Overcoming America's Debt Overhang: The Case for Inflation

Policy Paper
Sept. 9, 2009

It might be called the "World's Scariest Chart." It is a snapshot of the fragile foundations of the American economy and the epic boulder it now finds itself trapped beneath. The graph shows total debt outstanding in the United States, both secured and unsecured, as a percentage of GDP. In 1981 it was a manageable 168 percent, in 1996 253 percent, and by the first quarter of 2009 with the collapse of the housing and credit bubbles it had reached a staggering 373 percent of GDP. (See Chart 1)

Given that consumption makes up over 70 percent of the U.S. economy, the most worrying part of this huge debt burden is that of the household sector. In 1981, household debt as a percentage of GDP was 48 percent, in 1996 66 percent, and by 2009 it was nearly 97 percent. The last time the household debt to GDP ratio was near 1:1 was 1929. The average household credit card debt is $8,329. Undergraduates leave college with, on average, $27,803 in debt. One in four households is "underwater" on their mortgages, meaning they have negative equity.

It is not just American households that are in trouble. Corporate debt, particularly financial sector debt, has ballooned over the past several decades. In 1981, financial sector debt was just 22 percent of GDP; in 1996, it had climbed to 61 percent, and then exploded during the bubbles years to reach 120 percent of GDP in 2009.

As the private sector painfully de-leverages, and households dramatically cut back on consumption and attempt to pay down some of their debt, the federal government has (rightly) stepped into the breach. The $787 billion American Recovery and Reinvestment Act passed earlier this year, while almost certainly too small, is essentially debt-financed, as will be a significant portion of this year's budget. OMB projects the federal government debt-to-gdp ratio will this year reach 55.7 percent, its highest level since 1955.

Bubbles, busts and the widespread crippling they leave behind are not entirely novel. Indeed, they've been the hallmark of capitalist economies since the earliest days of industrialization. "Beautiful credit!" Mark Twain and Charles Dudley Warner wrote in their 1873 novel, The Gilded Age: A Tale of Today. "The foundation of modern society .... I wasn't worth a cent two years ago, and now I owe two millions of dollars."

While accessible credit fuels growth, too much debt kills it. The entire institution of bankruptcy exists because we recognize that otherwise functional economic entities can be paralyzed by debt, and that it ultimately benefits economic growth to allow some means of wiping out debt and starting fresh.

But even short of default, a vicious cycle can take hold. At a certain point households, firms, and even governments are forced to spend money on meeting short-term debt servicing obligations rather than on making long-term investments. What results is a form of debt serfdom. Farmers don't invest in new crops and land; businesses don't add needed productive capacity because every spare cent goes towards interest payments. Governments can't afford to provide basic services because they have to pay off onerous debts. Households can't send their children to college because credit card payments have eaten up their savings.

Avoiding the deadening effect of too much debt on the economy is the kernel of wisdom found in numerous ancient traditions and scriptural injunctions that require formalized periodic debt cancellation. Deuteronomy commands that every seven years (that is, during the sabbatical year) debts will be forgiven "because the Lord's time for cancelling debts has been proclaimed" (Deut. 15: 1-2). In the Judeo-Christian tradition, it is called Jubilee.

We don't have Jubilee in modern financial capitalism and for good reason: the understanding of moral hazard then wasn't quite what it is today. But if we are to emerge from the current crisis into an economic future of sustained growth and widespread prosperity, we are going to have to do something to lessen the burden that past debts now impose on investors, innovators, consumers, and the federal government. Failure to do so would likely lead to a Japanese-like lost decade of low or non-existent growth, or worse.

The surest way to avoid such a fate is to jettison a central, indeed the central axiom of post-1970s neoliberal global capitalism, and that is to embrace a period of moderate, sustained inflation.

Historical parallels for our current predicament are difficult to come by. But given that fiscal scolds, inflation fear-mongers, and other critics point to the levels of government of debt rising to WWII levels, it is worth looking at just how the United States recovered from that period of unprecedented debt. The answer, to simplify a bit, was growth and inflation, with the two likely reinforcing each other. From 1948 - 1980, the annual inflation rate was 4.1 percent while real GDP growth averaged 3.7% a year. By 1980, federal government debt held by the public had been cut by more than half, falling from 84 percent of GDP in 1948 to just over 26 percent.

