Been there, done that.

There’s a lot of interest in the recent moves by the Abe administration to push for faster growth in Japan.  Paul Krugman’s comments:

As far as I can tell, Posen is going with the notion that unconventional monetary policy, by working both on asset demand and on expectations, can do the job. Maybe, but most of us have taken the limited payoff to quantitative easing as a cautionary tale. There’s a lot to say for the notion of using temporary fiscal stimulus to push the output gap down, ideally even causing some economic overheating, to jump-start the transition to an inflationary regime.

And beyond that, the credibility of a higher inflation target in the face of the deflationary bias of central bankers may well be best established by (a) reducing the central bank’s autonomy and (b) getting the central bank in the business of supporting — indeed, monetizing — government deficits, at least for a while.

I don’t have any big problems with the technical framework used by Krugman, but I interpret the situation quite differently.  Let’s start where we agree.  I think neither of us are 100% convinced that Abe plans to carry through with aggressive stimulus.  But suppose he does, what will that tell us?

1.  Krugman see a coordinated fiscal-monetary push, whereas I see markets reacting mostly to the monetary side.  In my view the Japanese have already tried something like what Krugman discusses, and it failed.  They combined aggressive fiscal stimulus, lots of big government construction projects, and aggressive QE.  Been there, done that.

2.  One reason it failed was that the QE was partly temporary.  Krugman’s expectations trap model shows that temporary monetary injections are not effective.  I would add that temporary monetary injections combined with fiscal stimulus are also not effective, or at least they weren’t in Japan.

3.  The huge plunge in the yen began in mid-November, the day Abe announced he’d ask the BOJ to set a 2% inflation target.  I did a post that day, talking about the story.  I’ve followed it very closely ever since.  Lots of Keynesians seem to have jumped on the bandwagon much later, when talk of fiscal stimulus also seemed to impact the stock market.  However it seems to me that the big plunge in the yen has been very closely linked to reports that Abe would push a higher inflation target on the BOJ.  One wouldn’t even expect fiscal stimulus to depreciate the exchange rate at all.  So while we can’t be certain, I think the evidence strongly supports the view that expectations of easier money are depreciating the yen.  And the rise in stocks is very closely correlated with the fall in the yen.  Given that fiscal stimulus didn’t work in the late 1990s and early 2000s, I see little reason to believe that a modest fiscal stimulus would be a game changer today.

Having said that, I don’t dispute that a modest portion of the gain in the stock market, and more importantly the fall in the yen, was linked to a fiscal stimulus announcement, supporting Krugman’s argument that fiscal stimulus might help push the BOJ toward a higher inflation target.  That’s obviously a psychological argument that can never be precisely modelled.

4.  I’ll be focusing more on the BOJ, not fiscal policy.  What sort of target does the BOJ set?  Is it precise or vague?  Do they do level targeting?  When they fall short, how do they respond?  Unlike Krugman, I don’t think expectations traps are a real problem.  I see central banks as being like small children.  Markets can read their moods better than they can read their own mood.  (That’s why despite the fact that they have the technical ability to do “insider trading,” they often lose to people like George Soros.)  So if the BOJ sincerely wants 2% trend inflation, the markets will recognize that fact, and they’ll get 2% trend inflation.  But will they want it?  I’m still a bit dubious, although the odds have obviously improved in recent weeks.

Some commenters ask what sort of outcome would show that I am wrong.  So far it’s been easy to show that no fiat money central bank has ever tried to inflate and failed.  But I could envision it being much harder in the future, which would make my claim more dubious.  What if the BOJ had not raised interest rates in 2000 and 2006?  What if they hadn’t reduced the monetary base sharply in 2006?  What if they had set a symmetrical 2% inflation target in 2000, and consistently failed to hit it?  Yes, I could envision a situation where it’s hard to tell whether they were really trying and failing, or not trying at all.

I suppose I could always point to more things that haven’t been tried.  Why not push the yen to 120/$, and do a Swiss style policy?  If someone responds that the US won’t let them, then I’d respond; “Fine, then it’s not a liquidity trap it’s a US trap. The US is declaring economic war on Japan and forcing them into perma-deflation.”  But like most sweet, innocent, naive Americans, I could never imagine us doing anything so evil.

PS.  Remember, they attacked us in 1941!  We are the good guys. Oh wait, wasn’t there something about an oil embargo . . .

