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The practical inflation question has little to do with rational policy [ClearOnMoney]
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The practical inflation question has little to do with rational policy

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Commentary

The practical inflation question has little to do with rational policy

16 Mar 2010 by Jim Fickett

There has been considerable discussion lately in the press of whether somewhat higher inflation would be in the interests of the nation. This policy discussion has occasionally been confused with the much more pragmatic question (for investors) of whether inflation is a likely outcome of the current fiscal stress. The two should not be confused, and the fact that high inflation is probably not a rational policy makes it no less likely.

There has been much recent discussion about whether a higher inflation rate is in the rational interest of the country. For example CNNMoney published an article on 11 Mar 2010 entitled, Why the U.S. can't inflate its way out of debt. It is good that, in this policy discussion, the consensus seems to be that inflation is not a good national strategy.

Some have, however confused the theoretical question of whether inflation is a good strategy with the practical question of whether inflation is likely to occur. For example, in an article widely quoted since, Megan McArdle, the business and economics editor for The Atlantic, wrote last summer,

It is a commonplace on the right that we're going to have enormous inflation, not because Ben Bernanke will make an error in the timing of withdrawing liquidity, but because the government is going to try to print its way out of all this debt. …

Inflating your way out of debt works if you're planning to run a pretty sizeable budget surplus–big enough that you won't have to roll your debt over. Otherwise, your debt starts to march upward even faster, as old notes come due, and you have to roll them at ruinous interest rates. Hyperinflation might wipe out that debt, but also your tax base.

The unspoken assumption in the above article is that the federal government is likely to carefully think through the options regarding inflation and choose a long-term, rational, strategic plan. As low inflation is smarter than high inflation, that will be the outcome.

Sure thing.

Think about the way Congress really works, in which everyone agrees that the budget should be cut … somewhere else. Think about the way spending is hidden off balance-sheet, and a formal debt limit is imposed … and raised whenever necessary. If we did not have an independent central bank, and Congress had the ability to create money, can anyone really doubt that it would fail to do so?

From a theoretical economic policy viewpoint, the right question may well be, 'What is a rational strategy for the nation?' However from a pragmatic investor viewpoint, the question is, 'If rising interest on the national debt makes it impossible to continue entrenched spending plans, what is likely to happen?'

Certainly cutting back on spending is one possibility. Judging from the historical record, defaulting on the debt, either explicitly or through high inflation, is also a real possibility.

Recall the McKinsey study on the aftermath of credit bubbles, mentioned earlier. Their study of the historical record showed:

While we cannot say for certain that deleveraging will occur today, we do know empirically that deleveraging has followed nearly every major financial crisis in the past half-century. We find 45 episodes of deleveraging since the Great Depression in which the ratio of total debt relative to GDP declined, and 32 of them followed a financial crisis. …

historic episodes of deleveraging fit into one of four archetypes: 1) austerity (or “belt-tightening”), in which credit growth lags behind GDP growth for many years [16 of 32 cases that followed a financial crisis]; 2) massive defaults [8 cases]; 3) high inflation [7 cases]; or 4) growing out of debt through very rapid real GDP growth caused by a war effort, a “peace dividend” following war, or an oil boom [1 case].

I.e., in about half the cases, inflation or outright default won out over austerity.

The real questions, then, are:

There is no obvious answer to either question. Hence, though inflation is no sure thing, it is a very serious danger.