Monday, November 23, 2015

Inflation Drumbeat

Noah Smith has an interesting Bloomberg View piece on Japanese inflation. Three crucial paragraph struck me
... Japanese unemployment is very low, and the economy is expanding at or above its long-term potential growth rate of around 0.5 percent to 1 percent. So according to mainstream theory, inflation would be an unnecessary and pointless negative for Japan’s economy. Why, then, are there always voices calling for Japan to raise its inflation rate?
Actually, there are several reasons. The main one is that inflation reduces the burden of debt. Japan’s enormous government debt represents the government’s promise to transfer resources from young people (who work and pay taxes) to old people (who own government bonds). Since Japan is an aging society, there are more old people than young people. That makes the burden especially difficult to bear. Young people also tend to have mortgages, the repayment of which is another burden.
Sustained higher inflation would represent a net transfer of resources from the old to the young. That would increase optimism, and hopefully raise the fertility rate, helping with demographic stabilization. It would also decrease the risk that the Japanese government will eventually have to take extreme measures to stabilize the debt.
I like these paragraphs because they so neatly distill the language used by the standard policy establishment to advocate inflation. Noah clearly separates the usual "stimulus" arguments from the new "debt" argument, which helps greatly.

Debt is a "burden." Sort of like snow on your roof, debt appears from the sky somehow and then represents a "burden" requiring "lifting," which would be beneficial to all.

Debt "represents the government’s promise to transfer resources from young people ... to old people.." Apparently, the government woke up one morning, and said "we promise to grab about two and a half years worth of income from young people and give it to old people." Undoing such an ill-advised promise does indeed sound worthy.

But, lest these soothing words lull you into idiocy, let us remember where debt actually comes from. The Japanese government borrowed a lot of money from people who are now old, when they were young. Those people consumed less -- they lived in small houses, made do with fewer and smaller cars, ate simply, lived frugally -- to give the government this money. The promise they received was that their money would be returned, with interest, to fund their retirements, and to fund their estates which young people will inherit.

Noah is advocating nothing more or less than a massive government default on this promise, engineered by inflation. The words "default,"  "theft," "seizure of life savings," apply as well as the anodyne "transfer." I guess Stalin just "transferred resources."


Amazingly, to Noah (and the views he ably summarizes here) this "transfer" will "increase optimism." Hmm. Let's look at the evidence for that. We have seen many large inflations, which wiped out middle-class savings along with government debts. Those events have generally been regarded as economically, politically, and psychologically destabilizing tragedies, not FDR-fireside-chat "optimism"-raising sessions. No surprise that few societies have voluntarily signed up for such treatment as Noah recommends. I would be curious to hear of a single happy historical antecedent. (I mean that. Perhaps I am mistaken in my understanding of Noah's proposal. A successful example might correct me.)

How does a government default benefit young people anyway? It does so if a large amount of tax revenue is being used to pay interest or principal on the debt, and the default is accompanied by a large tax cut for young families. Not by the same level of taxes and increased government spending on more railway-to-nowhere stimulus projects.  Without tax cut, there is no transfer. Noah is strangely silent on the essential big tax cut aspect of his plan.

Quiz: Find in Japanese (or American) government finances the actual "promise to transfer resources from young people (who work and pay taxes) to old people." If you say "government bonds," you (like Noah) got the wrong answer. The right answer is Social Security, Medicare, and public employee pensions. If Noah wishes to reduce the "burden" of intergenerational transfers, no matter that governments have promised to make those transfers and people have planned their lives around them, the silence on these promises is deafening.

If the purpose is default, why not just advocate default? A massive inflation also destroys private savings and wipes out private contracts. Oh wait, that's the point:
Young people also tend to have mortgages, the repayment of which is another burden.
Like the government, young people too I guess woke up one day and this "burden" parachuted down on top of their surprisingly big house.

So, according to Noah, a self-induced hyperinflation to generate an economy-wide debt default is necessary... to "decrease the risk that the Japanese government will eventually have to take extreme measures to stabilize the debt." I find it hard to imagine what more extreme measures he has in mind.

One practical difficulty: Like most governments, Japan rolls over debt fairly frequently. So inflation must come really quickly if it is to wipe out debt. A second practical difficulty: The BOJ, like our own Fed, seems completely unable to induce any inflation. With advice like this, thank goodness.

Another puzzle: What exactly is the "burden" of Japan's debt? Japan's interest rates have been zero for 20 years. Japan's growth rate g, as low as it is, is larger than its interest rate r. Japan pays next to nothing in debt service.  Is Noah joining the despised ranks of worrywarts like me that this can't last? But if it comes to an end, in a run on Japanese government debt and consequent inflation, then Noah gets what he wants. If it does not come to an end, Japan pays no debt service and gradually grows out of the debt. Where's the fire?

Again, this is not a post about Noah. One writes columns quickly, and space often prevents a full development of arguments.  I am resolved not to discuss or even imply criticism of a writer's motives, so if you infer that, undo the inference now.

Rather, let us appreciate and dissect Noah's language, logical loose ends, insouciant willingness to upend the lives of millions, and answers in search of questions, for how well they summarize so much policy blather; and therefore not to be lulled by that blather's repetition.  

15 comments:

  1. I think Noah's piece is indicative of the larger failure of popular (i.e, IS-LM style) macro-economics to incorporate rational expectations of agents. People aren't stupid (and you would be, if you think otherwise). The inflation lever that Noah suggests can be pulled only once. After that, you've shown yourself to be incapable of keeping your promises, which raises borrowing costs. How does that help?