PPS.  Lars Christensen reminds us that Japan did a bit better in the 2000s than the 1990s.  But that wasn’t because of growing AD—NGDP is lower than 20 years ago.  More likely the labor market partially adjusted.  However the Japanese natural rate of unemployment used to be about 2% to 3%, so it’s still quite possible that a bit more AD would help.  (I’m told that Japanese unemployment data is misleading.) That’s not to deny that structural problems are the number one concern in Japan.

HT:  Travis V


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45 Responses to “Been there, done that.”

  1. Gravatar of Geoff Geoff
    19. January 2013 at 14:22

    Every 1% rise in Japan’s cost of debt (interest rates) costs them another 25% of revenue.

    To all you who are calling for “more aggressive policy” from the BOJ, know that because their debt is so big, inflation will make their expenses rise exponentially more than their revenues.

  2. Gravatar of ssumner ssumner
    19. January 2013 at 14:36

    Geoff, Don’t confuse real and nominal variables.

  3. Gravatar of Geoff Geoff
    19. January 2013 at 15:25

    Dr. Sumner:

    “Geoff, Don’t confuse real and nominal variables.”

    OK, I won’t.

    But I don’t see what that has to do with what I said. What I said is all nominal. Interest rates, inflation, debt, expenses, revenues, etc.

    Japan’s debt is so high relative to their tax base that inflation no longer has a linear effect on expenses and revenues.

  4. Gravatar of Lorenzo from Oz Lorenzo from Oz
    19. January 2013 at 16:53

    Geoff: if you inflate, (nominal) income goes up; that’s why folk do it. Which is why Austrians, for example, see large public debts as major future inflation risks. Taking the interest rate effects and ignoring the revenue effects doesn’t work.

  5. Gravatar of TravisV TravisV
    19. January 2013 at 18:33

    Prof. Sumner,

    Thanks for weighing in. However, it would still be nice if we could get your take on Krugman’s suggestion that Japan’s parliament should have a strong influence over the BOJ’s decisionmaking (Stiglitz has said similar things about the U.S.).

    Seems to me that breaching the central bank’s independence could be dangerous. In the long-run, shouldn’t the consensus of elite economists be more reliable than elected officials at maintaining good monetary policy?

  6. Gravatar of Joe Joe
    19. January 2013 at 19:07

    “Geoff: if you inflate, (nominal) income goes up; ”

    Yes, but the debt is 230% of GDP.

    Lorenzo, you think GDI will also be 230% of GDP: -)

    The strategy is not without risk and I would argue a bigger risk than thought about.

    The japanese chose deflation because it’s filled with a bunch of oldersters.

    Imagne they embark on this policy and then stop which could mean you’re left with higher prices, a damaged bond market and no rise in nominal incomes.

    My biggest concern is that they dont see it through.

  7. Gravatar of marcus nunes marcus nunes
    19. January 2013 at 19:36

    How to get it very wrong! Let “currency wars bloom”ott
    Christy Romer has “souded the trumpet” again:

    http://thefaintofheart.wordpress.com/2013/01/20/christy-romer-is-sounding-the-trumpet-again/

  8. Gravatar of Max Max
    19. January 2013 at 20:29

    Geoff, it debt/GDP is falling then interest payments could be 200% of revenue and it would be no problem. Interest payments can be financed with more debt, as long as the debt is sustainable.

    Conversely, interest rates could fall to less than nothing (<0% yield), and it would not help the government's finances.

  9. Gravatar of TravisV TravisV
    19. January 2013 at 21:07

    @Marcus,

    Meanwhile, here is that clown Stiglitz wringing his hands!!!

    http://opinionator.blogs.nytimes.com/2013/01/19/inequality-is-holding-back-the-recovery

    “We could have recognized that when young people are jobless, their skills atrophy. We could have made sure that every young person was either in school, in a training program or on a job. Instead, we let youth unemployment rise to twice the national average…..We are sowing the seeds of ever more inequality in the coming years.”

    Joe, if skill erosion is such a problem, then why aren’t you endorsing a higher inflation target??? Your comrade Krugman is. So why aren’t you? If anyone should be blamed for this, it’s influential economists like you who should get it but don’t.

  10. Gravatar of Joe Joe
    19. January 2013 at 21:40

    Max

    How would it be sustainable if debt and expected debt servicing rises 25% with every 1% increase in yields?

