Monday, December 22, 2008

Steve Chapman's Strange Defense Of Inflation

I see via Anthony Gregory that over at Reason magazine, Steve Chapman argues that inflation is the solution to the current downturn.

He has the following arguments for that assertion: first, he argues that inflation is a substitute for increased government spending, and inflation is a lesser evil. Second, it would increase consumer spending by making credit more available and lowering the incentive to postpone purchases. Thirdly, he argues that by redistributing for debtors to creditors, one makes both a favor since the debtors will become more solvent and so reduce defaults, which will benefit creditors. Fourth, he claims that this would actually speed up adjustment of the housing sector by bidding up prices in other sectors more than house prices.

The argument that inflation is a substitute for government spending makes no sense, because first of all under current circumstances inflation is in fact government spending. The way the government achieves inflation is by having its agency the Federal Reserve buy up all kinds of assets in order to expand the monetary base, which in de facto terms is little different from TARP. And the only way it can avoid buying private assets, is for the Treasury to issue more Treasury securities in order to expand government spending. So, government spending is not a substitute for inflation, it is the way inflation is achieved.

As for inflation promoting consumer spending, there is some truth to that, as it usually lowers real interest rates. But insufficient consumer spending is hardly the problem in an America with a all too savings rate.

His argument that inflation is the best way to restore the value of the assets backing mortgage backed securities (houses) is difficult to square with his argument later that inflation would raise other prices more than house prices . Under the current circumstances, I think the argument that house prices would benefit less than other prices is probably correct. But that means that in order to make a really meaningful difference in terms of house prices, you'd have to bring on really serious level of inflation, at least a double digit level of inflation, a level which is really damaging in the long term. And to break that will be anything but painless, as the serious slump Paul Volcker brought on in 1980-82 to break inflation illustrates.

As for the argument that inflation is beneficial for both creditors and debtors, that first of all assumes that inflation will raise nominal income for troubled debtors, and raise it more than their cost of living. If the price of gas increases from $2 per gallon to $4 per gallon, that sure won't make it easier for home owners to spare enough money to make their mortgage payment, it will in fact make it more difficult. Only if their nominal income rises more than their nominal cost of other expenditure will it make it easier for them to pay their mortgages. And it is far from certain that that will actually be the case.

And moreover, even assuming for the sake of the argument that debtors will benefit from inflation, is it really true that creditors will benefit? Only if first of all the value of the repaid mortgages in the case of borrowers who will be able to pay back their loans because of inflation will exceed the value of foreclosed properties in the absence of inflation. But since the value of foreclosed property is ultimately based on the ability to pay of any interested owner, this would require that somehow the income of current owners would be disproportionably boosted in order for the decline in real value of the mortgage to be lower than decline in value for creditors that foreclosure would mean, something which seems implausible in most cases. And moreover, that supposed surplus must exceed the large losses they make in the case of mortgages that would have been paid off anyway, or where no disproportionate income gains for borrowers occur, making it a lot more likely that they will lose a lot.

As for speeding up the relative decline of the housing sector, that may be true, but only in the sense that the housing bubble speeded up the relative decline in business investment after the end of the tech stock bubble. Or in other words, assuming that house prices will be bid up less than other prices, it will not create a new housing bubble, but it could create another bubble. And as the housing bubble created to reduce the pain from the tech stock bubble sure wasn't, nor is another bubble in a new sector a good idea.


Anonymous newson said...

chapman - "hair of the dog".

hey, merry christmas to you swedes! below the tropic of capricorn, we're going to be sweating it out on the beach, and tarting up the house with aerosol snow.

1:58 AM  
Blogger stefankarlsson said...

Merry Christmas to you Aussies! Up here in the north we may not be able to sweat on the beach this time of the year, but we are capable of finding ways to do it in other places.

8:56 AM  
Anonymous Per-Olof Samuelsson said...

Merry non-inflationary Christmas to everyone! (If possible.)

9:16 AM  

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