Inflation vs Austerity

When facing unsustainable sovereign debt dynamics, a country which is a currency printer* may response with any of the following three approaches (ranked from most to least common): fiscal austerity, a period of heightened inflation, and default. The conventional wisdom is that default is so devastating that it should be avoided at all costs, and while this may not necessarily be reflective of reality (see Iceland, among others) I do not intend to challenge that assumption here.

I would like to debate inflation versus fiscal austerity as approaches to unsustainable sovereign debt. Once again, conventional wisdom (which weighs in overwhelmingly on the side of austerity) appears to have stifled any real discussion in this direction. I suspect that this is due to policymakers’ memories of the stagflation era, and the extraordinary efforts of Volcker et al required to get inflation under control. This has led to a “don’t let that rabbit out of the hat again” mentality, effectively removing a period of heightened inflation from  policymakers’ toolkits.

Not being old enough to remember the aforementioned era removes leaves me more suited to engage in a measured assessment of inflation as a sovereign debt policy tool. The way I see it, the fear of inflation becoming ingrained is misplaced. I am a subscriber of the balance-sheet recession theory (is there really any debate left here?) which posits that the private-sector deleveraging we are witnessing causes considerable deflationary pressures in the economy. In such an economy, if monetary authorities generate elevated inflation, inflation may be brought back into target ranges simply by scaling down or reversing the inflation-stimulating policy.

Sticking to more conventional economics, concerns over ingrained inflation are still misplaced. Inflation-indexed wages negotiated by unions have been identified as a major driver of the persistence of inflation in the 1970s. Due to the sustained downtrend in union density in developed economies, this simply would not be a factor this time around, implying much less inflation "staying power."

A final argument against persistent inflation is the credibility that policy makers have attained in 15 to 20 years of largely successful inflation targeting. If policy makers were to explicitly target a given level of inflation until government debt fell to a predetermined level (or for a pre-specified period of time), and commit to a reversion to more traditional policy thereafter, I suspect that such commitments would be viewed as credible by the private economy.

Having established the reversibility of heightened inflation in today’s context, let’s consider its effects. With the exception of inflation-linked notes, all debt is denominated in nominal currency units, which means that inflation of say 5% is a very effective method of reducing the national debt burden. Who suffers from such a policy? Two demographics: (1) creditors (ie the rich), who have the real value of their savings eroded, and (2) the poor, who feel the most acute pressure from rising price levels. The middle class also feels the squeeze of rising prices, but not to the same extent as the poor. While no solution to unsustainable government debt is pleasant, these consequences are arguably more efficient than those of austerity.

In the case of austerity, the brunt of the pain is borne by the lower and middle classes. This is because, when compared with the rich, this area of the income curve is more reliant on government programs than the rich. Naturally, the poor again are the hardest hit, as they are the most reliant on government programs. Given that they are not as reliant on government spending the rich are left relatively unscathed. Additionally, fiscal austerity tends to lead to sustained periods of below-trend growth (or more usually, widens and sustains an existing gap between trend and realized growth), which has serious ramifications across the income spectrum.

Furthermore, taking the cynical view, inflation is also arguably more efficient from a social unrest perspective. While inflation leads to a slow burn of discontent (via slow, steady increases in price levels), government austerity has much more recognizable, tangible effects, such as the cutting of wages in the public sector, or a reduction in welfare benefits. Such identifiable consequences may come to represent rallying points for social unrest.

The reasoning above leads me to conclude that elevated inflation should at least enter the policy arena, although admittedly it would have to be precluded by an integration of monetary and fiscal policy, similar to  that advocated by Cullen Roche at The Pragmatic Capitalist (here).

*Currency printers (ie the US and UK) differ from currency users (any member of the EMU) in that they determine their own monetary policy, and therefore inflation.