  11. Gravatar of Geoff Geoff
    19. January 2013 at 23:05

    Lorenzo:

    “Geoff: if you inflate, (nominal) income goes up; that’s why folk do it. Which is why Austrians, for example, see large public debts as major future inflation risks. Taking the interest rate effects and ignoring the revenue effects doesn’t work.”

    You aren’t reading closely enough. I said quite clearly that inflation affects revenue.

    My main point was that when debt is do high relative to the tax base, inflation does not affect interest costs and revenues equally. Do you disagree?

    Max:

    “Geoff, it debt/GDP is falling then interest payments could be 200% of revenue and it would be no problem. Interest payments can be financed with more debt, as long as the debt is sustainable.”

    That’s just it. In that scenario I don’t think it is sustainable. Interest that is 200% of revenue, financed with more debt, would only increase that percentage even more, necessitating even more debt, and so on. Accelerating debt costs relative to revenues is not, IMO, sustainable. Maybe if they were both rising linearly, I would agree.

  12. Gravatar of RebelEconomist RebelEconomist
    20. January 2013 at 00:37

    If Japan considers that the problem of deflation is that it holds back purchases (being quite familiar with Japan myself, I doubt that, but if that’s what the authorities think….), there is an easy solution that fits in with the rest of their problems: Abe should go through with the consumption tax hike that he supported in the Diet as a quid pro quo for early elections. Then, everyone will know that there will certainly be widespread inflation next year, and will presumably move their purchases forward.

    The consumption tax has the advantage that it is paid by the elderly living off JGB income (via the life insurance companies if not directly). And if that is not enough, raise the withholdings tax on saving income. There is no need to take chances with inflation, which, as Geoff points out, runs the risk of a fiscal explosion.

  13. Gravatar of Joe Joe
    20. January 2013 at 04:36

    Realeconomist

    Japan’s problem is that it’s not growing and the debt level is quite astonishing.

    The inflation route, not higher taxes is the best one. The only problem is that they cut out at midstream and they are left with a real mess.

  14. Gravatar of ssumner ssumner
    20. January 2013 at 05:50

    Geoff, Yes, nominal interest costs rise, but not real.

    Travis, Hard to say. And Stiglitz doesn’t understand monetary policy–never has.

    Rebeleconomist, As Geoff points out? You do realize he confused real and nominal variables, don’t you? Inflation reduces their debt burden.

  15. Gravatar of RebelEconomist RebelEconomist
    20. January 2013 at 08:22

    “Inflation reduces their debt burden.”

    It is not as simple as that, Scott, as I think Geoff explained quite clearly. If anticipated inflation raises the cost of servicing government debt before revenue-raising inflation has actually happened, the government might want to print more money to cover their interest payments. Inflation could rise uncontrollably, causing financial turmoil. Or, don’t forget, Abe wants the BoE to raised their inflation target to 2% and is not proposing to repeal the Bank of Japan law, so the BoJ might put a spanner in the works as soon as inflation rises significantly above 2%.

  16. Gravatar of Suvy Suvy
    20. January 2013 at 08:39

    Japan is basically screwed. Any sort of shift in interest rates and they are doomed due to the fact that they spend 50% of their revenues on debt service alone. A small shift in their rates and they spend more than their entire central government tax revenue on debt service alone. Also note that they currently spend 65% of their revenues on social security. So in mandatory payments alone(social security and debt service) they are already over their tax revenues. If their interest rates shift, it’ll be game over. Also note that they have a declining population and a declining workforce while having one of the highest life expectancies in the world, so their social security expenditures will go up in the long run while their tax revenues fall. They have no chance.

  17. Gravatar of Geoff Geoff
    20. January 2013 at 08:45

    Dr. Sumner:

    “Geoff, Yes, nominal interest costs rise, but not real.”

    Governments default in nominal terms.

    It’s the difference between nominal expenses and nominal revenues that concerns me about Japan.

  18. Gravatar of RebelEconomist RebelEconomist
    20. January 2013 at 09:43

    Suvy, I am not so pessimistic about Japan, simply because their government debt is so domestically owned while their net foreign asset position is strongly positive. But putting off dealing with that fiscal imbalance, and other remaining post-bubble problems, not to mention the potential for turmoil from an inflationary solution gone wrong, is killing Japan, because it tends to lead people to hold back from making major commitments until they see how the situation will be resolved.

    What Japan really needs is leadership, but the political class are mostly morons who owe their position to nepotism (eg Abe). And constant sniping from the US, who always and everywhere want developed countries to stimulate their economies in the forlorn hope that they might buy some of the uncompetitive crap that America has to offer, does not help.

