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Inflation is the lesser evil in such a crisis
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By Kenneth Rogoff

It is time for the world's major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today's epic debt morass.

Yes, inflation is an unfair way of effectively writing down all non-indexed debts in the economy. Price inflation forces creditors to accept repayment in debased currency.

Yes, in principle, there should be a way to fix the ills of the financial system without resort to inflation. Unfortunately, the closer one examines the alternatives, including capital injections for banks and direct help for home mortgage holders, the clearer it becomes that inflation would be a help, not a hindrance.

Modern finance has succeeded in creating a default dynamic of such stupefying complexity that it defies standard approaches to debt workouts. Securitization, structured finance, and other innovations have so interwoven the financial system's various players that it is essentially impossible to restructure one financial institution at a time. System-wide solutions are needed.

Moderate inflation in the short run - say, 6 percent for two years - would not clear the books. But it would significantly ameliorate the problems, making other steps less costly and more effective.

True, once the inflation genie is let out of the bottle, it could take several years to put it back in. No one wants to relive the anti-inflation fights of the 1980s and 1990s. But right now, the global economy is teetering on the precipice of disaster. We already have a full-blown global recession. Unless governments get ahead of the problem, we risk a severe worldwide downturn unlike anything we have seen since the 1930s.

The necessary policy actions involve aggressive macroeconomic stimulus. Fiscal policy should ideally focus on tax cuts and infrastructure spending. Central banks are already cutting interest rates left and right. Policy interest rates around the world are likely to head toward zero; the United States and Japan are already there. The United Kingdom and the euro zone will eventually decide to go most of the way.

Steps must also be taken to recapitalize and re-regulate the financial system. Huge risks will remain as long as the financial system remains on government respirators, as is effectively the case in the US, UK, the euro zone, and many other countries today.

Most of the world's largest banks are essentially insolvent, and depend on continuing government aid and loans to keep them afloat. Many banks have already acknowledged their open-ended losses in residential mortgages.

As the recession deepens, however, bank balance sheets will be hammered further by a wave of defaults in commercial real estate, credit cards, private equity, and hedge funds. As governments try to avoid outright nationalization of banks, they will find themselves being forced to carry out second and third recapitalizations.

Even the extravagant bailout of financial giant Citigroup, in which the US government has poured in $45 billion of capital and backstopped losses on over $300 billion in bad loans, may ultimately prove inadequate. When one looks across the landscape of remaining problems, including the multi-trillion-dollar credit default swap market, it is clear that the hole in the financial system is too big to be filled entirely by taxpayer dollars.

Certainly, a key part of the solution is to allow more banks to fail, ensuring that depositors are paid off in full, but not necessarily debt holders. But this route is going to be costly and painful.

That brings us back to the inflation option. In addition to tempering debt problems, a short burst of moderate inflation would reduce the real (inflation-adjusted) value of residential real estate, making it easier for that market to stabilize.

Absent significant inflation, nominal house prices probably need to fall another 15 percent in the US, and more in Spain, the UK, and many other countries. If inflation rises, nominal house prices don't need to fall as much.

Of course, given the ongoing recession, it may not be so easy for central banks to achieve any inflation at all right now. Indeed, it seems like avoiding sustained deflation, or falling prices, is all they can manage.

Fortunately, creating inflation is not rocket science. All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20 or 30 percent instead of 5-6 percent.

Indeed, fear of overshooting paralyzed the Bank of Japan for a decade. But this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary.

It will take every tool in the box to fix today's once-in-a-century financial crisis. Fear of inflation, when viewed in the context of a possible global depression, is like worrying about getting the measles when one is in danger of getting the plague.

The author is a professor of economics and public policy at Harvard University and was formerly chief economist at the IMF

(China Daily via Project Syndicate December 5, 2008)

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