If attempting a repeat of this kind of performance seems a taboo suggestion, it is because in many ways it is. But this crisis has not been kind to orthodoxy. Nearly everything touted by economists and policy makers as the engines of American prosperity--low interest rates; increasing home ownership; financial innovation and deregulation; and globalization--have in one way or another played a role in bringing the global economy to the edge of collapse. And some of the most poisonous axioms--deregulation is always good; it is difficult to recognize a bubble until it has burst; markets police themselves; Alan Greenspan is a "maestro"--have already (rightly) come in for sustained re-examination.

Inflation fears will have to be the next orthodoxy to be slain. Before American policy makers can even be brought around to considering the taboo, cooler heads must prevail over the hysteria of the inflation fear-mongers. Earlier this summer, just one week of declining Treasuries prices provoked an avalanche of warnings that "the United States will be Zimbabwe before we know it."

"All in all," wrote Paul Krugman recently, "much of the current inflation discussion calls to mind what happened during the early years of the Great Depression when many influential people were warning about inflation even as prices plunged." As the British economist Ralph Hawtrey wrote, "Fantastic fears of inflation were expressed. That was to cry, Fire, Fire in Noah's Flood."

And yet, remarkably, given the totemic hold low inflation holds in the imagination of the economic elite, there is a gathering (though admittedly still small) chorus of voices from across the ideological spectrum advocating for a pro-inflationary policy, at least in the short term.

Greg Mankiw, former Chair of the Council of Economic Advisors under George W. Bush, argues that the Fed must make a credible commitment to inflation over the medium term in order to produce negative real interest rates, avoid a deflationary trap, and boost demand. In arguing in the Financial Times for a "pre-announced, temporary, globally co-ordinated bout of moderate inflation," the London School of Economics' Tim Leunig notes that 4 percent annual inflation would "help government finances by inflating away 10 per cent of total government debt," which would confer both "equity and efficiency benefits. It is (more) equitable as the cost of recession will be borne by wealth holders as well as income generators, and it is (more) efficient in that it reduces the extent of incentive-reducing tax rises on income in the future." It would also reduce negative equity in homes, taking some pressure off of those who are underwater and lift the debt servicing burden for both large banks and private households.

George Cooper, a British fund manager, comes to a similar conclusion at the end of his book The Origin of Financial Crises. In the wake of the crisis, he argues we are faced with three options: One, what he dubs the "free market" solution, is to simply allow the crisis to run its course. This is the "liquidationist" policy infamously advocated by Andrew Mellon in response to the beginnings of the Great Depression. A second would be to attempt to create an even larger credit-fueled bubble to offset the damage from the bursting of this one (more or less what Greenspan pursued in the wake of the dot-com bubble bursting). "The third option," he writes, "is to engage the printing press. Use the printing press to pay off the outstanding stock of debt, either directly with state handouts or indirectly with inflationary spending policies." While this strategy, in Cooper's view, is "deeply unpalatable," it is, he argues "the least inadvisable of the three available options."

But perhaps the most unabashed advocate of the policy has been Harvard University's Kenneth Rogoff. "I'm advocating 6 percent inflation for at least a couple of years," the one-time chief economist at the IMF recently told Bloomberg. "It would ameliorate the debt bomb and help us work through the deleveraging process....There's trillions of dollars of debt, in mortgage debt, consumer debt, government debt...It's a question of how do you achieve the deleveraging. Do you go through a long period of slow growth, high savings and many legal problems or do you accept higher inflation?"

Rogoff may understate the problem. In spite of hopes of positive GDP growth this quarter, we could very well be entering a period that makes Japan's infamous "Lost Decade" look like a smashing success: with households and businesses absorbed with servicing debt, demand will remain anemic, investment weak or non-existent, jobs hard to come by, wages depressed, and the standard of living of most Americans worsening by the year for the first sustained period in American history. We will be a nation of debt slaves.

We have a choice to make, not only for ourselves but much of the globe, about whether we will do what it takes to avoid this outcome.

