INFLATION IS OUR FRIEND?

OK, I should have been a bit clearer in my previous post where I discussed economist Paul Krugman's take on why the United State might be able to escape a bout of inflation. Here's what I should have included ...

In a few words, Krugman writes in The Return of Depression Economics that Japan's history during the 1990s is critical to understand because Japan experienced a banking collapse, which was brought on by a speculative real estate bubble that popped. Shades of America in 2008-2009, right? The collapse was followed by a massive transfer of government (i.e. taxpayer) funds that resembled our stimulus program, and an interest rate reduction that kept the cost of money effectively at zero.

So what happened in Japan? Economic stagnation. Banks could/would not lend, stimulus money (or deficit spending) did not work, and people would not spend/invest. As Krugman points out, this is what economists call a "liquidity trap."

A liquidity trap, if I can continue to oversimplify, is cheap money coupled with no spending.

This explains, in part, what kept inflation low in Japan and - according to economists today - is what's keeping inflation relatively low in the United States today (I'm not sure I agree because of international considerations, but that's another story). Krugman's solution for getting out of our current liquidity trap is rather simple and, for some, a scary proposition: Inflation.

The first thing someone might think about when they think of inflation is that it has the same effect as if you started burning your money: you have less and less of it. This may be true. But according to Krugman (and other economists) if inflation occurs during a liquidity trap, and people are afraid their money will be worth less in the future, they will eventually be compelled (scared?) into spending and investing. Why sit on $1,000 today if it's only going to be worth $800 next year?

So, in a few words, we are left with two options. First, in spite of record deficits we can keep inflation at bay if we're willing to suffer through a liquidity trap of cheap money with little spending. Or, we can court inflation which will help convince market players to spend and invest.

An interesting set of options indeed.

- Mark