Alan Blinder on the Inflation Debate

In recent posts (e.g., this one) we noted the views of Paul Krugman, John Taylor, and others on whether the Fed's responses to the financial crisis might lead to high inflation in future. Yesterday, Alan Blinder, the Princeton economist, former Fed governor, and long-time Democratic policy adviser weighed in on the debate in his Sunday New York Times Business Section column, Economic View: "Why Inflation isn't a Danger"). Blinder's argument essentially boils down to this: The Fed is aware that if it doesn't rein in the money supply in a timely manner as the crisis abates, this will lead to inflation. The Fed has planned for this, and has the competence to pull this off. Further, bond market participants appear to support this view. Blinder wrote,

[The Fed] has committed itself to an inflation target of just under 2 percent. Of course, none of that assures us that the Fed will hit the bull’s-eye. It might miss and produce, say, inflation of 3 percent or 4 percent at the end of the crisis — but not 8 or 10 percent.

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SKEPTICAL? Then let’s see what the bond market vigilantes really think.

The market’s implied forecast of future inflation is indicated by the difference between the nominal interest rates on regular Treasury debt and the corresponding real interest rates on Treasury Inflation Protected Securities, or TIPS. These estimates change daily. But on Friday, the five-year expected inflation rate was about 1.6 percent and the 10-year expected rate was about 1.9 percent. Notice that the latter matches the Fed’s inflation target. I don’t think that’s a coincidence.

But if the inflation outlook is so benign, why have Treasury borrowing rates skyrocketed in the last few months? Is it because markets fear that the Fed will lose control of inflation? I think not. Rising Treasury rates are mainly a return to normalcy.

In January, the markets were expecting about zero inflation over the coming five years, and only about 0.6 percent average inflation over the next decade. The difference between then and now is that markets were in a panicky state in January, braced for financial Armageddon; they have since calmed down.

More on the Inflation Debate: Hussman and Wolf Weigh In

In his market commentary this week, "Anything But Academic", John Hussman weighed in on the debate between Paul Krugman and John Taylor. Dr. Hussman first summarizes Dr. Krugman's thesis:

Krugman's argument boils down to the recognition that "monetary velocity" is currently very low - that is very accurate. The problem is that unless it remains low indefinitely, the more than doubling of the U.S. monetary base over the past year, along with the additional issuance of Treasury debt, leaves a far larger quantity of government liabilities to be absorbed until and unless those liabilities are extinguished by fiscal surpluses. The only way to absorb them without driving up the price level is to hold down velocity indefinitely, or to have an equal expansion in real economic output without any further expansion on the monetary side.

And then summarizes Dr. Taylor's thesis (while parenthetically noting his personal connection to Taylor):

In the other academic corner is John Taylor, an economics professor at Stanford (and more to the point, one of my former dissertation advisors), who wrote in the Financial Times last week “To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling in prices. That 100 percent increase would make nominal GDP twice as high, and thus cut the debt-to-GDP ratio in half, back to 41 from 82 percent. A 100 percent increase in the price level means about 10 percent inflation for 10 years^[1], but that would not be smooth – probably more like the great inflation of the late 1960s and 1970s, with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.”

Dr. Hussman seems to agree with Krugman's benign view of inflation in the short-term (i.e., the next few years) but share Taylor's view of a doubling of the price level within the next 10 years. Hussman also included an entertaining anecdote in his column which I'll quote below.

There's an economists' riddle that goes “Why are the debates in academia so bitter?” – the answer – “Because the stakes are so low.”^[2] Now, very often, that's true. I remember a presentation that Paul Krugman gave at Stanford where he was talking about a model of economic development. Paul drew a diagram on the board, and as he described it, he drew a few little arrows indicating migration of businesses from one area to another. A respected economic theorist at Stanford, Mordecai Kurz (who never drew an arrow without a differential equation), immediately jumped up and shouted “You haven't described the dynamics!!” to which Paul responded that he was indicating a general movement of economic activity toward one place to improve efficiency. Dr. Kurz pounded the table and screamed “Then erase the arrows!! ERASE THE ARROWS!!” and then stormed out of the room and slammed the door behind him. I think that was probably the exact moment that I decided to go into finance.

