Inflation, deflation, and monetary policy

This is an excerpt from the 2010 book
Crisis Economics: A Crash Course in the Future of Finance
by Noriel Roubini and Stephen Mihm.
Emphasis is added.


Defaulting on Debt


Though the United States and Japan
will likely avoid the bond market vigilantes for some time to come,
they too may one day incur their wrath.
The United States continues to run unsustainable current account deficits
and has an aging population and
plenty of unfunded entitlement spending on Social Security and health care.
Japan has an even bigger aging population
and has already racked up significant debts.
Both countries may soon face growing scrutiny of its fiscal position,
a prospect that poses particular dangers for the United States,
which until now has been able to borrow in its own currency.

Unfortunately, it has another, less honest option.
The United States (as well as the United Kingdom and Japan)
issues its public debt in its own currency.
That means it need not formally default on its debt
if it proves unable to raise taxes or cut government spending.
Instead, central banks can print new currency—or its digital equivalent—and
monetize the debt. [Wikipedia]
This time-honored method would send inflation soaring,
wiping out the real value of the debt
and transferring wealth from creditors to the government.
While the so-called inflation tax avoids an outright default,
it achieves the same end.

Proponents of the inflation solution argue that
it kills two birds with one stone.
First and most obviously,
a moderate rate of inflation helps erode the real value of public debt,
reducing the burden.
At the same time, it resolves the problem of debt deflation,
reducing the real value of private liabilities—
fixed-rate mortgages, for example—
while increasing the nominal value of homes and other assets.
This is a win-win: the public and private sectors
both get to wriggle free of their debts.

It sounds smart, but it’s not.
If inflation rose from near-zero levels to the low single-digits—
let alone double digits—
central banks could lose control of inflation expectations.
Once the inflation genie gets out of the bottle, it’s hard to control.
While Paul Volcker’s success in fighting inflation in the early 1980s
confirms that this credibility can be regained,
doing so comes at the considerable cost of a severe recession.

Moreover, while inflation can reduce
the real value of nominal debt at fixed interest rates,
much of the debt in the United States and other advanced economies
consists of short-term obligations with variable interest rates.
These include
bank deposits, variable-rate mortgages, short-term government debt,
and other short-term liabilities of households, corporations,
and financial institutions.
Expectations of rising inflation would mean that
these liabilities would be rolled over at higher interest rates.
The rates would effectively keep pace with inflation.
In the case of short-term and variable-rate debt,
the inflation solution would be ineffective:
you can’t fool all of the people all of the time.

Needless to say,
trying to use inflation to erode the real value of private and public debt
would carry other risks.
Foreign creditors of the United States
would not sit back and accept a sharp reduction
in the real value of their dollar-denominated assets.
The resulting rush toward the exits—as investors dumped dollars—
could lead to the collapse of the currency,
a spike in long-term interest rates,
and a severe double-dip recession
The United States would not have the sway that it did
the last time inflation started to rage, in the 1970s.
Back then the country was still running current account surpluses.

That’s no longer the case:
the United States has become the world’s biggest debtor,
owing a whopping $3 trillion to the rest of the world.
Its current account deficits—$400 billion a year—
have become the stuff of legend.
As its creditors become increasingly leery of holding long-term debt,
it will have to resort to borrowing on a shorter time frame
to finance its various deficits.
That makes it increasingly vulnerable to
the kind of crises that hit emerging markets in the 1990s,
with the sudden collapse of the dollar more likely.

The Chinese and other U.S. creditors—
Russia, Japan, Brazil, and the oil exporters in the Gulf—
would not accept such a loss on their dollar assets.
Convincing China to accept such a financial levy would require
some rather unpleasant negotiations.
China might ask the United States for some other form of compensation,
such as giving up on its defense of Taiwan.
Such trade-offs would be likely in a world
where the great powers on both sides of large financial imbalances
vie for geopolitical leadership.

This “balance of financial terror” would seem to rule out the possibility that China would simply stop financing the U.S. fiscal and current accounts deficits.
For China to halt its interventions in the foreign exchange markets, much less dump its stock of dollar assets, would severely damage the competitiveness of its exports.
But should political tensions rise, and the United States begin actively to debase its own currency,
China may well walk away from the table, even if its interests suffer in the short term.
This outcome may be as unlikely as a nuclear exchange at the height of the Cold War, but it is not inconceivable.

Given these risks, U.S. authorities will likely not resort to the printing press to deal with the country’s debt, even if the temptation to use inflation—just a little bit—to depreciate the debt will remain strong.
But prudent policy makers should know that the costs and the collateral damage of such a solution would be significant, if not catastrophic.