Debtflation

October 23, 2009 By Spyros Andreopoulos London The recent downturn has called many of the old certainties into question. In the world of central banking, a prominent victim of the downturn is the - previously orthodox - view that central banks should neglect asset prices when conducting monetary policy. Yet more recently, another major tenet of central bank doctrine is being challenged - the view that monetary policy should not be used to help out governments under debt pressure. We think that the risk of independent central banks creating some amount of (controlled) inflation going forward cannot quite be dismissed out of hand. We have flagged inflation as a major long-term risk going forward: if the recovery is as tepid as we expect, central banks will be inclined to err on the side of caution when it comes to withdrawing the unprecedented conventional and unconventional monetary stimulus. But we believe that there will be a familiar additional source of inflation risk - the mounting public debt burden. There is no doubt that, last winter, with the global economy slumping, central bankers welcomed the help they got from hugely expansionary fiscal policy. However, the result has been a massive increase in developed countries' public indebtedness - the extent of the debt build-up in some countries resembles the consequences of wars. Historically, developed economies have escaped high debt by growing out of it rather than inflating it away or defaulting (with the notable exception of Germany and Japan). Growth after World War II for example was fast, not least because war-ravaged economies were rebuilding their capital stocks. This time around, however, eroding the debt through faster growth may not be an option. Instead, growth in many developed countries is likely to slow significantly going forward as labour forces shrink due to the demographic transition. Worse, population ageing will impose added pressure on public expenditure through higher pensions and healthcare costs. If outgrowing the debt is unlikely, and if governments lack the resolve to cut spending and/or raise taxes sufficiently, the remaining options are default and inflation. No policymaker in the developed world - and, by now, few in the developing world - would want to countenance default as an option. This leaves inflation. The question is familiar: could central bankers be forced to engineer inflation - ‘monetise the debt'? Almost all developing world central banks are independent from an institutional point of view. Indeed, one of the main reasons for setting up independent monetary authorities is precisely to avoid pressure from governments to inflate away the debt. So, central banks cannot be forced by their governments to generate inflation (unless governments were prepared to change the statutes of their monetary authorities; this would in most cases require going to the legislature). With governmental coercion being unfeasible, is there a possibility that independent central bankers might generate inflation out of their own volition? If nothing else, they would take a big gamble with their hard-won credibility. And history teaches us that the reason behind most, if not all, episodes of very high inflation has been monetary expansion to finance government expenditure or reduce debt (see "Could Hyperinflation Happen Again?" The Global Monetary Analyst, January 28, 2009). Still, there is a reason why a rational and forward-looking, independent central bank may want to consider generating (some) inflation. If the fiscal path is deemed unsustainable, it may be preferable to create limited inflation early on - to nip the debt problem in the bud - rather than to allow a mounting debt burden and having to inflate a lot more in the future. So, it may be best to bite the bullet and allow inflation now. But how does one avoid throwing the credibility baby out with the debt bathwater? Above all, if a central bank is to inflate, it has to do so in a controlled fashion. Former IMF Chief Economist Kenneth Rogoff's proposal of a 6% inflation target for a limited period of time could be a way of doing it. We think that for Rogoff's proposal to work, the central bank would have to communicate explicitly to the public the level of inflation targeted, the duration of the new policy, and the timeframe for a return to a lower target - the exit strategy. Another possibility would be to adopt price level targeting (PT). As we have argued before, PT could give the central bank wiggle-room to allow inflation to drift above target for some time without unanchoring inflation expectations (see "From Inflation Targeting to Price Level Targeting", The Global Monetary Analyst, July 15, 2009). If implemented correctly, the public would know that prices would ultimately return to the target path as the overshoot would eventually have to be corrected by an undershoot. Still, the risks for a central bank that follows such a strategy are substantial. Beyond putting its credibility at stake, there could be a run on assets denominated in that central bank's currency. And that's not to mention the political ramifications - inflation is known to redistribute wealth from lenders to borrowers. Yet, policymakers have shown that they are prepared to resort to unprecedented means if circumstances demand. We live in interesting times.