Inflation as Generic Debt Forgiveness
By Arnold Kling
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 resorting 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.
I agree that the rescue plans are confounded by the complexity of the contemporary financial system. But I worry about trying to achieve 6 percent inflation as a way of easing credit risk. Maybe you do manage to reduce credit risk. But then at some point you kill some institutions with interest rate risk, because eventually nominal interest rates will rise and folks will be stuck with long-term bonds that lose value. In fact, high nominal interest rates tend to hurt the economy, even if real interest rates are low. They make house payments high relative to incomes, and they seem to depress stock prices (see the 1970’s).
Actually, the more I think about the inflation idea, the less I like it. I give Rogoff credit for thinking outside of the box of rescue plans, but I’m not a fan of the inflation strategy.
Thanks to Mark Thoma for the pointer.