Controlled-Burn Inflation

The following expresses my personal views, not those of the SEC or its staff.

Suppose all the Good Guys (Joe Consumer and Homeowner) are loaded with debt, and suppose that this debt is payable to the Bad Guys (Rich People and Foreigners). What can you do about it? Oh, and also suppose that the debt is mostly in nominal terms.

Answer: You inflate.

We cringe when inflation is mentioned. Maybe it is from the horror stories of hyperinflation; maybe it is from memories of the inflationary episode of the mid-1970s. (Remember Ford’s WIN buttons)? But I am not talking about hyperinflation, or even inflation in the double digits. Rather, a controlled burn inflation, something that is, say, in the six or seven percent range. Something that will drop the debt burden by twenty or thirty percent after a few years.

On the positive side, controlled-burn inflation will drop the real obligations we will “pass on to our children” – put that phrase into Google and see how many hits you get – for our $8 trillion of public debt. It will reduce the real effect of our nearly $1 trillion to China – China being recently highlighted by Paul Krugman as a Big Problem of 2010. Not to mention the nearly equal amount we have with Japan, which Krugman does not see being as much of a problem. It will drop the real debt obligation for mortgage borrowers in terms of their principal, and, for those with fixed rate mortgages, drop the real cost of servicing their debt as well. Anyone with adjustable rate mortgages or short-term revolving debt will be running in place in terms of their debt servicing. But the real value of their principal obligation will drop for them as well.

The negative is the stickiness of wages versus prices. For those who remember the 1970’s, it seemed like wage levels were always one step behind in ratcheting up to meet the higher prices. And there were costs in making the price adjustment, both in terms of processing and informational lags. But we are in a different world today, and I wonder if the frictions of a “helicopter drop” would be anywhere near as significant. In our electronic age, prices can be adjusted with far less cost, information on prices is quickly and cheaply accessible. And I believe wages can similarly be adjusted for less cost; there are fewer institutional and processing constraints to keep wages sticky – although this is a proposition that has not had to be broadly tested because inflation has been a non-issue for a generation.

To do inflation right, you have to be a little sneaky. Especially if you don’t want your creditors feeling totally screwed and have them walk away the next time you need to borrow. Don’t announce it as a policy. Have it just happen. In fact, have it happen in spite of all of your best efforts to reign it in. So you need a controlled burn that looks like it is spontaneous. Who knows, maybe this idea actually is making the rounds.


Originally published at Rick Bookstaber’s Blog and reproduced here with the author’s permission.

29 Responses to "Controlled-Burn Inflation"

  1. MG   January 7, 2010 at 10:57 am

    All this talk of controlled inflation or the deliberate use of inflation as a policy tool is so absurd that I don’t know where to begin. First, consider the basic logic that all your “evil” creditors cannot be so dumb as to sit by and let inflation do its thing -if they were that dumb, they probably would not have managed to become net creditors in the first place. What happens in practice is that interest rates go up and stay up at the first hint of inflation.Second inflation has a myriad of effects, only one of which is to temporarily reduce the real value of existing (fixed-rate) debt. Look at the empirical evidence in countries which have had high inflation, and the chaos experienced. Labour union negotiations anyone? Consumer purchasing power? Confidence goes down, the risk premium on everything goes up. The result is a toxic mix of asset de-ratings (look at how equities have done in high inflation countries and weep) and plunging consumption.This is sort of like a rich frat kid shooting his mouth off about a little fun with crack. He should go downtown and see a few a crack houses first.