Tuesday, May 26, 2009

Can We Inflate Our Way out of this Mess?

Three ways the U.S. can decrease the level of nominal debt as a percent of GDP:

  • Default (not going to happen... at least while we still own the printing press)
  • Increase productivity (and GDP), while paying down or maintaining the debt load
  • Inflate our way out of it (decreases the value of debt in real terms)
Of the three, in theory, inflating our way out of it will be the easiest, as it does not require true real economic growth. In Wolfgang Munchau's recent FT article 'We Cannot Inflate our Way out of this Crisis' he states that it may not be all that easy after all. Wolfgang details:
Of course, it can be done, but only for as long as the commitment to higher inflation is credible. Inflation is not some lightbulb that a central bank can switch on and off. It works through expectations. If the Fed were to impose a long-term inflation target of, say, 6 per cent, then I am sure it would achieve that target eventually. People and markets might not find the new target credible at first but if the central bank were consistent, expectations would eventually adjust. In the end, workers would demand wage increases of at least 6 per cent each year and companies would strive to raise their prices by that amount.
Yves at Naked Capitalism agrees that it is a challenge, but possibly due to a different reason:
You may have noticed a crucial assumption...."workers will demand wage increases." Pray tell, how? Workers have no bargaining power in the US. Merely goosing interest rates does not a a tight labor market make.

Stagflation was seen as impossible until it took place. I wonder if we could wind up with rising bond yields due to concerns about large fiscal deficits, with a lower rate of goods inflation due to the lack of cost push (wages are a significant component of the cost of most goods, save highly capital intensive ones). In fact, we could see stagnant nominal wages with mildly positive inflation, which means wage deflation. If that was also accompanied by high yields, you would have much of the bad effects of debt deflation per Irving Fisher (high real yields and reduced ability to service debt) since real incomes would be falling in the most indebted cohort.
The key point is that in the current environment, workers have no power. While we all know about the spike in the unemployment rate, the other side of the story is the cliff dive in the number of new job openings. The odd thing is I first became fully aware of this information in Sunday's NY Times article Bleak Picture, Yes, But Help Still Wanted that made the case that the market was actually FULL of opportunity.
Consider that in March, nearly 700,000 jobs disappeared. But now consider this: At the end of March, there were 2.7 million job openings. What tends to get lost in the data picture is that just as some companies are laying off workers, other companies are hiring. In fact, the business world is changing at such a dizzying rate that some companies are cutting and hiring workers at the same time.
Uh.... no. 2.7 million is down from 4.8 million openings as recent as the Summer of 2007; when 6 million less people were unemployed. In other words, the number of job openings has halved, while the number of those unemployed has doubled. That is not "bleak"... that is frightening.

This in turn has pushed the number of unemployed, as a percent of job openings, up more than three-fold to 500%. Yes, for each opening... 5 people want that job. That my friends is why, as Yves points out, workers don't have ANY bargaining power.

Thus, the concern I have is that inflation won't be driven through via wage increases (where at least workers salaries are keeping up), but by a spike in the price of commodities. If inflation concerns = dollar concerns = commodity spike, then that impossible stagflation may be possible once again.

Source: BLS


  1. Thank you for this post. One of the best I've ever read, on any blog.

    I think demographics make your second bullet unlikely....

  2. I think you may be dismissing the first option, i.e. default, a bit too easily.

  3. I did put the caveat "while we own the printing press" in there. as long as we can print our way out of it, no reason to default

  4. I think that defaulting on foreign debt is the easiest option politically,especially if you can convince your citizens that foreigners got you into your mess. Kind of like Ecuador today.Here, people would focus on China.

    Inflation is problematic in that there will be losers in your own citizenry, and they vote.

    Don the libertarian Democrat

  5. Even in this market there are entire categories of jobs where its hard to find great people. In fact, great employees are generally in short supply. There's something to the argument that inflation will affect the mediocre and those with bad attidues disproportionately. My 2 cents.

