Boyd Erman
A small group of influential economic thinkers has a controversial proposal for central bankers: Drop the fight against inflation for a while.
Encourage prices to rise faster than they have in decades, the argument goes, because deflation and the inevitable long recession that comes with it are a greater risk than inflation; because rising prices will prod consumers to spend; and because inflation devalues past debts and will help people who are underwater.
The idea is anathema for those raised on the anti-inflation orthodoxy of recent decades, or those who endured the rapid price jumps of the 1970s.
Yet, the proponents of the idea have serious credentials. They include Ken Rogoff, a former research director at the International Monetary Fund and now an economics professor at Harvard; Paul McCulley, a portfolio manager at Pimco, which runs the world's biggest bond mutual fund; and John Makin, an economist at the conservative American Enterprise Institute (not the kind of think tank that would normally espouse such a radical idea).
With reports this week showing that consumer prices in both the U.S. and Canada fell in May, the risk of deflation should be a hot topic.
Instead, many investors dismiss it as a blip, fixating on the chance that the money printed by governments to prop up economies and lubricate financial markets will spark runaway growth and inflation.
So even with deflation on the radar, government bonds had another rough week as investors bailed out on inflation concerns, while stocks rose on recovery hopes.
"Any student of history and bubbles bursting is very nervous about deflation getting out of hand," Mr. Makin said in an interview. "If it really gets rolling, you really have a hard time turning things around."
So why the focus on the risk of inflation?
"Intuitively, people are probably not very well informed about deflation and disinflation because it hasn't been around very much," Mr. Makin said. "It's very easy for commentators to get worked up about all this government debt, printing money - the end of the world - but with excess capacity where it is, it's more likely that we'll see the inflation rate drifting down."
Drifting down it is. North America has been experiencing disinflation, the wonkish word for a period when prices are still rising but ever slower, for months. And now, there is deflation, where overall prices are actually going down.
After its recent peak of 3.5 per cent in August of 2008, the inflation rate in Canada has steadily dropped and in May read negative for the first time in 15 years at minus 0.3 per cent, a report yesterday showed.
The inflation rate has been negative in the U.S. for four months now.
Much of that admittedly has to do with gasoline prices, which have slumped after soaring in the middle of last year. However, with so much slack in both economies, high unemployment, stagnating wages and companies struggling for, it's hard to imagine prices for other goods going up very quickly any time soon.
So Mr. Makin and his peers argue that the answer, should sustained deflation become more of a risk, is for central bankers like Canada's Mark Carney and the U.S. Fed's Ben Bernanke to broadcast that they would allow inflation to be much higher than the 2 per cent or so that it's averaged over the boom years. How much higher? Mr. Rogoff has suggested 6 per cent for a couple of years, if need be.
That would stop the cash-hoarding instincts that are holding back recovery in what Mr. McCulley of Pimco recently called "a liquidity trap." It would essentially be an ultimatum: Spend the money you've got now, because it will be worth less tomorrow.
Also, inflation would increase asset values relative to debts incurred in the past, easing the burden on society of the massive borrowings taking place and even potentially arresting the slide in the U.S. housing market.
The problems with the idea are the flipsides of those advantages - inflation devalues savings and hurts lenders, who are paid back in dollars that aren't worth as much. Bondholders would scream long and loud, as would the inflation hawks who have had the ear of investors for a long time.
As Mr. McCulley puts it, embracing inflation is just not discussed in "politically correct circles."
But it may need to be, if the stimulus plans now under way can't get us out of the economic quicksand. The timing would be tricky. If the central banks say too early that they want or will allow more inflation, lenders will push up interest rates to compensate, which is counterproductive.
"You have to wait, wait, wait until people get very frightened about deflation and that runs the risk of actually moving too late," Mr. Makin said.
As Mr. Makin said, it's not a good option, but it may end up being what's needed.
"Maybe that's why post-bubble situations don't end very happily."