  19. Gravatar of Dan in Euroland Dan in Euroland
    20. January 2013 at 10:30

    Japan is doing well considering their demographic problems

    http://super-economy.blogspot.com/2010/05/paul-krugman-wrote-in-nyt-that-we-are.html

  20. Gravatar of Geoff Geoff
    20. January 2013 at 10:31

    RebelEconomist:

    Whatever happened to self-leadership? The political class aren’t leaders, they’re enforcers.

  21. Gravatar of Max Max
    20. January 2013 at 10:38

    “How would it be sustainable if debt and expected debt servicing rises 25% with every 1% increase in yields?”

    A 1% increase in yield increases the debt growth rate by 1%. If GDP growth increases by 1% at the same time (i.e. the only thing that changes is the inflation rate), then it’s a wash.

  22. Gravatar of RebelEconomist RebelEconomist
    20. January 2013 at 10:43

    Geoff: deru kugi wa utareru

  23. Gravatar of Mike Sax Mike Sax
    20. January 2013 at 10:46

    RebelEconomist, I never come across anyone fretting over Japan’s debt-or the U.S’s for that matter-who can tell me why it’s a worry as interest rates are so low.

    Clearly there are no bond vigilantes around.

    So the reason to be conserneed is why? Is there any reason other than “some day it could be a prolbme I know not when, but it’s coming?”

    T

  24. Gravatar of Suvy Suvy
    20. January 2013 at 12:11

    Rebeleconomist,

    Japanese bonds are mostly held by its population, but my worry has to do with the population/workforce decline. Their current account surplus is now a deficit(same for their balance of trade), their savings rates have plummeted, their investment rates have plummeted, and Japan has no real way to reduce their deficit due to the fact that they spend more than 115% of their revenues on mandatory payments alone. Due to the reducing tax base and the increased people needing social security, massive austerity would be the only way to cut the deficit, but that wouldn’t hang too well on the economy. I don’t know when Japan breaks(that’s impossible), but I do know that it will. It may take another 10 years, but I just don’t see a way out for them.

  25. Gravatar of Kenan Kenan
    20. January 2013 at 12:19

    What evidence is there that Japan is producing below potential output? I believe the current estimate of the output gap is around -3%, but this estimate is prone to a lot of error. Japan doesn’t have any data on capital utilization in non-manufacturing sectors, so they assume 100% utilization and errors also arise from quality changes in production factors. The point is, what if Japan is producing at potential output? Then inflation will be a lot more destructive than what we think, especially considering their debt problems.

  26. Gravatar of RebelEconomist RebelEconomist
    20. January 2013 at 12:52

    Mike Sax, JGB yields won’t be so low if people believe that inflation might rise out of control. Why go there; put up taxes and engineer the same intergenerational transfer in a controlled way.

  27. Gravatar of RebelEconomist RebelEconomist
    20. January 2013 at 13:06

    @Suvy, I don’t think that there is an easy way out for Japan, either. But their ability to move from a large positive net foreign asset position into the red can cushion their transition. And allowing in some more foreigners such as from SE Asia can help if the Japanese can learn to accept and respect them (again, Abe, with his record of downplaying Japan’s treatment of Korean “comfort women”, is a bad choice of leader).

  28. Gravatar of dtoh dtoh
    20. January 2013 at 15:44

    Scott,
    We’ll see what happens today. I’m almost certain we will see a 2% inflation target. I think that’s already been discounted. The real test will be in April with the appointment of a new BOJ Chair and the two Vice-Chairs.

    As for fiscal stimulus, Japan has pretty poor infrastructure. There’s a ton of stuff that could be done that makes sense economically so I don’t have such heartburn with that.

  29. Gravatar of Benjamin Cole Benjamin Cole
    20. January 2013 at 21:01

    Japan can’t service its debt?

    Sure, they can—by printing money. They should print money to pay down existing federal debt, and then print more to pay interest on what is outstanding.

    And stop any more fiscal stimulus.

    BTW, why, why, why, why oh why, and 1000 times more why, do not Western economists ever—ever, ever, ever—discuss the People Bank of China’s explicit 4 percent annual inflation ceiling?

    Gee, do you think monetary policy might play a role in China’s boom?

    So, we believe monetarism is vital, crucial, explanatory—from Sweden to USA to Japan—but not in China?

