What Is Our Problem and Why It Will Be “Cured” With Inflation
Sure the stock market bubble burst and few years ago, and sure economic activity remains tepid despite more than a year of declining interest rates, and a significant increase in government deficit spending, but what’s the crisis?
The big problem is that the debt we all have. The debt is the problem because it requires that a substantial part of what we earn over the next decade be used to pay off this debt rather than be used to buy new stuff. Over the last 12 years we have taken on a level a debt based on the assumption that the atypically high growth rate that we were then experiencing was going to continue and in many cases even accelerate.
So there is really no way to just start the economy back on the road towards growth and wait until we get there. That is because in any process that does not instantly put the economy back where it was and have it growing at the rate at which it had been growing, also instantly, for all the time that that is not the case there are going to be a significant number of defaults on loans.
And loan defaults beget more loan defaults, bankruptcies, and the type of economic uncertainly that further slows growth and therefore inhibits and undermines whatever economic redevelopment that otherwise might occur.
One of the things, which might occur as a result of a significant amount of debt and increasing defaults on that debt, is deflation. In an economy that had been making decisions based on the assumption of perpetual high growth indebted consumers do not have the money to buy any of the increased capacity which industry has created (but still is yet to pay for). Therefore supply is greater than demand and prices start falling. Which of course only exacerbates the debt problem because the amounts due are not indexed for deflation they become greater and greater as prices decline. Which obviously means that even to the extent that some of the debt is being paid off what remains gets larger in current dollar terms.
The fact is that a significant portion of the debt is not going to be paid back. It can’t be. Obligations were taken on for resources that never existed and never will exist.
There are basically three alternative ways in which the problem can be resolved.
Under the first alternative, which I would call the free market solution, the situation is allowed to unfold naturally and non-performing debt is identified and written off. That part of the debt burden that is non-perfoming debt overhang is written off with the economic cards falling where they may. After all it is the creditors who need to experience the consequences of irresponsible lending so that they don’t do it in the future. Capitalism includes the right to fail – indeed requires it. To the extent industry, regulators, and government get involved it is to see that it the process unfolds in as timely manner as possible.
Under the second alternative, which I would call the political solution, the government (and regulators) act to “cushion” and “temper” the process by implementing accommodative policies intended to give all parties involved the greatest amount of time to work out the bad debt. The hope is that such a resolution is less painful than that which would otherwise occur hopefully limiting the number of defaults and bankruptcies. The problem is when the amount of debt is too large the time that it takes to “work it out” drags on and for all of that time it continues to be a drag on the economy. Ultimately deflation, as discussed previously, begins to set in and an increasing number of loans and entities become threatened. This is what has occurred in Japan.
The third alternative, monetization of the debt, requires that the economy have fiat money and a central bank willing to accommodate. Under this alternative the real value of the debt is decreased by decreasing the value of the dollars in which it is denominated. To cause this to occur the central bank pursues an inflationary monetary policy, which means that the economy will be growing in dollar terms faster than real terms, thus the real value of the existing debt becomes smaller in the future in real economic terms, although not in nominal dollar terms. Essentially this is a negative interest rate. What is occurring is that there is a real and expected positive return on debt. The problem that this alternative presents is that to work it will require a total perversion of the capital markets.
The capital markets typically respond to the expectation of increased inflation by increases in the nominal interest rate. This increase in rates is required if lenders are to be paid back at least as much as they lent and some appropriate payment for the time value of money. Of course if lenders are not going to get back at least as much as they lend they will not lend.
Unfortunately allowing this to occur would prevent the monetization of the debt that is the whole point of creating the inflationary condition if the first place. So part of the central banks effort much include attempts to maintain interest rates lower than the market would otherwise require. In fact the strategy only works if they are capable of maintaining long term interest rates at levels in which not only is their no economic incentive for lenders to lend but their actually is a cost of their doing so.
Clearly they have the ability for some period of time (I think they will find that this period of time is far shorter than they expect, and far shorter than will be required to resolve the debt problem but be that as it may) directly or indirectly (by subsidizing the cost of economically rational lenders) to meet all lending needs.
The immediate cost of their doing so is the decline in the dollar and the introduction of an inflationary bias into prices.
It will take a little while though to sort through all of the adverse implications associated with the central bank implementing a monetary policy that is predicated on negative returns on capital. Clearly there will be costs
We are not in a position, however, where there is any pain or cost free solution to our current economic problem. And it remains to be seen, or more likely we will never know if the Fed solution is more or less painful than the traditional “free market” solution.
But it is important to understand that the current strategy is predicated on monetization of the current excessive debt burden through the introduction of an inflationary bias into pricing, acting to maintain interest rates at below market and indeed negative real levels, and to the greatest extent keeping as many people as possible either unaware of, in denial, about these facts. |
