Saturday, December 6, 2008

Kenneth Rogoff makes the case for more inflation . . .

I don't buy it

Prof. Rogoff is a highly respected Harvard economist. In this article, he argues that deliberate inflation policies should be considered to fight the housing downturn. Here's a bit of what he says:

In addition to tempering debt problems, a short burst of moderate inflation would reduce the real (inflation-adjusted) value of residential real estate, making it easier for that market to stabilise. Absent significant inflation, nominal house prices probably need to fall another 15% in the US, and more in Spain, the UK and many other countries. If inflation rises, nominal house prices don't need to fall as much.

Of course, given the ongoing recession, it may not be so easy for central banks to achieve any inflation at all right now. Indeed, it seems like avoiding sustained deflation, or falling prices, is all they can manage.

Fortunately, creating inflation is not rocket science. All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20% or 30% instead of 5-6%. Indeed, fear of overshooting paralysed the Bank of Japan for a decade. But this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary.

It will take every tool in the box to fix today's once-in-a-century financial crisis. Fear of inflation, when viewed in the context of a possible global depression, is like worrying about getting the measles when one is in danger of getting the plague.

I understand his point. And Prof. Rogoff has forgotten more than I know about economics. But I find his prescription absurd. Why are economists bending over backwards to manipulate markets into behaving the way we think we want them to? The fact is, and nobody disputes this, housing prices rose due to a severe, artifical propping up of available credit. The bubble has now popped and Americans, and America, are now finding out we aren't as rich as we thought we were.

It is best if we let this market correction occur, and instead of inflating our way out of the problem, it is best if we do the long, hard work of creating sustainable forms of new wealth. To do this, we will need steady, productive employment for America's families and individuals. We are going to get out of this problem with neither easy credit nor inflation. Rather, we need to create wealth-producing jobs and incomes. I am thinking in terms of a $600 billion - $1 trillion demand-side economic stimulus. I hope it goes into effect as soon as President Obama takes office.

1 comment:

Adam Rafalovich said...

Very solid points! Let me offer some additional comments:

The primary problem with the perhaps trillion dollar economic stimulus is its HIGHLY inflationary nature. To fund this stimulus requires the offering of even more US debt and a possible collapse of the US dollar. Embarking upon this stimulus (in addition to the TARP funds—half of which have been used, the other half, who knows?) risks serious usurpation of individual buying power and, of course, individual wealth. Who is to guarantee that other countries are going to keep the US dollar around as a reserve currency? What is the saturation point for those who hold US debt?

While I agree that something has to be done, if the post-stimulus economy does not "grow its way" out of this massive debt-issuance hurdle we might be in Argentinean, even Weimar Germany territory.

With that rather ominous statement let me state what I think is going on with the US economy:

I believe that we are BEGINNING (I laugh when economists predict the end of the recession in the middle of this year!!) a protracted period of economic restructuring. We may call this a recession, depression, whatever. The reality is that the level of consumer indebtedness in the US that gave the middle class the illusion of wealth for the last 25 years (thank you Mr. Reagan and Mr. Greenspan!) will come down drastically. We have now come to the end of easy revolving credit and the “house as ATM machine” refinancing craze. There will NOT be a resurgence of the US consumer sans a war, or some other consolidation of US economic power. The US consumer is done, and that is that.

Home prices are so far out of whack with median income, we still need an additional 20-30% correction in the housing market for people to afford homes again. Difficult-to-attain credit, job losses, and stagnate or declining real wages are all viciously feeding into this housing market correction. Also, let me add here that the fact that this whole thing “began” with the housing implosion and therefore must be corrected through a revitalization of housing really underscores the fundamental problem here in the US: HOUSING IS ALL WE HAVE!

Discard the drivel from the “Big Three” auto manufacturers that have provided a case study in outsourcing and do not have near the economic importance that they had a generation ago.

Discard the 1990s neo-liberal lie that we now live in a “new economy” where we can “sell” knowledge.

Finally, discard the idea that developing nations have “decoupled” from the US in this great experiment of global capitalism. When we cough, the UK gets the flu, India gets small pox, and China gets bubonic plague. And, right now, the US economy is in intensive care!

Again, the problem is that we don’t make anything in this country anymore. Neo-liberal policies have forced us to move all of our eggs into the housing basket, which has become a source of wages (through housing-related jobs), consumer spending (through tapping home equity lines of credit), and retirement (through paying a hefty mortgage, selling one’s house and moving someplace cheaper). This is the primary reason for Bernanke’s lowering of the federal funds rate and target rate, and the reason that the US government (that is, with a little help from our tax money!) is now engaging in the unprecedented and dangerous process of buying mortgage backed securities. The idea is that if you make money easier to get and mortgages more safe, mortgage rates will go down, which is exactly what they have done. But this misses a fundamental problem: artificially inflating asset prices is unsustainable and this will ultimately come home to roost, not with the wealthy, but with wage-earning, middle-income families.

Because housing is all we have, if we allow this correction to move through its natural course, you will see individual balance sheets virtually destroyed. The Fed cannot let that happen because that would necessitate an even great stimulus, the issuance of even larger amounts of US debt, and a further weakening of our currency.

Thanks for listening!!

Best Wishes,

Adam Rafalovich, Ph.D.
Sociology Department
Pacific University