So: Do you go through a long period of austerity with slow growth, high unemployment, and painful foreclosures or do you accept higher inflation?

The answer for policy makers should be a forceful, unequivocal, "yes to inflation."


Between the Great Depression and the 1970s, American policymakers did not unduly concern themselves with a rise in the price level. Inflation figured as a political issue from time to time (particularly in the first years after World War II, when it rose above 10 percent), but the general consensus among economists was that inflation of, say, 4-5 percent a year was a manageable side-effect of low unemployment. But as Robert Samuelson documents in the Great Inflation and its Aftermath that consensus was destroyed by the stagflation of the late 1970s. "Thirty years ago, many economists argued that inflation was a kind of minor inconvenience and that the cost of reducing inflation was too high a price to pay," economist Martin Feldstein said earlier this decade. "No one would make those arguments today."

Ever since the stagflation of the 1970s, keeping inflation low has been the central obsession of economic policy-makers in Washington. "Inflation," Ronald Reagan said in 1978 "is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man." But it wasn't just Reagan. The balanced-budget Rubinite economic policies of the Clinton years grew out of similar obsession: "We must not take our economic strength for granted," Clinton said in 2000, as he prepared to pass the baton. "That's why it is critical that we continue to pay down the debt -- to keep inflation and interest rates low." Clinton's successor touted Greenspan for his "prudent judgment and wise policies," which "kept inflation low," and introduced Ben Bernanke as "the right man to build on the record Alan Greenspan has established."

In this respect, the first decade of the 21st century saw the final culmination of a decades-long project begun in the late 1970s by Paul Volcker, and continued through Republican and Democratic administrations alike, to vanquish inflation from the American economy. Average inflation during Bill Clinton's eight years in office was 2.6 percent. For Bush, it was 2.8 percent.

There are a lot of factors that contributed to the two-decade long period that some call the Great Disinflation. But, looking back on those years from the perspective of today, it is hard not to see those years as something of a Pyrrhic victory. High inflation can clearly undermine the conditions needed for a productive economy, but that does not mean that low inflation is not without its problems. Inflation, in fact, can be too low. The 2002 World Economic Outlook report from the IMF (hardly a body with a soft spot for loose monetary policy) noted that inflation in the 2-3 percent range restrains the flexibility of monetary policy and makes it difficult to respond to shocks and crises. (Cue crisis.)

More importantly, as we have learned from the past decade and half, an economy with inflation that is too low can produce perverse incentives: it stokes the financial economy at the cost of the real economy, and it can be a reflection (as Alan Greenspan once frankly admitted) of a working class suffering from stagnating wages and thus of an economy with insufficient aggregate demand. The boom years of low inflation saw a dramatic decrease in the prices of many household consumer goods from electronic equipment to clothing to food. This was partly due to the outsourcing of production to low-wage developing countries and partly due to rapid productivity gains in manufacturing. But those same dynamics also helped create massive global trade imbalances, and the profits captured by firms poured into capital markets, lowering interest rates and increasing the ravenous search for yield and the taking on ever more risk.

Defenders of the post-Volcker economy will often point to the high-growth, low-inflation delivered as an argument-stopper. (Chicago School economist Robert Lucas once famously pronounced, "Once you start thinking about growth, it's hard to think about anything else.") But upon closer inspection, this argument does not hold up. The annual real growth rate from 1948-1980, the bad old days of high inflation, was 3.7 percent. From 1980-2009, the brave new era of low inflation, it was a mere 2.9 percent.

We are, in many ways, now reaping what decades of historically low inflation have sown: a massive upwards redistribution of wealth, an oversized financial sector, an eviscerated tradable goods sector, and a grotesquely large trade deficit. In other words, the imbalances and structural weaknesses of the post-Volcker economy, the ones that built up to create the crisis, were partly produced by the Great Disinflation that Volcker ushered in. Recovery will involve a fundamental restructuring of our economic engine, shifting from the supply-side nostrums of the past two decades that paradoxically led to an unhealthy pattern of asset bubbles and debt-financed consumption to policies that bolster global demand by investing in quality-of-life improvements and by raising incomes and wages worldwide. That means the seeding of a global middle class and recalibrating the share of profits captured by labor as opposed to capital. Such an economy will almost certainly be an economy with higher inflation than has been the case over the past two decades.

