Monday, February 15, 2010

Yes, Yes, Inflation Solves All Economic Problems

If inflation really could save the world, then we would be looking to Zimbabwe as our savior, given that its government over the past few years has been producing some memorable moments in the history of crankdom. Alas, inflation is a scourge, not an economic solution.

Unfortunately, Paul Krugman does not seem to get it. In his latest column, "Making of a Euromess," he blames the economic crisis in Spain on...the Euro. Now, I am no more fond of the Euro than I am of the 1923 German Mark, but Krugman's reasoning is something to behold. In his own words:
And there’s not much that Spain’s government can do to make things better. The nation’s core economic problem is that costs and prices have gotten out of line with those in the rest of Europe. If Spain still had its old currency, the peseta, it could remedy that problem quickly through devaluation — by, say, reducing the value of a peseta by 20 percent against other European currencies. But Spain no longer has its own money, which means that it can regain competitiveness only through a slow, grinding process of deflation.
Notice that he is saying that Spain really is in trouble because it cannot engage in inflation, since it does not control the Euro, unlike its former fiat currency, the peseta. However, devaluation really does nothing but put off the Day of Reckoning for a while, but that day will arrive.

On the other hand, perhaps the best thing that Spain needs is the "grinding process of deflation," as that simply means that the prices paid for overvalued Spanish factors of production (and especially labor) are going to have to fall into line with economic reality. Most people, and especially the heavily-unionized Spanish workforce, don't want to hear that "option," as they would like to continue the charade that economic recovery is not going to require some short-term painful medicine.

However, if the Spanish were willing to take the medicine, they would be hurting now, but their economy would recover and become a beacon in Europe. Inflation, while delivering the "good effects" in the short-run, runs the economy off the rails as bout after bout of money devaluation takes its toll.

Not surprisingly, Krugman advocates inflation and denounces deflation. Yet, the only hope for Spain is deflation. The European Union is not going to bail out Spain, and that is a good thing. No, Spain needs to get its house in order. Likewise, on this side of the Pond, perhaps the USA needs to get its own house in order and stop preaching the Gospel of Inflation.


sb101 said...

Maybe I am not smart enough to follow your reasoning here, but I do not recognize where Krugman is advocating Spain inflate its way out of an inflation problem.

If Spain never joined the Euro, the exchange rate and thus relative costs would have adjusted with the capital flows in and out of the country. So if the peseta existed, as Spain’s housing market collapsed, and as capital exited the country, the exchange rate would have adjusted accordingly, and some of the slack in the Spanish economy would have been offset by an increase in exports. If Spain had its old currency, there would be no need to devalue; the market would have taken care of it. Since they essentially have a pegged exchange rate and inability to cut interest rates, the market is inefficient and can not adjust. Spain is in a tight spot, and unlike Greece not because of irresponsible fiscal policy. It’s mainly due to the lack of its own currency, and as you both (correctly) point out, deflation is the only cure.

William L. Anderson said...

When a country devaluates its currency, it does so by inflation. For example, in 1971 when he closed the gold window, President Nixon devalued the dollar, which is a nice way of admitting the government had been inflating it for a while.

During a period of deflation, the value of money gets back into line with the fundamental assets of the economy. I'm glad to see that you recognize this fact; would be that our "policy makers" did.

sb101 said...

“When a country devaluates its currency, it does so by inflation.”

Yes, but Spain does not have the option to depreciate or appreciate its currency. So when capital entered the country, it drove up relative prices, and now that capital has exited the country, they are left w/ “deflation as their only hope”. However, had they maintained a flexible FX, the peseta would have adjusted w/ capital flows, and relative labor costs would not have gotten so far out of line. Krugman lays out a pretty good argument that the fixed exchange rate is why relative labor costs have gotten so far out of line with the rest of the region. Would you not agree?

“During a period of deflation, the value of money gets back into line with the fundamental assets of the economy.”

Doesn’t a flexible exchange rate achieve this as well? Spain does not have this option, and aren’t they paying the price in higher labor costs?

I do apologize, but I still do not understand the conclusion that Krugman feels “inflation really could save the world”. It’s seems to me he is criticizing the Euro and shows that if Spain had a flexible exchange rate labor costs would not be so out line with the rest of the region. He is, in fact, demonstrating why a market based exchange rate for Spain vs. the rigid currency regime the Euro would be beneficial.

William L. Anderson said...

I apologize for not giving you an answer right now. I'm working on a paper that I have to present in two days, and am preparing for a trip, so I have to try to get back with you later. I'm not blowing off your questions, but just have to do my day job right now!

sb101 said...

Understood! Many thanks.

Chuck said...

Krugman is a man of many opinions and it seems half contradict the other half....

I love his recent article about Obama's deficits being good for the country. Two years ago, Bush's smaller ones were a terrible drain and devastating to our future...Which time was he lying or does he simply tailor his message to suit those he wishes to worship?