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  2. Well, one argument would be that bondholders benefited from lower-than-expected inflation in the 1990s. This also had the side effect of lowering inflation expectations. Now we need higher-than-expected inflation to undo the earlier transfer and to restore expectations to target. It would have been better to have and achieve a clear target from the beginning.

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  3. The fact that Japan's public debt is owned domestically is often cited as an advantage (and, per Krugman, a reason why high government debt isn't a problem). After all, the government's liability is someone else's asset. But, If you want to engage in the game of inflating away your public debt, as Noah Smith suggests Japan should, it isn't as damaging if it is foreigners whose oxen are gored.

    A much more straightforward solution to achieve what Noah is suggesting would be to enact a steep estate or inheritance tax on those old folks. Seize the assets when they die. Or, establish a special (higher) rate of tax on Japanese bond interest. The difference between those solutions and the proposed inflation is that the former has to go through the political process and the latter does the dirty work indirectly. Why isn't Noah Smith (and others) who favor high inflation as the policy solution frank enough to admit that that's the main advantage?

    Alas, there is no easy way out for Japan.

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    1. The estate tax is an interesting wrinkle, and an often overlooked fact about how Japan can escape its large debt. But Noah justified inflation by a transfer from "old" to "young." Estates also transfer assets from "old" to "young." Now it turns in to just which young get the money.

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    2. Yes, that's what Noah uses as a justification. But, as I think you previously noted, inflating away the assets of those older bondholders eats into an estate, too---in much the same manner as an estate tax would. The generational transfer is not as simple or easy as Noah would have us believe.

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  4. As someone who lived through the late 1970s and early 1980s I know that inflation puts enormous cash flow burdens on debtors when they are required to pay high nominal rates that incorporate an allowance for inflation. Count me as opposed to the inflation as debt relief argument.

    The other argument for inflation is that it will deal with downward stickiness in wages and thereby stimulate the economy. But for that to be true there must be: (1) a large group of people; (2) who's real wages are materially in excess of a current market rate; but (3) who lack the bargaining leverage to get a cost of living increase on their pay checks. To the "downward sticky" people I ask: who are these overpaid people; how many are they; how much are they overpaid by; how did they get to being overpaid without having the power to extract a cost of living increase; and how would materially cutting the incomes of a materially large number of working people stimulate the economy?

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  5. I am a big fan of both John Cochrane and Noah Smith. I've been reading their blogs for years.

    However, I have to ask: Have you actually published anything, Noah? I see that you have a handful of working papers but that's it. I see zero publications let alone a single R&R. Cochrane's reputation and scholarship are outstanding -- what about you? I don't mean to criticize. I think your blog and Bloomberg column are excellent but is this all you do at SUNY Stony Brook?

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    1. Let me defend Noah here. In science, your arguments are either true or false. Authority carries no weight. That I might have written things in the past that got published in academic journals gives me no special authority above what I can argue by logic and fact. There are plenty of Nobel Prize winners far more illustrious than me, who on occasion write drivel. I certainly don't want to accept he who has the most accolades is right, or I would have to be quiet about that. Finally, if Noah ends up being a literate economic journalist with no academic publications, that activity will have great value, given the amount of completely incoherent economic journalism out there. I still think he got it wrong here, but we argue on facts and logic, not on vitas.

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  6. "Noah is advocating nothing more or less than a massive government default on this promise, engineered by inflation. The words "default," "theft," "seizure of life savings," apply as well as the anodyne "transfer.""

    How is this different than what the Fed says it wants to do?

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  7. John,

    "The main one is that inflation reduces the burden of debt"

    So does converting that debt to equity.

    "How does a government default benefit young people anyway? It does so if a large amount of tax revenue is being used to pay interest or principal on the debt, and the default is accompanied by a large tax cut for young families. Without tax cut, there is no transfer. Noah is strangely silent on the essential big tax cut aspect of his plan."

    No default necessary. Instead of giving a tax break to young families, Japanese government sells time discounted tax breaks ($1 Yen paid now will cover $1.20 Yen in tax liability 5 years from now) to young families. Japanese government uses proceeds of sale to buy back it's debt.

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  8. Pace the first commenter, I think it's John who's forgetting rational expectations here. Assuming RE, the purchasers of Japanese government bonds are hardly the virtuous but naive yeomen John portrays. Rather, they -- at least, in the aggregate -- incorporate an estimate of the risks of future inflation in their bond buying decisions. (Moreover, RE actually holds that their subjective risk assessments are objectively correct, i.e. that the joint probability distributions of all variables is known ex ante.) So: inflation risk is priced into Japanese bonds, and bondholders have been receiving payments for assuming that risk. For decades.

    Side note on "unexpected" inflation: as far as I can tell, "unexpected" inflation was invented simply in order to be able to impute real consequences to monetary policies in a framework in which money is neutral or super-neutral. Policy analysis is just too easy if we "know" that monetary policy has no real results whatsoever...plus we can never say that a particular policy -- such as deliberate high-single-digit inflation -- is "bad." Saying "Oh, but this outcome was a surprise" is equivalent to abandoning RE as a discipline on modelling altogether and falling back to an intuitive "theory" of expectations far more "ad hoc" than anything proposed in the dreaded 1970s.



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  9. Noah basically defends himsel by arguing that the Japanese government screwup with the money they borrowed and now they have to present the bill to savers because there is no other alternative. I find the idea that such an argument has traction preposterous. What about the government stop protecting corporations, become more efficient, adopting policies that let a private economy to thrive, so that productivity increases and the government debt is sustainable and starts to be reduced ?

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