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Inflation involves a tradeoff for long-term creditors in mortgage and corporate bond markets. The values of earlier loans or bond issues depreciate, but delinquencies and foreclosures fall as asset values and consumer spending recover. The real value of U.S. Treasury debt also declines with inflation, but other assets will appreciate as consumer spending recovers. Most debt holders should benefit from moderate inflation, except those whose only investments are U.S.Treasury debt.
Although inflation may be the best way out of a deflationary spiral, the Japanese experience suggests we may not be so fortunate. In 2005, after 15 years of a debt-deflation spiral in Japan, private firms finally became net borrowers (and hence investors) again. Throughout this terribly long and arduous recovery, Japan relied on public spending and an export-driven industrial sector to maintain production and employment and to work off the stultifying debt loads of households and firms from prior asset bubbles. Political consensus for public sector spending over a 15-year period will be difficult to maintain in the United States. Strong exports that helped sustain Japan through the "lost decade" depended on the rapid growth of worldwide demand.Long-standing American trade deficits and the slowing worldwide economy make export-driven growth an unlikely way out of the U.S. downturn.
Declining demand for private credit reduces the money supply, which in turn reinforces the deflationary spiral. Even the large increase in the Federal Reserve balance sheet in September 2008 may not presage inflation. In usual circumstances, the Fed's asset purchases increase bank reserves and lead to more lending, but its recent purchases have not had the usual effects. Banks are reluctant to lend to any but the best credit risks, while many households and firms are reluctant to buy assets in a declining market.Japan has faced this dilemma for almost 20 years now.
If inflation does arise, the excess reserves of banks provide a simple means to contain it.The enormous increase in the Fed balance sheet from about $800 billion to $1,800 billion creates an unprecedented surge in the monetary base, but the Fed could limit the impact of this increase by placing a lower limit on excess reserves and thereby control credit creation by banks. Consequently, it appears now that deflation could pose a more serious risk than inflation.
Steven Gjerstad (firstname.lastname@example.org) is a research associate at Chapman University. Vernon L. Smith (email@example.com) is a professor of economics at Chapman University and the 2002 Nobel laureate in economics.
The Fed Fears Unemployment More Than Rising Prices
Donald L. Luskin
Inflation is inevitable in the intermediate and long term. Short-term inflation, however, is unlikely, because the recent financial crisis had the deflationary effect of creating enormous global demand for money balances.
The Federal Reserve responded to that demand with an enormous increase in the money supply. Politics and economics conspire to make it unlikely that the Fed will contract that supply rapidly enough to prevent inflation as the crisis ebbs and recovery ensues.
First, the economics. The Fed makes its policy decisions under extreme uncertainty and therefore must err on the side of avoiding unacceptable risks even if that means deliberately taking on acceptable risks. To the Fed, deflation is an unacceptable risk. Most economic historians, including Ben Bernanke, believe that deflation was the greatest single cause of the Great Depression; averting a repetition of that was uppermost in Bernanke's mind as he expanded the money supply so copiously during the last three quarters.
Inflation, on the other hand, is an acceptable risk. While it leads to the diminution of the real value of savings and induces all manner of economic distortions, the Fed feels confident that it is not catastrophic. Thus the Fed will surely keep the money supply extremely generous even as the economy recovers, preferring to accept the near certainty of inflation rather than any risk at all of deflation.
Second, the politics. The Fed is tasked by statute not only with ensuring "price stability"-that is, no inflation -but also with achieving "full employment." As the economy slowly recovers from an unprecedented global recession, the Fed's employment mission may have to take priority over its inflation mission. Unless inflation becomes extreme, employment is a much more potent political concern.
The Fed is likely at some point to judge that the risk of deflation has passed; yet it will not dare to take the restrictive policy actions required to quell inflation for fear of disrupting recovery in the labor market. If Ben Bernanke signals to the Obama White House that he will not support the labor market at the price of inflation, I have no doubt he will be replaced by someone else who will.
Donald L. Luskin (firstname.lastname@example.org) is chief investment officer of Trend Macrolytics.