Causes Of A Great Inflation: Tunneling For Resurrection

Here is Ben Bernanke’s problem.

1. The financial sector is busy setting up arrangements in which employees are guaranteed high levels of compensation if they stay on through the difficult days ahead.  These retention-type payments allow firms to survive in their existing form, pursue business-as-usual, and gamble for resurrection, i.e., make further risky investments.

2. But these same payment schemes, e.g., Goldman Sachs’ loans-for-employees deal, are a form of poison pill with regard to further bailouts – the Administration may want to help these firms down the road, but this kind of tunneling means Congress will put its foot down.  Do you think that President Obama’s $750bn for bailouts (scored as $250bn) will survive the budget process?  No New Bailout Money is a slogan reaching from here to the midterm congressional elections.

3. And the financial system is in big trouble.  Unless the economy turns around, somewhat miraculously, we are in for a big slump.  Or even for a Great Depression – watch closely the words and body language in Bernanke’s interview on 60 Minutes.

The big banks are essentially making themselves Too Politically Toxic To Rescue, and this has potentially bad macroeconomic consequences.  So what will Bernanke do?

As he sees the world, there is only one course of action remaining: print money and hope for a moderate degree of inflation.  The money part was, of course, the announcement yesterday from the Fed.

The inflation part is a leap of faith.  If inflation is driven by the so-called “output gap,” i.e., how far the US economy is below potential output, then prices will not increase much, the yield curve steepens moderately, and banks make out like bandits (it’s just an expression).

But if the whole world is moving more into an emerging market-type situation then (a) inflation expectations become deanchored (central bank jargon for “really scary”), (b) potential output falls as we massively deleverage, and (b) people move increasingly into alternative assets – storable commodities spring to mind – and we get some serious inflation.

If oil prices jump, then we have an even bigger inflation problem.  Oil is not storable, supposedly.  But if you can explain to me exactly why oil prices rose as they did during the first part of 2008, despite the slowing global economy, I might be greatly reassured that we are not heading immediately into a runaway inflation spiral.


Originally published at the Baseline Scenario and reproduced here with the author’s permission.

One Response to "Causes Of A Great Inflation: Tunneling For Resurrection"

  1. AWB   March 20, 2009 at 9:08 am

    GO COFFEE!!!!!