To sacrifice such a new economic approach on the alter of the previous era's low inflation orthodoxy would be to commit a historical error of epic proportions, akin, as Greg Mankiw wrote in his op-ed arguing for embracing inflation, to maintaining the gold standard during the Great Depression. "Of all the things that Roosevelt did to get the economy out of the Depression, jettisoning the gold standard was the most successful," Mankiw argues. "Today, monetary policy is fettered not by gold but by fear of inflation. Perhaps it is time is get over that fear, at least for a while."


Inflation is a term that at once covers too much and too little. It is generally accepted that it is an inescapable feature of modern, industrial economies, and regulated by central banks. But just because prices are going up does not necessarily tell you what you need to know about the health of an economy and the prospects for the future, because much of that depends on what is causing the inflation.

There are, roughly, two schools of thought on this question. In the years following Volcker's triumph over the highest peace-time inflation in American history, many economists and policy-makers fell under the sway of Milton Friedman's monetarism. Friedman believed that inflation was, in his famous formulation, "always and everywhere a monetary phenomenon." According to this view, inflation is caused by one thing and one thing only: poor central bank policy. If central banks increase the money supply more rapidly than GDP growth, inflation is an inevitable result, as too much money chases too few goods. In other words, there was simply no relationship between the "real" economy--productivity, labor markets, and growth levels--and inflation. They existed in parallel and unconnected economic universes.

This view stood in direct contrast to the prevailing consensus that had preceded it, embodied in what economists called the Phillips curve. Under this view, higher levels of inflation could positively impact the real economy by inducing faster growth and lower unemployment. Or, viewed in a slightly different way: lowering unemployment, which was the chief economic policy goal of any Democratic administration in the post-war era, produced, as a negative side effect, higher inflation. The task of Fed was to balance these competing imperatives, or as the Humphrey-Hawkins legislation of 1978 stated, the Federal Reserve was to have a dual mandate of pursuing both price stability and full employment.

In the wake of the trauma of the double-digit inflation of the late 1970s and Paul Volcker's successful conquest of inflation in the late-Carter/early-Reagan years, the monetarist line enjoyed a period of tremendous fashionability. Many economists even came to believe there were no tradeoffs between unemployment and inflation: the latter had nothing to do with the former and therefore higher inflation would not lower unemployment or grease the wheels of growth.

The main competition to monetarism in the 1980s and 90s was not Keynesianism, which continued to fall out of favor, but a politically related but theoretically distinct theory, about the "non-accelerating inflation rate of unemployment" (NAIRU or natural rate for short). The natural rate partisans held that there was a "natural rate" of unemployment, the necessary amount of joblessness to allow labor markets to churn and function with maximal efficiency. If unemployment dropped below this boundary (generally believed to be somewhere in the neighborhood of 6 percent), inflation would spike. In the late 90s, the theory was put to the test. As unemployment dipped below 4 percent in the 1990s, panicked natural rate advocates urged the Fed to raise rates to stave off inflation. Greenspan, in possibly the single highlight of his tenure at the Fed, refused, and inflation remained at historic lows. So much for the natural rate.

The logical conclusion of a study of the history of inflation is that it can not be reduced to a single doctrine: that both monetary and fiscal factors and real economy developments like productivity affect inflation. Which brings us to this point: if inflation is not just caused by bad Fed policy, then what is else is it caused by? In traditional economic terms, there are, roughly speaking, three main causes of inflation: demand-pull, supply-shock (alternately, cost-push), and inertial inflation. The distinction is of more than technical import: if policy-makers (specifically, central bankers) fail to properly identify the source of inflation, they can take actions with negative consequences for the health of the economy, prematurely putting the brakes on an economy that is trucking along just fine, or failing to raise rates in the belief that inflation is merely the result of a temporary supply disruption.

The most commonly understood cause of inflation is an increase of aggregate demand that happens in an economy that is, in the somewhat metaphorically confused argot of central banking, over-heating. At the beginning of recovery, increased demand can be met by bringing back online unused capacity, but as a recovery ages, demand begins to outstrip supply and prices begin to rise. Tight labor markets bid up wages, which then, in turn, can also put upward pressure on prices. This is the feared wage/price spiral, which converts demand-pull inflation into a serious, long-lasting rise in prices. But given the weakness of labor in an age of globalization, a wage/price spiral no longer appears to be a part of American political economy.

