Inflation is never the solution

One of my favorite economist today, Raghuram Rajan, has an important article in today’s FT: “Why we cannot inflate our way out of debt?”. Of course he is talking about US, but a lot of parallels can be drawn for countries flirting with the idea of exiting the euro.

There are very many good questions regarding this strategy. Will it work? Who is going to lose? What is happening withe credibility of central banks when they change targets?

Here are few of his answers:

“Japan’s central bank tried and failed to generate higher inflation. Banks were too willing to hold the reserves that the central bank put out as it bought back bonds. Perhaps if a central bank announced a higher inflation target, and an asset purchase programme financed with unremunerated reserves, to continue until the target were met, it could have some effect. More likely though, any target would lose credibility once it became changeable. Market participants might conjecture that the programme would be abandoned once it reached an alarming size, and well before the target is reached. ”

“Inflation will do little for entities with floating rate liabilities (many households that borrowed near the peak of the boom) or relatively short term liabilities (banks). The US government, with debt duration of about 4 years, is unlikely to benefit much from a surprise inflation unless it is huge; and the bulk of its promises are social security and healthcare that cannot be inflated away. Even distressed households that have borrowed long term could be worse off – with unemployment likely to subdue nominal wage growth, and higher food and fuel prices cutting disposable income.”

“Moreover, inflation will clearly make debt holders worse off. Who are they? Rich people, but also pensioners who moved into bonds as the stock market scared them away, banks that will have to be recapitalised, state pension funds that are already deeply underwater, and some insurance companies that will have to default on their claims. Will inflation just shift the problem, ensuring the malaise persists? In the best of worlds, it would be foreigners with ample reserves who suffer the losses, but they may be needed to finance future deficits. ”

 

The entire article here.

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