Neil Irwin’s Washington Post piece (HT: Klein) prompts me to sketch an argument I have been toying with for a while.

Irwin reviews the opinions of economists and suggests they come in two camps. First, there are those who think that deep recessions produce swift recoveries. Those economists see a the economy turning around later this year. Then there are those who note the tattered conditions of the US household and can’t see how consumption turns around any time soon.

I’m torn between the two. I respect empirical regularities. It also makes sense to me that simply reducing the rate high rate of job destruction will produce a failing unemployment rate and with it increased production.

However, when we break down where this growth will come from it seems like a large increase in investment is necessary. The current politics don’t look like they will permit even deeper deficits and net exports can only contribute so much in an environment of increasing oil prices – something I strongly suspect we will continue to see.

So where will this investment come from? The most plausible answer to me seems to be lower real interest rates. Of course we have a problem. We are currently experiencing deflation and short term interest rates are zero. This puts obvious limits on the ability of the Fed to generate lower real rates.

To solve this we need an increase in inflation, however, the shakiness of household balance sheets lead me to suspect the usual target of roughly 2% is insufficient. It does not provide enough room for negative real rates and potential easing in the face of some future shock.

If the Fed were to adopt a higher target, of say 5%, and state that more or less explicitly then we can provide ourselves with extra room and keep inflation expectations anchored.

We can think of low or even negative real rates as lowering the cost of investment but we can also think of them as adding the repair of household balance sheets as well. Households have an overhang of mostly nominal debt. There are those with adjustable rate mortgages but I am willing to be the overwhelming majority of household debt is at fixed interest rates. As inflation rises so will nominal wages and thus the ability of households to repay that debt is eased.

Now this represents a transfer of income from those who lent money to those who borrowed, in many cases irresponsibly. We can debate the morality of that, but as a first approximation I don’t see how lenders in general are in a better position if unemployment stays high. Each lender would of course prefer that her debt was not inflated away, but inflating away the debt of other lenders improves the job prospects of her lenders and lowers her default rates. Thus on net it is possible for lenders to benefit from moderately higher inflation.

In addition we can see inflation as increasing the value of collateral. In a 5% inflation environment real high house prices can continue to gently fall while nominal house prices stay the same or even rise. This provides more security to the system.

Finally, of course inflation gives us the ability to generate negative interest rates in the short term and increase the attractiveness of investment. Obviously this is not sustainable over the long or even medium term. However, it does not need to be. Falling unemployment rates will increase consumption and allow us to reduce the incentive for investment. In the short term, however, what we need is more investment and negative real rates seem the most plausible way to get there.

About these ads