already concluded that Greek default is inevitable. The danger is that other European countries could also been seen to be headed for default, leading to a major new financial crisis.

Blanchard and other analysts now regret that European countries did not run budget surpluses in the preceding boom years, creating fiscal headroom for deficits in the inevitable recession that followed. But that’s crying over spilt milk. How does one proceed forward from the existing sorry mess? There are five ways forward. One is a grim austerity drive that slashes public spending, inducing a deep recession.

This can in the medium run reduce the debt/GDP ratio, but in the short-run may increase it as the recession sinks tax revenue. The second option is debt default. Bondholders will have to take a “haircut”. This can take many forms — lower interest rates, longer maturities, or a reduction in redemption value.

All haircuts cut real debt. The big disadvantage is that the banks holding government bonds will suffer a sharp fall in assets, making many technically insolvent and in dire need of additional capital to survive. THEthird option is devaluation. This reduces the real value of bonds held by foreigners.

However, devaluation will not reduce real debt if the bonds are owned entirely (or almost entirely) by local institutions and investors. Nor will devaluation work if the debts are denominated in euros or dollars, as is the case with most European countries.

In such cases devaluation will increase the nominal value of debt as fast as it increases nominal GDP. The fourth option is for governments to force their banks to hold a big chunk of their deposits in gilts. India already does this through its statutory liquidity ratio.

In the West this would be condemned as financial repression, that subsidises government debt. It will be a hidden form of taxation that squeezes lending to the productive sectors of the economy. This could worsen rather than revive a recessionary economy in the short run.

The fifth option is inflation, which cuts the real value of debts. This will be a haircut by other means. A temporary surge in inflation may not have too much effect, but a doubling of long-term inflationary expectations from 2% to 4% will hugely depress real debt.

Inflation is often called hidden taxation, but it is more than that — it benefits all debtors, private or public, at the expense of all creditors. It temporarily boosts profitability, and so can help revive a flagging economy, and revive tax revenues. Now, inflation is not a panacea for all ills.

In the 1970s, many governments sought to use inflation to accelerate growth, and instead got stagflation (high inflation without growth). The poor people with fixed incomes (like retirees with fixed pensions) suffered most. Rising inflationary expectation kept raising wages and interest rates, not output.

This is what finally led to the Reagan-Thatcher war on inflation, going for sky-high interest rates and a deep recession to squeeze inflationary expectations out of the economy.

Most people said “never again” to inflation as a recipe for growth. However, the stagflation of the 1970s was due in substantial measure to the power of trade unions, which could bargain for higher and higher wages as inflationary expectations rose.

That was possible because import barriers were still substantial in those days, and foreign competition did not wipe out industries with high wages. But trade unions have now lost their old power because of freer trade and cheap imports. To that extent, inflation has greater potential to raise growth rather than prices.

It would not help if inflation targets were raised first to 4%, then to 6%, and then to 8% in an unending search for haircuts.

All creditors would simply disappear. But a once-and-for-all rise in inflation targets in the West to 4% might be the least risky of the five ways forward. It is by no means an ideal solution. But neither are the alternatives.

Earlier this year, IMF chief economist Olivier Blanchard suggested that countries should raise their inflation targets from a typical 2% per year to 4%. His suggestion was greeted with hoots of derision.

Yet in a world where there are no good solutions to the European debt crisis, inflation could be the best of bad alternatives.

Blanchard said that if 2% inflation was the norm, and interest rates were around the same level, central banks could not cut interest rates by more than 2% in a slump: they could not go below zero.

This greatly restricted the power of monetary policy as an anti-recession tool. Besides, it was politically difficult to cut wages in a highly indebted country requiring structural adjustment, but a wage freeze was easier. If 2% inflation was the norm, then a wage freeze would lower real wages by only 2%.

But if 4% inflation was the norm, a wage freeze would cut real wages very substantially and produce sizable structural adjustment. The Sukhamoy Chakravarty Committee in 1985 came out with the same 4% inflation target for India. Chakravarty did not worry that the RBI would not be able to cut interest rates below 0%.