Martin Wolf also weighed in on this debate in his Financial Times column earlier this week, "Rising government bond rates prove policy works". It's worth reading in its entirety, as is Hussman's commentary, but here are the most salient excerpts:

Is the US (and a number of other high-income countries) on the road to fiscal Armageddon? Are recent jumps in government bond rates proof that investors are worried about fiscal prospects? My answers to these questions are: No and No. This does not mean there is no reason for worry. It is rather that there are powerful arguments against fiscal retrenchment right now and strong reasons for welcoming recent moves in the bond markets.

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People need to believe that the extraordinarily aggressive monetary and fiscal policies of today will be reversed. If they do not believe this, there could well be a big upsurge in inflationary expectations long before the world economy has recovered. If that were to happen, policymakers would be caught in a painful squeeze and the world might indeed end up in 1970s-style stagflation.

The exceptional policies used to deal with extreme circumstances are working. Now, as a result, policymakers are walking a tightrope: on one side are premature withdrawal and a return to deep recession; on the other side are soaring inflationary expectations and stagflation. It is irresponsible to insist either on immediate tightening or on persistently loose policies. Both the US and the UK now risk the latter. But their critics risk making an equal and opposite mistake. The answer is both clear and tricky: choose sharp tightening, but not yet.

The illustration above, by Ingram Pinn, accompanied Martin Wolf's column.

^[1]Here Dr. Hussman, a former options mathematician, repeats the basic math error Dr. Taylor made in his Financial Times column: due to compounding, it wouldn't take 10 years for 10% annual inflation to double the price level; it would only take about 7.3 years. This error was noted by an FT letter writer earlier this week, who in turn made his own mathematical error in his letter, which was corrected by a subsequent letter writer. All of this raises the question of why one of the world's leading business newspapers didn't have a numerate enough editor to catch Taylor's error in the first place.

^[2]Dick Armey, the economics professor and former GOP House Majority Leader once shared this same quote when asked by a reporter if the debates in academia were more civil than those in Congress.

Are Inflation Fears Overdone?

So say (separately) the editors of the Financial Times and New York Times columnist/Princeton economist Paul Krugman.

In an editorial yesterday ("US not in bondage") the FT editors wrote,

Shock, horror: US government bond rates are jumping. Soon, goes the story, long-term interest rates will leap, the Federal Reserve will monetise, inflation will soar and civilisation will end. Actually, no. What is happening is precisely the normalisation the Fed has sought. The government is not off the fiscal hook. But it does have at least some time.

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What has happened, quite simply, is normalisation of inflation expectations

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Does this mean nobody needs to worry? Certainly not. Desirable normalisation could yet become a panic over the massive prospective bond issuance. Now that the worst of the panic has passed, the administration and Congress need to agree a credible plan for elimination of the huge structural fiscal deficits. As the Congressional Budget Office’s forecasts demonstrate, President Barack Obama’s budget proposal is not such a plan: it leaves deficits of between 4 and 6 per cent of gross domestic product as far as the eye can see. This will need to change soon. But, right now, everybody needs to keep calm. Normalisation is a big success, not a danger.

In his New York Times column yesterday ("The Big Inflation Scare"), Dr. Krugman made a similar point: Inflation isn't a near-term concern, but we do

[H]ave a long-run budget problem, and we need to start laying the groundwork for a long-run solution.

Krugman also brought up the example of Japan, which has borrowed massively in recent years without driving up its interest rates or inflation. What many Americans fear -- our country losing its triple-A credit rating and having its government debt exceed 100% of its GDP -- has already happened in Japan (The CIA World Factbook says Japan's public debt exceeds 170% of its GDP). And yet, Japan's borrowing costs are significantly lower than ours. For example, according to Bloomberg, the current yield on 10-year U.S. Treasuries is 3.46%, versus 1.49% on the 10-year Japanese government bond.

I've wondered for some time about why Japan has so much lower borrowing costs than the U.S., despite having a lower sovereign debt rating and a much higher ratio of debt to GDP, but I haven't heard a convincing explanation yet. When I asked The Atlantic's Megan McCardle about this, she said the answer was Japan's Postal Savings System, but according to Wikipedia, prior to the beginning of its privatization in 2007, that system only held about 20% of Japan's government debt. Perhaps someone will leave a more convincing answer in the comment thread below.