    Maybe 4 percent ceiling is a better target than 2 percent, an 2 percent is better than 0 percent?

    Based on empirical evidence….based on results….but why use experience as a guide, when you have theories!

  30. Gravatar of Saturos Saturos
    20. January 2013 at 22:15

    Geoff, one of the costs of inflation is that it makes people pay more in taxes (in real terms).

  31. Gravatar of Benjamin Cole Benjamin Cole
    20. January 2013 at 23:31

    Saturos–

    Not true—inflation and resultant level of taxation depends on the shape of the tax code.

    For example, in the USA federal taxes are about the same percentage of GDP as they ever have been in the postwar era. We have had a lot if inflation in the meantime.

    The shape of the federal revenues has changed since WWII, relatively away from corporate income taxes and to payroll taxes. That’s the big shift. Did inflation do this? I don’t think so.

    If you are saying that only progressive income taxes are used, and they are not adjusted to inflation, then you might have a case that inflation raises people’s taxes relatively.

    In California, inflation has steadily reduced property taxes (relative to income or general prices) for those people and businesses who do not sell their property. Taxes are re-assessed only on sale of property. These people love inflation–it cuts their taxes!

    In general, moderate inflation is benign, or mildly redistributional.

    But more important than the absolute rate of inflation, is what rate of inflation accommodates the greatest sustained real growth?

    Europe and Japan are asphyxiated at 0 percent inflation targets; the USA blue in the face at 2 percent, but…China is booming, at a targeted ceiling of 4 percent annual inflation. Those are the facts on the ground.

    Monetary policy is not the only explanation, but….why do people say monetary policy is key until it results in an outcome that does not fit their theories?

  32. Gravatar of RebelEconomist RebelEconomist
    21. January 2013 at 01:14

    Do you just make this stuff up, Benjamin? “Europe and Japan are asphyxiated at 0 percent inflation targets; the USA blue in the face at 2 percent, but…China is booming, at a targeted ceiling of 4 percent annual inflation. Those are the facts on the ground.”

    The ECB has an official target of “below but close to 2%” ( http://www.ecb.int/mopo/html/index.en.html ) – which is presently being exceeded – and the BoJ has an official inflation target of 1% ( http://www.boj.or.jp/en/announcements/release_2012/k120214a.pdf ). I’ll give you a pass on the US though. You are also correct about China’s inflation target (actually a goal set from year to year), but note that this allows for the fact that the country is poorer, meaning that food and energy prices have a larger weight in its consumer price basket and hence that China’s inflation is more volatile.

    By the way, you may have missed my reply to you on central bank incentives here: http://www.themoneyillusion.com/?p=18790#comment-221234 . If there is one misconception of yours that I could fix most of all, it would be your idea that central bankers have a cultural antipathy for inflation. When I joined the BoE, it had a fixed rate, subsidised mortgage loan scheme, so BoE staff actually had an incentive to raise inflation (I pointed this out to the Governor of the time, who was not very pleased!). The scheme has now gone, but something of the attitude it engendered may persist.

  33. Gravatar of Geoff Geoff
    21. January 2013 at 05:45

    I see some folks are having a difficult time fully appreciating exponential functions.

    Max:

    “A 1% increase in yield increases the debt growth rate by 1%. If GDP growth increases by 1% at the same time (i.e. the only thing that changes is the inflation rate), then it’s a wash.”

    Max, when the debt is relatively high as compared to the tax base, then an increase in debt yields makes expenses rise exponentially greater than tax revenues. It isn’t a wash.

    RebelEconomist:

    “Geoff: deru kugi wa utareru”

    ???

    Saturos:

    “Geoff, one of the costs of inflation is that it makes people pay more in taxes (in real terms).”

    Yes, that’s true, but in the case of Japan, and other highly indebted nations, that increase in taxes does not match, percentage-wise, the increase in expenses. Expenses come to take up exponentially more percent of revenues, because expenses rise more than revenues rise.

    Inflation does not have linear effects in highly indebted nations.

  34. Gravatar of Scott Sumner Scott Sumner
    21. January 2013 at 07:03

    Geoff, Your claim that government’s default in nominal terms not real terms proves my point. You and Rebeleconomist need to study basic macro. Inflation helps debtors. It reduces the real debt load for any given nominal debt. If you prove that wrong I can guarantee you both a Nobel Prize in economics.

    Dan, No Japan is not doing well–I’ve addressed that issue in many posts.