  6. don- i must disagree (but i see your point on the politics of it). both situations may result in inflation. if the u.s. were to default, the demand for the dollar gets CRUSHED as the implied contract between the u.s. and investors is gone.

    if that happens, the dollar is no longer the world's reserve currency --> the dollar is worthless --> imported commodities go through the roof --> we have inflation that you wanted to prevent in the first place.

    not to mention the risk of a world war should we tell EVERY other country in the world to go f%^k off costing them trillions.

  7. Inflating your way out of an obligation only works when the obligation is external. We have unsustainable external AND internal obligations. For example, a generation of baby boomers has begun to retire and we will not have the resources to support them. Inflation will not make that problem go away. At least not in any politically acceptable manner.

  8. good post Jake,

    i absolutely agree.

    over here in germany over the last 10 years workers lost their bargaining power completely due to the high unemployment rate.

    falling real wages are one of the reasons why consumption just won´t pick up, even amidst the latest boom.

    a significant number of well paid jobs has gone over the last years. they were replaced by lower paying temporary working jobs.

    result: companies hire temporary workers if they need them. they often end up doing the same qualified work as their colleagues but are paid only half of the wages.

    i don´t know how´s the trend for staffing in the us.
    maybe that´s a topic for some nice charts? ;)

    but i predict that IF some of the lost jobs will come back, they will come with lower wages from staffing companies like manpower, adecco...

    for the ongoing reflation trade i´ve got my own theory:

    it has a lot to do with gold.
    gold was bought bigtime over the last year as a protection against a meltdown of the financial system.

    with the stabilizing of the economy and the fincial markets it has lost of importance.

    i guess that a lot of (wealthy) people/institutions would love to sell some of their holdings, but that would depress the price too much.

    with real (wage) inflation not in the cards i suspect that the big players are trying to manufacture an inflationary scenario to get gold above it´s highs.

    once that´s accomplished a lot of new money will flow in giving the smart guys the chance to unload their stuff.

    ->i excpect the strenght in commodities and the weakness in treasuries to continue until gold is solidliy trading above 1.000.
    then i´ll watch for some stagnation followed by a sharp reversal returning to the deflationary trend of 2008.

    granted that sounds a bit crazy. i´ll admit that i´m wrong on that as soon as i see it.

  9. Inflate or die will likely equate to die inflating.

    The dollar will go. The deficits are not supportable. The debt (if you add in the off balance sheet obligations) is at 80 trillion. GDP is as baked as Enron's books and unemployment is at 19.8% (ShadowStats).

    Without any doubt this is a depression (time when debt and asset values get destroyed.)

  10. It's hard to discuss absolute job gains & losses without looking at which sectors are driving the numbers. The overall trend is that manufacturing jobs are decreasing while service/technology jobs are increasing (http://www.bls.gov/oco/oco2003.htm). This trend has been observed for well over a decade, so it's no surprise that an economic meltdown would help catalyze this shift. Look no further than the car industry.

    Economic friction guarantees that the exact number of job losses in manufacturing will probably not equal the gains in service-based sectors. But as Greenspan notes, the shift necessitates change in how we think about America's economy. Rising commodity prices, for instance, have a larger effect on manufacturing sectors than service sectors. While rising commodity prices will be passed on to the consumer no matter what, they can also be offset by gains in productivity, such as moving more manufacturing overseas.

    Employees may lack direct bargaining power, but in theory this is carried out by an efficient economy. GM might be able to continue making cars if it halved all employee's salaries/benefits. But even if it could do that, employees would go to better low-paying jobs, or pursue education.

    This friction in & of itself is reason for tremendous anxiety on the micro & macro level, as many American sectors threaten to become obsolete. Bad policy also threatens to prevent it from occurring, eg gov't bailouts & lenient bankruptcies. But 2 things are certain: Everyone stands to benefit from increased productivity in the end. And a service-based economy is categorically different from a manufacturing-based economy. One question I'm curious about is whether the effects of inflation differ in these 2 types of economies.