"Mad Ireland"

That was the headline of Megan McCardle's post on her Atlantic blog in response to Paul Krugman's New York Times column today about Ireland, "Erin Go Broke". In his column, Dr. Krugman suggested that Ireland got into trouble (it's economy is projected to contract by as much as 10% this year) because it was too free market oriented, noting that Ireland was ranked #3, behind only Hong Kong and Singapore, on the Heritage Foundation's Index of Economic Freedom. What Krugman didn't mention is that Australia, which was ranked #4 on that Index last year (and is ranked #3, switching places with Ireland, on the 2009 Index of Economic Freedom) is weathering the economic storm much better than Ireland or the United States. Australia is in a recession now, but its economy is projected to contract by less than 1% this year. So perhaps having a free market economy wasn't the proximate cause of Ireland's economic troubles.

Megan's post in response to Krugman's column isn't worth quoting here -- the best part of it was the headline, in response to which I wrote,

Hey, is that an allusion to Auden in the headline (from his poem "In Memory of W.B. Yeats"*)? If so, nice: the sign of a tasteful and expensive education (to borrow Neal Stephenson's phrase).

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*I'm thinking of the great line "Mad Ireland hurt you into poetry", which I think of whenever I flip the channels and see Celtic Woman on a local PBS station. I wonder if "Mad Ireland" hurt them into doing their 50-piece Enya covers.

The photo above, of what apparently are the stars of Celtic Woman, is from the Celtic Woman website. Note that the neither the photo nor the name "Celtic Woman" gives a sense of the scope of the enterprise that is Celtic Woman. It appears to be comprised of dozens of Celtic women, along with dozens of Celtic men.

Son of TARP

The Wall Street Journal explains the Obama Administration's new plan to buy bad assets off of the books of banks ("U.S. Sets Plan for Toxic Assets"). Economist and New York Times columnist Paul Krugman criticizes it ("Despair of Financial Policy"), and criticizes it again ("More on the bank plan"); economist Brad DeLong defends it ("The Geithner Plan FAQ" -- Hat Tip: Matt Yglesias), and Krugman responds to Brad DeLong's defense ("Brad DeLong's Defense of Geithner").

Since this new plan is, essentially, a return to the original, rejected, tack of the TARP plan last fall, it's also worth revisiting John Hussman's objections to the original TARP plan, ("You can't rescue the financial system if you can't read a balance sheet"). I suspect Dr. Hussman will reiterate some of those objections in his market commentary this week.

Economics as Politics by Other Means

Although Greg Mankiw didn't mention it specifically in the post I linked to previously ("News Flash: Economists Agree"), I wonder if part of what prompted him to write it was the row set off by Clive Crook's Financial Times column last week, ("Politics is damaging the credibility of economics"). In that column Crook wrote,

Economics outside the academy has become the continuation of politics by other means. If you wish to know what Mr [Paul] Krugman thinks on any policy question, do not read his scholarly writings; see which policies are advocated by the progressive wing of the Democratic party. Mr Krugman agrees with liberal Democrats about most things, and for the rest gives as much cover as the discipline of economics can provide - which, given its scientific limitations, is plenty. He does this even on matters where, if his scholarly work is any guide, the economics is firmly against his allies. Liberal Democrats are protectionists. Mr Krugman is not, but politics comes first.

The syndrome affects economists on the right as much as on the left. Just as there is a consensus among economists that protectionism should be opposed, most economists believe that a powerful fiscal stimulus is both possible and desirable in present circumstances, and that the best stimulus would include big increases in public spending. Yet recently, Robert Barro, a scholar with conservative sympathies, wrote in the Wall Street Journal that this view was an appeal to "magic".

The problem is not that Mr Krugman questions the consensus on trade (if indeed he does), or that Mr Barro questions the consensus on fiscal policy (as he certainly does). It is that both set the consensus aside so carelessly. In doing so, these stars of the profession destroy the credibility of their own discipline. Mr Krugman gives liberals the economics they want. Mr Barro gives conservatives the same service. They narrow or deny the common ground. Why does this matter? Because the views of readers inclined to one side or the other are further polarised; and in the middle, those of no decided allegiance conclude that economics is bunk.

Crook threw in a (mostly accurate) criticism of the blogosphere as well:

The web, for all its blessings, is an aggravating factor. Many of the most successful economics blogs promote communication within political groupings, not across them. On the web you best build an audience by organising a claque and stroking its prejudices. Extend elaborate courtesy to people you agree with and boorish contempt to those who do not get it. Celebrate exasperation and incivility as marks of intellectual authenticity - an attitude easier to tolerate in teenagers under hormonal stress than in professors at world-class universities.

For Krugman's and Barro's respective responses to that column, see Crook's Atlantic blog post, "The Dismal Science, Revisited".