Weighing the Risk of Inflation

Rebutting Paul Krugman on Inflation

If you don't know whether to worry more about inflation or deflation -- economists seem to be evenly split at the moment -- a good technique is to parse the arguments being made by the two camps.

Here is the case made by Paul Krugman, a leading proponent of the "worry more about deflation" school ("The Big Inflation Scare"). As you'll see from my rebuttals (in parentheses), I don't find him persuasive.

PK: At the moment, all the leading price indices show that inflation is quite modest. If anything, the direction of prices is deflationary (especially home prices).

Rebuttal: Three days before Katrina hit, the weather in New Orleans was sunny. Simply extrapolating from current conditions doesn't constitute rigorous forecasting.

PK: Historically, very few countries have purposely used inflation to pay off a runaway national debt. For example, France after WWI. On the other side of the ledger, countries such as Japan, Canada, and Belgium have serviced national debts that, relative to the size of their economies, were even bigger than the U.S. debt is soon projected to be.

Rebuttal: Canada? Belgium? How does the experience of these countries -- literally a fraction of the size of the U.S. -- portend anything for the U.S? Even Japan's experience is a dubious precedent for the U.S.: it is a nation of savers, and traditionally has run huge trade surpluses. The U.S. is by far the world's biggest economy, and now has the dubious distinction of being the biggest debtor nation -- by far -- in history.

PK: At the moment, all the money stuffed into banks to repair holes in their balance sheets is just sitting there, rather than funding new loans. So, at least at the moment, the Fed's decision to "monetize" the banks' bad debts isn't inflationary.

Rebuttal: So what? A warehouse full of dynamite isn't safe just because there aren't any matches around at the moment.

Echoes of LTCM

Ultimately, what I find most unsettling about the arguments advanced by Krugman et al is their assumption that, simply because something is historically rare, therefore, it's unlikely.

That sounds a lot like the thinking baked into the models used at Long-Term Capital (Mis)Management ("LTCM"), the Nobel laureate-advised investment fund that famously blew itself up in 1998 -- and threatened to take the U.S. financial system with it.

Or, much more closer to home (pun intended), the arguments economists made to justify perpetually rising housing prices, or at least a long-term plateau.

As recently as 2006, they argued -- correctly -- that U.S. housing prices had never fallen in aggregate on an annual basis since The Depression.

So much for that one . . .