Then there is supply-shock inflation. The classic example of this is the rapid escalation in oil prices that came with the two oil embargoes in the 1970s. In 1973 when OPEC responded to the Yom Kippur War with an embargo, oil shot up from $3.07 a barrel to $11.65. In 1979, a second embargo resulted in a price increase from $14.34 a barrel to $34.41, a 140 percent increase. The cost shocks of the oil embargoes came, crucially, amidst a macroeconomic baseline already disposed to inflation, which meant the supply shocks seemed to soon embed themselves fully in the entirety of the economy. The question is: can you have supply-shock inflation that doesn't bleed over to the rest of the economy?

As it happens, we recently had a test case of just this question. During the summer of 2008, a heated debate broke out among economists and market analysts over both the source and likely ramifications of rapidly accelerating commodity prices: the pace of oil price increases was shocking, with oil going from $100 a barrel to $147 in just seven months. Wheat, corn and dairy likewise had large price spikes upward. For the first time in recent history, Americans saw the prices for food staples rapidly increasing before their eyes. Gas prices, in particular, rose at an alarming rate, peaking at over $4.00 a gallon in the summer and momentarily becoming the single most pressing issue for both presidential candidates.

Controversially, the Federal Reserve did not raise rates, largely because its "core inflation" measure, which excluded volatile commodities, remained stable. As headline inflation continued to rise that summer, critics from many corners began to howl in alarm. Writing in the Financial Times, Wolfgang Münchau warned: "Inflation is rising and it seems the world's central banks have critically misjudged the situation...The only historical period that bears any resemblance to what is happening today is the 1970s. Then, and now, an oil price shock turned into a rise in the general price level. Both then and today, central banks largely accommodated this price rise, which was a mistake then and is a mistake now."

On the other side of the debate was the Fed itself, and some of its defenders in the financial press. They made the case that far from being a convenient fiction created to hide inflation caused by loose monetary policy, the "core inflation" measure provided a more reliable indicator of the overall state of price stability, since volatility in the commodity market tended to obscure the fundamentals.

Paul Krugman was prominently in the latter camp. "In the 70s," Krugman noted in The New York Times, "core inflation quickly shot up after the energy and food price spikes. But this time that's not happening at all: the rise in inflation is all commodities, with no sign that expectations of inflation are getting embedded in price-setting through the rest of the economy." In the end, the Krugmans of the world were right. Inflationary expectations never became embedded in the economy and as soon as the subprime crisis began to wreak its havoc, demand fell and prices plummeted. Indeed, the United States found itself not confronting inflation but dangerously dangling over the precipice of deflation, expectations of which can also initiate a vicious cycle that, as Japan learned in the 1990s, is even more difficult to stop.

The major lesson to draw here is that a supply shock can rapidly raise energy and commodity prices without bleeding into the fundamental price dynamics of the rest of the economy. That means keeping an eye on core inflation makes a good deal of sense in the months and years to come, because many of the underlying structural factors that pushed up the prices of supply-constrained products (read: oil) will eventually kick in again as global demand recovers. Over-reacting in the face of such price spikes would kill the recovery before it even has a chance to gain traction.

Of course, the argument against any inflation at all, made recently at an impromptu debate at a Fed meeting by Paul Volcker, is, chiefly an argument about slippery slopes: allow a little inflation, and soon you've got a little more and a little more and so on. But that conception is based on a previous era in which central banks had no credibility to fight inflation and in which the real economy itself was predisposed to inflation. The former has now largely changed, thanks to Volcker himself. In other words, now is the time to spend the reputational capital the Fed has built up over 28 years, a widely shared belief (embodied in the continued low prices of inflation-protected securities) that it will not allow inflation to get out of hand.

