Sunday, October 3, 2010

Inflation might be good right now.

We are between a rock and a hard place. Normally, we should pay down debts when the economy is booming (this slows the economy) and increase government debt levels (which stimulates the economy) during lean times. Unfortunately, Bush squandered the Clinton surpluses on two wars and tax cuts, so now that we need the flexibility to increase deficit spending it doesn't look like we can do so without risking that the Chinese will worry that inflation will eat away the value of their US Treasury holdings and reduce the amount of our debt that they will finance. We'd end up with inflation, rising interest rates, and a weaker dollar. That might not be so bad.

My friend Eric was advocating for a payroll tax holiday, financed by debt but was worried that it would spark an inflationary spiral.

What would inflation do?

Inflation would reduce the number of homes that were underwater as real estate prices inflated and homeowners would have less trouble paying mortgages. This would strengthen banks with large mortgage holdings.

Our national debt would become more manageable since most is at a fixed interest rate.

If China reduced purchases of Treasuries the Yuan would strengthen, helping our balance of trade without a trade war. US manufacturers would become more internationally competitive. China might be forced to allow the standard of living to rise (to reduce the surplus they run and invest in treasuries). This would stimulate demand for imports and help the entire world's economy.

What about runaway inflation?

1. It is easier to stop an inflationary spiral than a deflationary one.
2. Runaway inflation is unlikely to take hold since there is slack in the labor and real estate markets.

What about the effect on retirees and those on fixed incomes? Many benefits (social security, medicare) will adjust. 401K stock values will inflate. Retirees will be able to invest at non-zero interest rates.

The payroll tax holiday would also help redistribute wealth, reducing the lopsided distribution we now have that leads to speculative bubbles caused by the wealthy having too much to invest and retards growth because the middle class has little room to spend. Robert Riech makes a very detailed argument for this in his latest book.