Tuesday, December 2, 2008

The Center Cannot Hold

Holy smokes! Conservative economist Ken Rogoff is recommending "moderate inflation in the short run – say, 6% for two years" as the only way out of the crisis. The financial system is just too screwed up to fix one institution at a time. I can hear the alarm bells ringing at the European Central Bank. Mon Dieu! The end is nigh.


TexExile said...

Whether a bout of "moderate" inflation is desirable or not, I've been convinced for months that it will be well nigh inevitable. Controlling inflation is not rocket science; what's hard about it is the politics, not the economic policy tools. More often than not, it's a political economy problem, not a purely economic one. We tend to observe inflation when powerful interests have good reason to fight stabilisation and to see it brought under control when the coalition for price stability is strong.

In the current crisis, vast numbers of households, banks, companies and governments find themselves with enormous amounts of debt, far in excess of what they were planning to carry. The political constituency for low inflation policies is being eroded. A nice bout of inflation will do wonders to ease the debt servicing burden of all these groups and they will surely push for more lax policies in the next decade than we've had recently.

In most countries, independent central banks will not be able to prevent this. Central bank independence is not an institutional fix for politics; it emerges at times and places where the anti-inflation coalition is strong. When it is weakened, many central banks will, one way or another, find themselves unable to hold the line on price stability.

The interesting question is how the ECB will behave when faced with such pressures, since it is a supra-national institution and somewhat (but only somewhat) insulated from these pressures.

In saying this, I am not calling into question the value of low inflation. I think if we inflate our way out of this mess, we will pay a price for it for a long time. Nor do I not think that inflation is necessarily the optimal path out of the crisis. I just think it’s likely (almost certain) to be a significant part of the exit. Politically it seems almost inevitable and it is probably not the worst path out of the mess, even if it is not, in principle, the best one.

Unknown said...

A cogent presentation, Tex. So, should I buy more TIPS? :)

TexExile said...

Just at the moment, I am tempted to advise you to buy tinned goods, firearms and gold, but that may be just a bit too gloomy.

BTW, if you want to see what a country looks like when it tries to get out of a post-bubble financial crisis without either resorting to inflation or doing quite brutal things to the banks, look at Japan for most of the 1990s -- not an example any of us would care to follow.