Monday, May 4, 2009

Merle Hazard: "Will we Become Zimbabwe or will we be Japan?"

Is the United States is about to fall into a deflationary spiral or is it on the brink of run-away inflation? Allan Meltzer has looked at the near-zero interest rates, the blow up of excess bank reserves, and the more than doubling of the Fed's balance sheet and is certain that the United States is set to repeat its 1970's experience with inflation. Paul Krugman, on the other hand, takes a look at the large negative output gap and declining wages and sees deflation as a more likely threat. What are we to make of this debate? As noted by Mark Thoma and Martin Feldstein, the answer is that both outcomes are possible; it is just a question of timing. In the near term there is no doubt that the clear and present danger is deflation as domestic demand continues to collapse. At the same time, the Fed's vigorous (if somewhat haphazard) monetary expansion intended to stabilize nominal spending and prevent deflation will be very difficult to reverse once the recovery begins. If so, inflation will become a major problem. So brace yourself for the possibility of deflation in the near term, but plan in the mid term for the specter of inflation.

For further clarity on these issues I present Mr. Merle Hazard and his sidekick Mr. Bretton Wood:

3 comments:

  1. Very interesting. And it seems to me that this paper by Chris Sims is very much a propos to this difference of opinion http://sims.princeton.edu/yftp/CapeCod2008/Sketch.pdf
    Sims argues here that the Phillips curve/ output gap (stressed in your report by Krugman) is not the driver of inflation, instead it is expectations about future monetary and fiscal policy that are central. He also talks in this paper about how finance theory is moving away from rational expectations/ efficient markets and towards trying to model agents having different probability distributions over future states. Again, this seems of great relevance at this time of great uncertainty. Agents are currently trying to assess the budgetary and monetary implications of extraordinary recent events, and the sustainability of the time path of fiscal policy.

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  2. ECB:

    Thanks for the link. That was an interesting paper. The rational inattention theory with agents having different probability distributions over future states is intriguing. It is interesting that this approach allows for systematic errors while still salvaging rationality.

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  3. I must admit I’m loving the little catfight between Meltzer and Krugman. Inflation vs. deflation debate between Allan Meltzer and Paul Krugman is a rather interesting and insightful. Allan Meltzer says inflation is our greatest threat and I'm agree with him. Meltzer’s warning remains relevant.

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