The actions of the Volcker Fed were not the only or even the principal cause of the Great Disinflation. A number of structural factors--rising productivity; weak wage gains; globalization; and the emergence of the producer-oriented economies of Asia--all contributed. Indeed, some of these factors turned out to create the bubble crisis of the decade and therefore should be avoided in the future. The first of these was the productivity/wage gap that emerged in the mid-1970s, whereby increasing productivity did not translate into higher wages, but rather into higher profits. With real wages stagnating, it is not surprising that inflation remained low.

The second main factor was globalization, and more specifically the remarkable explosion of trade between the United States and Asia, in the 1990s with the Asian tigers and over the past decade with China. China's massive labor pool, low wages, and rapid industrialization created a system whereby they sent us cheap goods, essentially exporting disinflation, and we sent them dollars. This system worked remarkably well in keeping wage and price inflation down, but it created huge current account imbalances and an even bigger problem of asset inflation.

Indeed, the defining feature of the economy of the last decade and a half has been asset bubbles and asset inflation, not wage or price inflation. There is reason to believe this remains the case even after the bursting of the housing and credit bubble. In the wake of the housing crash, the world is left with excess capacity in most goods-producing sectors of the economy, high unemployment, and the lack of labor bargaining power. With such conditions, wage and price inflation will be very difficult to generate in the near to medium term. But that is not the case with asset inflation. At the slightest uptick in demand, commodities such as oil spike upwards. First it was stocks, then houses, and now commodities? Unless the balance between the real and financial economy is recalibrated capital will flow into a new bubble and start the process all over again.


There are a number of reasons we should regard a sustained period of wage and price inflation as a positive development, indeed even as a policy goal.

The first and most obvious is that a rise in the price level will be an initial signal that a sustained recovery is underway. This may seem blindingly obvious, or even tautological. But it is important to stress given that a sustained recovery depends ultimately upon rising incomes; otherwise, households will not be able to both increase their consumption and pay down their debt and businesses won't have any incentive to expand production beyond rebuilding their inventories. It is also important to emphasize this because there is a real risk that the chorus of inflation hawks will smother the recovery in its crib. Over the past few months, they have been lurking in the nursery holding the pillow, darkly warning that the Fed's quantative easing will set off inflation, despite interest rates being near historically low levels.

Earlier this summer, a sharp, but by no means epic, uptick in the price of long-term treasuries had commentators screaming like Chicken Little. The specter of elevated prices so panicked economist John Taylor that in his Financial Times op-ed "Exploding Debt Threatens America," he managed to screw up an elementary bit of computation. "To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices...A 100 per cent increase in the price level means about 10 per cent inflation for 10 years." (In fact, as several economics bloggers pointed out, inflation of 7 percent would double prices over ten years.

The point is that the inflation hawks are already making their case in advance of any real sign of inflation. Once recovery begins in earnest and prices begin to creep up, these same voices will bring tremendous pressure to bear on the Federal Reserve to raise rates and on the Administration to close the deficit. The large deficits, we are told, will fuel inflation and will push up long-term interest rates. So the deficit must be cut sooner rather than later.




Thus far, the Fed, while it has acted in all kinds of unaccountable and non-transparent ways, has avoided the major, central crucial error of the four major central bankers who helped make the Great Depression great. Aware that massive injections or liquidity are necessary to prevent a complete meltdown (and no longer constrained by the gold standard), the Fed has stayed clear of the mistakes of the past. So has the Administration. In 1937, FDR succumbed to the orthodoxy of the day and raised taxes, cut spending, and tried to balance the budget, kneecapping in the process the impressive recovery that was underway.

Should the Fed succumb to the pressures of the inflation hawks or the administration give in to the calls to show its commitment to fiscal responsibility now, the result could be equally disastrous. Raising rates and cutting back on government spending before consumers and businesses have been able to do more to repair their balance sheets could send the economy back into a tailspin. "The urge to declare victory and get back to normal policy after an economic crisis is strong," Christina Romer, Chair of the President's Council of Economic Advisers, recently wrote in The Economist. "That urge needs to be resisted until the economy is again approaching full employment."