But he did emphasise that 4% inflation was “acceptable”, providing flexibility for relative prices and wages to adjust without causing a backlash from voters or trade unions. Blanchard’s proposal to raise the western inflation target from 2% to 4% was regarded as brave by some.

Yet he funked highlighting one of the most important advantages of 4% inflation: it will slash the real debt of countries with excessive debt overhangs, and could help revive growth sustainably. Europe, Greece, Italy and Belgium already have national debts exceeding 100% of GDP, and so does Japan.

Ireland and Portugal are not far behind, and Britain’s debt is galloping upward. Their debt/GDP ratios look like rising much higher, given the grim outlook for European growth (and hence government revenues), and the huge welfare entitlements they are politically committed to.

The interest rate on their debt is also rising fast. Markets have already concluded that Greek default is inevitable. The danger is that other European countries could also been seen to be headed for default, leading to a major new financial crisis.

Blanchard and other analysts now regret that European countries did not run budget surpluses in the preceding boom years, creating fiscal headroom for deficits in the inevitable recession that followed. But that’s crying over spilt milk. How does one proceed forward from the existing sorry mess? There are five ways forward. One is a grim austerity drive that slashes public spending, inducing a deep recession.

This can in the medium run reduce the debt/GDP ratio, but in the short-run may increase it as the recession sinks tax revenue. The second option is debt default. Bondholders will have to take a “haircut”. This can take many forms — lower interest rates, longer maturities, or a reduction in redemption value.

All haircuts cut real debt. The big disadvantage is that the banks holding government bonds will suffer a sharp fall in assets, making many technically insolvent and in dire need of additional capital to survive. THEthird option is devaluation. This reduces the real value of bonds held by foreigners.

However, devaluation will not reduce real debt if the bonds are owned entirely (or almost entirely) by local institutions and investors. Nor will devaluation work if the debts are denominated in euros or dollars, as is the case with most European countries.

In such cases devaluation will increase the nominal value of debt as fast as it increases nominal GDP. The fourth option is for governments to force their banks to hold a big chunk of their deposits in gilts. India already does this through its statutory liquidity ratio.

In the West this would be condemned as financial repression, that subsidises government debt. It will be a hidden form of taxation that squeezes lending to the productive sectors of the economy. This could worsen rather than revive a recessionary economy in the short run.

The fifth option is inflation, which cuts the real value of debts. This will be a haircut by other means. A temporary surge in inflation may not have too much effect, but a doubling of long-term inflationary expectations from 2% to 4% will hugely depress real debt.

Inflation is often called hidden taxation, but it is more than that — it benefits all debtors, private or public, at the expense of all creditors. It temporarily boosts profitability, and so can help revive a flagging economy, and revive tax revenues. Now, inflation is not a panacea for all ills.

In the 1970s, many governments sought to use inflation to accelerate growth, and instead got stagflation (high inflation without growth). The poor people with fixed incomes (like retirees with fixed pensions) suffered most. Rising inflationary expectation kept raising wages and interest rates, not output.

This is what finally led to the Reagan-Thatcher war on inflation, going for sky-high interest rates and a deep recession to squeeze inflationary expectations out of the economy.

Most people said “never again” to inflation as a recipe for growth. However, the stagflation of the 1970s was due in substantial measure to the power of trade unions, which could bargain for higher and higher wages as inflationary expectations rose.

That was possible because import barriers were still substantial in those days, and foreign competition did not wipe out industries with high wages. But trade unions have now lost their old power because of freer trade and cheap imports. To that extent, inflation has greater potential to raise growth rather than prices.

It would not help if inflation targets were raised first to 4%, then to 6%, and then to 8% in an unending search for haircuts.

All creditors would simply disappear. But a once-and-for-all rise in inflation targets in the West to 4% might be the least risky of the five ways forward. It is by no means an ideal solution. But neither are the alternatives.

What do you think?