Economy a little flat? Whip in some inflation!

Sometimes economists make analogies to make policies coherent. I find this by line particularly appetizing, imagining Bernanke as a soufflé chef trying to keep his light dessert fluffy. According to Menzie Chinn and Jeffry Frieden, the solution is just to whip in a little inflation to keep that soufflé/economy healthy.

The basic idea they convey is that debt-driven slumps are tough on many parties, but inflation can help everyone by easing the burden of debt across the board. For instance, let’s say I took a loan for $1000 dollars a year ago, and because of the recession I’m having trouble paying it back. Inflation makes it easier, since it dilutes the value of all dollars in the economy, so I can pay back the loan in less valuable money. Additionally, the result of a weaker dollar worldwide would result in countries buying more American goods. In their own words:

“Raising the expected inflation rate will lower real interest rates and spur investment and consumption. It will also make it difficult for the de facto dollar peggers, such as China, to sustain their policies. The resulting real depreciation of the dollar would stimulate production of U.S. exports and domestic goods that compete with imports, boosting American production.”

Ignoring all the political problems a central bank program like this presents (which the authors recognize is happening in Europe), this prescription still gets it wrong.  These authors are even insightful enough to identify the problem: simultaneously spurring investment and consumption.

Austrian capital theory teaches that expanding the base of the structure (consumption) with investment (all other stages) against people’s natural inclinations to save and consume will distort the structure. (good image here)  People’s saving/consumption patterns have yet to really change, so they are insufficient resources for both to expand at the same time. Eventually scarce resources must go somewhere, leaving some projects unfulfilled and unprofitable, leading to layoffs, bankruptcy, etc.

This has been conventional economic wisdom for years on end. Common sense and Austrian capital theory offers an out. After two rounds of quantitative easing, geared to spur the very inflation the authors are talking about, the money sits idle in banks. How many more times do we have to try to inflate before we go back to the drawing board? If we’re comparing the economy to a soufflé, maybe we should try a new recipe instead of whipping in more and more inflation.

Oh, and if you were drawn in by their promise of increasing American exports, don’t buy it. It’s just an extension of what has already been debunked. If this sort of neo-mercantilism is true, then let’s stop buying anything from China, or better yet, anything out of your own city.

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2 Responses to Economy a little flat? Whip in some inflation!

  1. Ryan Fitzgerald February 21, 2012 at 8:26 pm #

    Quantitative easing was never intended to spur inflation in the way discussed in the way you presented. QE1 was used to address liquidity concerns and to prevent deflation, while QE2 was used to push long term inflation expectations back to Bernanke’s preferred level of 1.7 to 2.0 percent. Further, the Fed’s policy of paying IOR at a level above the market interest rate is part of the reason “…the money sits idle in the banks.” The other reason is that the Federal Reserve allowed nominal GDP to fall well below historic trend levels because it did not adequately do two things, set future expectations about the price level and offset the increased demand for money starting in 2007.

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