Allowing some natural inflation as a perfectly acceptable side effect of recovery is just the beginning. Inflation in and of itself would confer two major positive benefits on the economy, and therefore should be explicitly be pursued. First, and most crucial, it would help depreciate the mind-boggling amounts of debt on the balance sheets of the U.S. government, banks, and households. As nominal incomes and wages rise, it would be easier for indebted households to pay back debts that are fixed in value. Homeowners in particular would benefit because the value of their homes would also rise with inflation, lifting the equity value of many of the millions of homes which have mortgages that are now under water. (Admittedly, not every debtor would benefit equally. Those with adjustable rate mortgages, for example, may face higher future interest payments, and thus would not gain the full benefits of inflation.)

Second, higher inflation would most likely lead to a weaker dollar. Not only would a weaker dollar reduce the value of the debt held by foreign creditors, it would help the United States reduce its trade deficit, thereby facilitating the rebalancing of international capital flows. A weaker dollar would of course increase the price of imports, thereby further contributing to inflation, but it would also make U.S. goods more attractive, thereby increasing production and employment in the U.S. economy. That in turn would allow American workers to improve their incomes and pay down their debts without making the same sacrifices in consumption that they otherwise would need to make.

There are, of course, several arguments against inflation. But none of them is persuasive under today's circumstances. The first is that inflation unfairly punishes savers and investors. In the 1920s, John Maynard Keynes laid out the distributional impacts of inflation, noting that it took from some sectors of society and gave to others: from savers to borrowers, from banks to government, from wage earners to speculators. But the central tug of war over inflation is between creditors and debtors: inflation is good for debtors and bad for creditors.

That's why creditors, and finance capital more broadly (if I may use that category), have almost always and everywhere resisted inflation of any kind. But the central policy question we are now confronting is how to reduce the value of debt that is dragging down the entire system. Indeed, virtually every sector of the economy is weighed down by debt, and virtually everyone will suffer as a consequence. For sure, creditors will complain about the insidious effects of inflation, but they too would be hurt by an extended period of negligible growth, with their investments constantly under threat of foreclosure and default.

Inflation would in fact be the best of a number of unpleasant options. One alternative to inflation would be bankruptcy. But it is hard to imagine that, under existing law, bankruptcy would do the trick. Thanks to the more restrictive bankruptcy law passed in 2005, individuals now find it more difficult to file for Chapter 11 (though even with that obstacle, bankruptcies have spiked up to levels not seen since before the legislation was passed). But even if it were possible to pare down the value of outstanding private debt via mass bankruptcy proceedings, it would impose massive transaction costs and trigger an explosion of legal proceedings.

Likewise, there is little hope of systemic debt forgiveness: just look at the housing market. Despite a large push by the Obama Administration, and economic incentives that would produce loan modifications that would save all players money, there has been basically no movement towards any kind of systemic write-downs of principal of underwater mortgages.

Inflation accomplishes much of the same ends as bankruptcy and debt forgiveness but with nowhere near the disruptive effects, or legal costs.

The second argument is that inflation would cause a run on the dollar and with it a disastrous rise in interest rates. Here much of the concern focuses on the likely reaction of China, one of the largest holders of dollar reserves and one of the largest buyers of U.S. treasuries. No doubt, the Chinese will not be happy about the fact that inflation will erode the value of their dollar holdings. But China's own options are limited. Any move to divest from U.S. debt runs a risk of precipitating some kind of move away from the dollar en masse, with China left holding the bag.

More importantly, China has little choice but to continue to buy U.S. denominated assets in order to maintain the competitiveness of its export sector and the health of the U.S. market on which it depends. Like it or not, China's economic fate is still intimately tied to an American economic recovery. For the past year, China has maintained positive growth mainly by expanding fixed investment--in other words, by increasing the capacity of its factories to export more goods. Thus, in spite of the effort it has made to reduce its dependence on global demand, China's growth for the foreseeable future still depends in large part on exports to developed country markets. In order to keep its currency from appreciating too much vis a vis the dollar and other currencies, it will need to buy dollars. Otherwise, it risks a major economic slowdown and a politically destabilizing rise in unemployment.

