by Raghuram Rajan, a former chief economist of the IMF, is Professor of Finance at the University of Chicago's Booth School of Business and the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy, the Financial Times Business Book of the Year.
CHICAGO – Recently, a number of commentators have proposed a sharp, contained bout of inflation as a way to reduce debt and reenergize growth in the United States and the rest of the industrial world. Are they right? To understand this prescription, we have to comprehend the diagnosis. As Carmen Reinhart and Kenneth Rogoff argue, recoveries from crises that result from over-leveraged balance sheets are slow and typically resistant to traditional macroeconomic stimulus. Over-levered households cannot spend, over-levered banks cannot lend, and over-levered governments cannot stimulate.
So, the prescription goes, why not generate higher inflation for a while? This will surprise fixed-income investors who agreed in the past to lend long term at low rates, bring down the real value of debt, and eliminate debt “overhang,” thereby re-starting growth. It is an attractive solution at first glance, but a closer look suggests cause for serious concern. Start with the question of whether central banks that have spent decades establishing and maintaining anti-inflation credibility can generate faster price growth in an environment of low interest rates. Japan tried – and failed: banks were too willing to hold the reserves that the central bank released as it bought back bonds.
Perhaps if a central bank announced a higher inflation target, and implemented a financial-asset purchase program (financed with unremunerated reserves) until the target were achieved, it could have some effect. But it is more likely that the concept of a target would lose credibility once it became changeable. Market participants might conjecture that the program would be abandoned once it reached an alarming size – and well before the target was achieved. Moreover, the central bank needs rapid, sizeable inflation to bring down real debt values quickly – a slow increase in inflation (especially if well signaled by the central bank) would have limited effect, because maturing debt would demand not only higher nominal rates, but also an inflation-risk premium to roll over claims. Significant inflation might be hard to contain, however, especially if the central bank loses credibility: Would the public really believe that the central bank is willing to push interest rates sky high and kill growth in order to contain inflation, after it abandoned its earlier inflation target in order to foster growth?
