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Krugman Says Inflation Is The Answer

Economics / Inflation Feb 17, 2010 - 07:09 AM GMT

By: Mike_Shedlock

Economics

Best Financial Markets Analysis ArticleInquiring minds are considering The Case For Higher Inflation by Paul Krugman.


Olivier Blanchard, normally at MIT but currently the chief economist at the IMF, has released an interesting and important paper on how the crisis has changed, or should have changed, how we think about macroeconomic policy. The most surprising conclusion, presumably, is the idea that central banks have been setting their inflation targets too low.

I’m not that surprised that Olivier should think that; I am, however, somewhat surprised that the IMF is letting him say that under its auspices. In any case, I very much agree.

No Praise For Blanchard

While Krugman praises Blanchard, I took the opposite view in Inflation Targeting Madness and Economically Illiterate Fools at the IMF.

Inflation Targeting Madness

Taking property prices into consideration, inflation was running well over 4% in 2005-2006.

But Keynesian fools do not measure asset bubbles or housing prices. They only measure their distorted look at the CPI. By the time the Fed reacts to that, bubbles have already been blown and are about to implode.

Imagine Spain and Greece attempting to target for 4% inflation now. Hells bells, imagine the EU to do it in general.

One of the reasons the EU is in trouble now is its one interest rate fits all policy fueled massive inflation in Spain but not Germany.

It is the height of idiocy to think Soviet Union style command economics works. But that is exactly what Blanchard proposes. He wants central bankers to control interest rates, inflation targets, capital requirements, domestic spending, and asset prices.

History has proven central planning to be the height of economic folly. It led to the collapse of the Soviet Union. Bernanke's 2% targeting led to the biggest credit boom and housing bubble in history, yet instead of seeing inflation and cheap money as the problem, Blanchard wants even cheaper money in the asinine belief "higher inflation would make monetary policy more effective in crisis periods."

Real World Q&A

Once again, Krugman supports his view with academic formulas instead of real world functionality.

Let's play real world Q&A.

1Q. In the real world, if the ECB were to target inflation at 4% what would it be in Germany, what would it be in Greece, and what would it be in Spain?
1A. The answers are unknown. However, the higher the inflation target, the bigger the economic distortions between countries in the European Union. Spain had an enormous property bubble that has now burst. Spain also has unemployment above 20%. Somehow we are supposed to believe this would not have happened if the ECB opted for higher inflation. The idea is silly.

2Q. Is there anything magic about a 4% target?
2A. Of course not. The Fed could not spot bubbles at Bernanke's 2% target. Is it supposed to spot them at 4%? Why is 4% better than 3% or 8% anyway? What would our housing bubble or stock market bubble have looked like at 4%? Blanchard and Krugman are guessing at numbers, guaranteed wrong. On the other hand, I am not guessing. The ideal inflation target is zero.

3Q. Can the Fed determine where liquidity goes?
3A. The Fed can only supply liquidity. The Fed cannot determine where the money goes or if it goes anywhere at all. Excess reserves at $1.2 trillion is proof enough. So is Japan's 20 year history of foolish deflation fighting. Bear in mind, the Fed cannot adequately measure prices in the first place.

4Q. Will wages keep up?
4A. They never do.

5Q. What would rising prices do to those out of a job?
5A. Those out of a job would be crucified.

6Q. What about interest on the national debt?
6A. It would soar. The national debt is $12.3 trillion. Interest on the national debt is already $383 billion and rising.

7Q. Who benefits from inflation?
7A. Inflation benefits those with first access to money, the banks and the already wealthy. It is a stealth tax on the middle class and poor whose wages never keep up with inflation. That problem is compounded by rising property taxes, sales taxes, etc, that eats consumers alive. Those at the bottom end of the totem pole get hit even harder. Their wages do not rise and they have no assets to inflate.

8Q. Has printing money ever solved anything? Anywhere?
8A. No.

Three Paths Forward

Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City has no praise for Blanchard either, as noted in "Three Paths Forward" - Kansas City Fed on Current U.S. Fiscal Imbalance, Hyperinflation, Printing

"Last Friday, I read that an economist at the IMF raised a question of whether central banks should allow higher rates of inflation during normal times to give them more room to adjust for shocks. While this may sound like a reasonable theory from a credible economist, my concern is that it rationalizes solutions to short-term problems that too often take an economy down the wrong path. ...

There are no short-cuts. We currently must adjust from a misallocation of resources. There is no way to avoid some short-term pain in fixing the fundamentals in our economy. It is inconvenient for the election cycle, and it is undeniably terrible to have at least 10 percent of the labor force out of work. But short cuts now mean people out of work again in only a few years because we again try and avoid difficult adjustments. Outlining a credible course for managing our debt for the future will accelerate the restoration of confidence in our economy and contribute importantly to sustainable capital investment and job growth."

I seldom applaud speeches from the Fed. However, Hoenig deserves a standing ovation. Please read his speech if you haven't already.

Inflation as a Cure - a Preposterous Theory

The idea that 4% inflation would cure any problem is preposterous for at least three reasons.

1) The Fed can only supply liquidity. The Fed cannot determine where the money (credit) goes or if money goes anywhere at all. Excess reserves at $1.2 trillion is proof enough. So is 20 years of Japan's foolish deflation fighting that has Japan in debt to the tune of 200% of GDP. Clearly the idea that inflation will go where Krugman or any other economist wants it to go is ridiculous. The most likely place inflation would manifest itself is in asset bubbles, energy prices, gold and commodities. Makeshift work programs would die as soon as stimulus money stopped flowing.

2) Inflation benefits those with first access to money, the banks and the already wealthy. It is a stealth tax on the middle class and poor whose wages never keep up with inflation. That problem is compounded by rising property taxes, sales taxes, etc, that eats consumers alive. Those at the bottom end of the totem pole get hit even harder.

3) Belief in inflation is belief in something for nothing. It is an expectation that money conjured into existence, backed by nothing, with no sweat of labor, can cure problems. Common sense alone is all it should take to see the folly of inflation as a cure for anything.

Krugman and Blanchard remain in Academic Wonderland, with no understanding at all as to how the real world functions. It is amazingly refreshing to hear someone from the Fed suggest just that.

By Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com .

© 2010 Mike Shedlock, All Rights Reserved.


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