Is Inflation the Answer?

CHICAGO – Recently, a number of commentators have proposed a sharp, contained bout of inflation as a way to reduce debt and reenergize growth in the United States and the rest of the industrial world. Are they right?

To understand this prescription, we have to comprehend the diagnosis. As Carmen Reinhart and Kenneth Rogoff argue, recoveries from crises that result from over-leveraged balance sheets are slow and typically resistant to traditional macroeconomic stimulus. Over-levered households cannot spend, over-levered banks cannot lend, and over-levered governments cannot stimulate.

So, the prescription goes, why not generate higher inflation for a while? This will surprise fixed-income investors who agreed in the past to lend long term at low rates, bring down the real value of debt, and eliminate debt “overhang,” thereby re-starting growth.

It is an attractive solution at first glance, but a closer look suggests cause for serious concern. Start with the question of whether central banks that have spent decades establishing and maintaining anti-inflation credibility can generate faster price growth in an environment of low interest rates. Japan tried – and failed: banks were too willing to hold the reserves that the central bank released as it bought back bonds.