Mostly Economics

Nouriel Roubini (Dr Doom) presented his views on faltering GDP to US Congress Joint Economic Committee. He is really bearish and expects all things to collapse. He suggest number of fiscal measures to resurrect the US economy. Roubini’s predictions are all very well known and this is a summary at one place.

Towards the end he says:

So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question is: likely not.

It will be interesting to see if this prediction also comes true. I am less optimistic as Roubini as this. His reasons:

 First of all, the massive injection of liquidity in the financial system – literally trillions of dollars in the last few months – is not inflationary as it accommodating the demand for liquidity that the current financial crisis and investors’ panic has triggered. Thus, once the panic recede and this excess demand for liquidity shrink central banks can and will mop up all this  excess liquidity that was created in the short run to satisfy the demand for liquidity and prevent a spike in interest rates.

Second, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized as opposed to being financed with a larger stock of public debt. As long as such deficits are financed with debt – rather than by running the printing presses – such fiscal costs will not be inflationary as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.

Third, wouldn’t central banks be tempted to monetize these fiscal costs – rather than allow a mushrooming of public debt – and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers? Not likely in my view: even a relatively dovish Bernanke Fed cannot afford to let the inflation expectations genie out of the bottle via a monetization of the fiscal bailout costs; it cannot afford/be tempted to do that because if the inflation genie gets out of the bottle the rise in inflation expectations will eventually force a nasty and severely recessionary Volcker-style monetary policy tightening to bring back the inflation expectation genie into the bottle. And such Volcker-style disinflation would cause an ugly recession.

Fourth, in the US economy a lot of debts – of the government, of the banks, of the households – are not long term nominal fixed rate liabilities. They are rather shorter term, variable rates debts. Thus, a rise in inflation in an attempt to wipe out debt liabilities would lead to a rapid re-pricing of such shorter term, variable rate debt. And thus expected inflation would not succeed in reducing the part of the debts that are now of the long term nominal fixed rate form.

I was not very convinced of the reasons. Infact all the four explain how could the entire “current fiscal support” turn into “a high future inflation”. Let’s see what happens. Roubini has been right so far. I hope he is right over the future inflation scenario as well.