  35. Gravatar of Kenan Kenan
    21. January 2013 at 10:30

    Professor Sumner, yes inflation does help debtors when that debt is fixed, but Japanese debt has an average maturity of 6 years and more than 60% of JGBs will need to be rolled over in the next 5 years. This combined with the fact that debt service is 43% of revenue is the reason why a rise in nominal interest rates from increased inflation would not help debtors in this case.

  36. Gravatar of Max Max
    21. January 2013 at 12:00

    Geoff, inflation causes debt and revenue to increase at the same rate.

    What is true is that inflation increases budget deficits. It literally makes it harder to balance the budget. But this is irrelevant. What matters isn’t the size of the deficit, but whether the debt/revenue ratio is increasing or decreasing. Changing the inflation rate (and assuming nothing else changes) doesn’t affect this.

  37. Gravatar of RebelEconomist RebelEconomist
    21. January 2013 at 13:15

    Geoff, It is a Japanese saying meaning “the nail that stands up gets hammered down”, in response to your question “whatever happened to self-leadership”? Basically, the Japanese are discouraged from thinking for themselves.

  38. Gravatar of RebelEconomist RebelEconomist
    21. January 2013 at 13:41

    “You and Rebeleconomist need to study basic macro. Inflation helps debtors. It reduces the real debt load for any given nominal debt.”

    You are being annoyingly obtuse again, Scott, as I am sure you know. Of course, in the end, inflation reduces the real debt load for any given nominal debt, but the path of the process is difficult to control so that it does not produce unacceptable intermediate outcomes.

  39. Gravatar of Benjamin Cole Benjamin Cole
    21. January 2013 at 17:38

    Rebel-

    Thanks for your correx. I will check out ECB inflation targets…I thought under the Teutonic hoof, they were at zero…

    BoJ has been at zero until recently (even less if you judge by their actions), and the USA is at 2–2.5 (unofficial, but) and China is at 4 percent.

    On central bank culture, I will affirm by beliefs, but concede I am Pacific-centric, that is Japan and USA. The speeches, the reports, the public commentary (especially Fisher) is ever about the battle against inflation, holding the line etc etc etc.

    They never say. “We have to show resolve, be tough and obtain growth even in the face and at the cost of moderate inflation.”

    This would have been a sensible message to send in 2008, and at almost anytime in Japan.

    But in central bank culture, being “tough” and “resolve” are never connected to obtaining real economic growth. This has to be a valid complaint and true observation, at least for the BoJ and Federal Reserve. If you can find someone quoted to that effect, I will read it!

    Stayed tuned, we have more arguments to make!

  40. Gravatar of Geoff Geoff
    21. January 2013 at 17:46

    Dr. Sumner:

    “Geoff, Your claim that government’s default in nominal terms not real terms proves my point. You and Rebeleconomist need to study basic macro. Inflation helps debtors. It reduces the real debt load for any given nominal debt. If you prove that wrong I can guarantee you both a Nobel Prize in economics.”

    This comment makes no sense to me. The fact that inflation reduces the real debt load for any given level of debt does NOT imply that it reduces the nominal load of expenses versus revenues.

    I take somewhat offense at your charge that I need to learn basic macro, for I have studied advanced macro in college, beyond the basics. I learned in advanced macro that the formula typically taught to undergrads for calculating the “real price” of a debt contract, whereby it is concluded that “inflation helps debtors”, is not universally true. It is true only with certain assumptions.

    I learned that if inflation of X% causes a person’s or government’s nominal income to rise by 5%, but it causes their nominal expenses to rise by 25%, then they are worse off, even if inflation has reduced the real value of the debt.

    I didn’t want to drag this down to patronizations, but since you did, I will say that you don’t seem to understand the fact that inflation only helps indebted people to the extent that inflation increases their revenues sufficiently. If it doesn’t, then inflation will end up making their situation worse, for their nominal expenses have grown more than their nominal income.

    You can’t just assume inflation helps those who are indebted as a universal truth. It depends on their cash flows.

    Max:

    “Geoff, inflation causes debt and revenue to increase at the same rate.”

    Not if debt is 25, 30 times the tax base. Then inflation causes expenses to rise by MORE than revenues.

    “What is true is that inflation increases budget deficits. It literally makes it harder to balance the budget. But this is irrelevant. What matters isn’t the size of the deficit, but whether the debt/revenue ratio is increasing or decreasing. Changing the inflation rate (and assuming nothing else changes) doesn’t affect this.”