To be sure, there is a strong possibility that sustained inflation will make China and other investors, including American investors, less likely to hold dollars, and as a result the dollar will decline in value. But would that be such a bad thing? As noted earlier, a devalued dollar would have the salutary effect of reducing the current account deficit, which would in turn actually make the United States less dependent on the net importation of foreign capital. The words "strong dollar" have a kind of totemic power in American politics: as if the entire nation's power, prowess, and prestige are determined by international currency markets. Yet it was the strong dollar of the past two decades that helped create the huge imbalances that led to the massive credit bubble and today's crisis. It is time therefore to stop equating U.S. economic well-being with a strong dollar, and instead look at what produces healthy and sustained economic growth.

Finally, some would argue that pursuing a policy of inflation is inconsistent with the role of the dollar as the world's principal reserve currency. Having the world's reserve currency confers both privileges and responsibilities. The privilege it confers is that the United States can borrow and repay its debt in its own currency. In many cases, taking advantage of this privilege to inflate away the value of its debt would be irresponsible, but not in this case. Indeed, under today's economic conditions, it is the responsible thing to do. For, ultimately, a global recovery for every nation depends on a strong and sustainable recovery here and that in turn depends upon reducing our own debt overhang.

It is unlikely that the world would be better off if the United States chose instead a path involving a prolonged period of austerity and slow growth. Would China, for example, be better off if it had to close its factories and lay off tens of millions of workers because of chronically reduced demand from American consumers? If inflation reduces America's debt overhang and spurs a stronger and sustained economic recovery, then the net benefits to other countries in terms of employment and income will far exceed the lost value of their holdings in dollars. This may not be true under other conditions, but it is most certainly true of a world economy that is suffering from debt deflation and that is desperately in need of more demand and more growth.


If inflation can be helpful for a variety of reasons, the real question confronting policy-makers is how to maximize its benefits and minimize its costs.

First, it must be stressed that whatever loose talk there is of a stronger than expected rebound, we are a very long way from having to deal with this question in practice. The consumer price index is still in decline, and we are still facing the possibility of deflation for the first time in decades. The economy is still operating at postwar lows--at below 70 percent of capacity, with a multi-trillion dollar output gap. Somewhere in the neighborhood of 30 million Americans are either unemployed or underemployed. The latest estimates by the Federal Reserve estimate it will take six to seven years to return to pre-recession full employment.

But let's say recovery proceeds much faster than anticipated, and prices do, at some point, start to rise. How do we allow for a healthy rate of inflation--say, somewhere on the order of 5-6 percent--without allowing the self-fulfilling prophecies and vicious cycles of inertial inflation to kick in?

The answer has to do with, in Krugman's phrasing, whether inflation expectations become "embedded' in the economy or not--whether investors, consumers, and financial institutions all come to expect that prices will rise at unpredictable intervals, foreshortening the time span of decision-making and kicking in an auto-catalytic process that leads to more consumption, less investment, and more inflation.

The solution to this problem is something that, coincidentally, the current Fed Chair Ben Bernanke happens to be an expert on: inflation targeting. The literature on this topic is copious, and I won't rehash it here. Much of the most important work has been done by Bernanke himself. The principle is simple enough: the central bank announces what its annual target for inflation is and then conducts open market operations accordingly. This takes away a good bit of the guess work about whether the Fed will raise or lower rates, and accordingly limits the improvisational latitude of the Fed.

Historically, this approach has been favored by inflation hawks, who feel that it would serve as a control on the temptation for the Fed to cut rates to spur economic growth, or to allow recovery to go on too long raising prices too much. In the context of promoting inflation, it would be used as a kind of check against the fears of spiraling inflation that a sustained rise in the price level might bring about. If global investors come to credibly believe the target, even if the target is 5 percent, then it will reduce speculation in commodities and gold and avoid a rush away from bonds. For investors can price a predictable rate of inflation into the futures markets now, creating stable prices, rather than rushing to place bets that inflation will go to 10 or 12 percent. (Some of those bets are likely to be placed regardless.)

Through an amazing historical coincidence, fate has put a man who studied the Great Depression at the helm of the Fed as we work through the greatest financial disaster since that time. Bernanke relied on his scholarship of that period to avoid that era's mistakes, injecting massive amounts of liquidity into the market with a variety of unorthodox and creative gambits. Now, he can help us work our way out of our debt overhang, and facilitate the creation of a new, more equitable, more robust economy by marshaling his other area of expertise.

Inflation now.