    I disagree. When a government has a high debt to tax base ratio, then inflation will make a government’s interest expenses rise much more than their revenues.

    It’s almost certainly why Japan isn’t so gung ho about inflation. They probably get it.

    RebelEconomist:

    “Geoff, It is a Japanese saying meaning “the nail that stands up gets hammered down”, in response to your question “whatever happened to self-leadership”? Basically, the Japanese are discouraged from thinking for themselves.”

    Maybe their conformist culture has finally caught up with them.

  41. Gravatar of Geoff Geoff
    21. January 2013 at 18:24

    This is the scenario I have in mind:

    Suppose I am indebted by $10,000 million, and I roll it over every year, and current interest rates are 1%. My interest expenses are $100 million. Suppose my annual income is $200 million. That means my expenses are 50% of my revenues.

    Now suppose inflation rises and adds just 1% to the rate of interest on my debt, to 2%. Suddenly my interest expense is now $200 million. Interest expenses have now taken up my entire income.

    Now, if we assume that inflation has also raised my nominal income, then in order to have the same PERCENT of interest expense to nominal income as before, my income would have to rise to $400 million, which is a 100% increase. In reality of course, my income would not rise by that much if inflation adds 1% to interest rates, so I would end up with having a much higher expenses relative to revenues ratio than before.

    This is what happens when debt principle is so very high relative to revenues.

  42. Gravatar of Max Max
    21. January 2013 at 22:26

    “Now suppose inflation rises and adds just 1% to the rate of interest on my debt, to 2%. Suddenly my interest expense is now $200 million. Interest expenses have now taken up my entire income.”

    Yes, but you haven’t explained why that is a problem. The $100 million in extra interest payments increases the debt by 1%. Meanwhile, revenue increases by 1%. So the debt load (debt/revenue) is unchanged compared to the case without the inflation.

    Another way to look at it is that inflation reduced the real value of the debt by $100 million. The debt holders aren’t gaining anything from the higher interest payments. It just offsets the loss from inflation.

  43. Gravatar of Geoff Geoff
    22. January 2013 at 05:01

    Max:

    “Yes, but you haven’t explained why that is a problem.”

    I thought it was pretty self-explanatory, Max.

    “The $100 million in extra interest payments increases the debt by 1%. Meanwhile, revenue increases by 1%. So the debt load (debt/revenue) is unchanged compared to the case without the inflation.”

    Wait, why did you add $100 million to the debt? Those are additional interest payments, not additional debt.

    The more important thing is expenses relative to revenues. Expenses went from $100 million to $200 million, while revenues (assuming they went up 1% too) went from $200 million to $220 million.

    If inflation increases again, adding another 1% to both, then interest expenses would rise from $200 million to $300 million, while revenues increase to $232 million. Uh oh.

    “Another way to look at it is that inflation reduced the real value of the debt by $100 million. The debt holders aren’t gaining anything from the higher interest payments. It just offsets the loss from inflation.”

    Real values are irrelevant when it comes to an institution’s solvency.

    If my expenses rise above my revenues, you won’t console me by telling me that the real value of my expenses declined.

  44. Gravatar of Max Max
    22. January 2013 at 08:04

    “Wait, why did you add $100 million to the debt? Those are additional interest payments, not additional debt.”

    Government spending went up $100 million, which automatically adds $100 million to the debt.

    Again, it’s not the size of the deficit that matters for solvency but whether the debt is growing (forever) as a % of revenue. If the debt/revenue ratio is expected to stabilize, then the government is solvent.

    That’s not to say that a high debt/revenue ratio isn’t risky. But the risk doesn’t come from inflation, it comes from higher real rates. Since nobody knows whether a real interest rate increase might be permanent, it can cause a self fulfilling prediction of insolvency.

    Believe me, I’m not expounding an exotic theory, this is 100% orthodox finance.

  45. Gravatar of Geoff Geoff
    23. January 2013 at 04:32

    Max:

    “Government spending went up $100 million, which automatically adds $100 million to the debt.”

    No, not if it is financed out of revenues.

    “Again, it’s not the size of the deficit that matters for solvency but whether the debt is growing (forever) as a % of revenue. If the debt/revenue ratio is expected to stabilize, then the government is solvent.”

    Again, no, what matters is expenses relative to revenues.

    “Believe me, I’m not expounding an exotic theory, this is 100% orthodox finance.”

    I don’t think so.

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