Don't Worry Mr. Mankiw, Mr. Rogoff, I'll Defend You!

The hot topic on economics blogs lately, has been how the US needs to approach its post-recession economic policy. It is entirely amusing how passionate and polarized the debates are on either side (In particular, I'd advise checking out Paul Krugman's editorials for the New York Times).

Today, this lowly, green economist will take his first stab at discussing economic policy amidst the "big boys". This article is a response to a blog from Ludwig von Mises Institute website by William Anderson. Now, as background, I know little about the Mises Institute except that they come from a background of classical liberalism, libertarian political theory, and the Austrian School of economics.

http://blog.mises.org/9979/economists-and-the-zimbabwe-solution/

The article criticizes recent propositions by Greg Mankiw (Harvard Economics professor and former chief economic advisor to George W. Bush) and Kenneth Rogoff (former chief economist at the International Monetary Fund) regarding US monetary fund. They argue that a temporary lax on inflation (Rogoff suggests around 6 percent for a couple of years) would take the pressure off debt-strapped consumers and governments trying to meet their obligations.

Anderson seems to object to any monetary policy that accepts expansion as a part of regular policy. He says,
"Note that what they [Mankiw and Rogoff] really are advocating is the repudiation of debt via monetary debasement. Now, when you and I receive debased products, such as lower-quality food and other goods, we don’t like it and believe we are being cheated."
His argument hinges on the idea that by allowing more lax inflationary policy, the intrinsic value of US currency will drop. However, the value of a unit of currency is essentially a function of how much money is produced and how much a country produces. So if the inflation rate was absolutely zero, then the value of money should increase relative to other currencies because each dollar represents a larger absolute chunk of productivity.

Granted, I'm really simplifying this concept. But my main, first point is this. To say that money is becoming worth less because of inflation, is not completely accurate given general growth.

counter-argument: but Jonathan, the US economic growth rate was only 3.2 percent in Q1. Wouldn't a 6 percent inflation rate still make each dollar decrease in value.

This is true, and ultimately, the point of Mr. Rogoff's prescription. It means that, after one year, a US dollar could buy 6 percent less than it could before. Generally, a net inflation rate is acceptable for most central banks. Because people know it to be consistent, most employers generally increase wages to compensate every couple of years (or at least they should). This keeps the real wage (real value of your work) relatively constant to what you can buy. This is to say that, ya, this type of policy may decrease the value of your money a bit over the next few years a little bit faster than your employer knows to respond to, but in reality the impact of a temporary policy like this will be very small to the average consumer and, with time, wages should adjust to prices.

Now, the argument for why we should do this. While wages lag behind prices in adjusting to inflation (i.e. prices tend to increase before wages do), the one thing that doesn't change is debt. Because most debt grows at a fixed interest rate, whenever the inflation rate is higher than that interest rate, the value of the debt decreases. To make this more concrete, let's say the interest rate is 6% for the next year. As a result, the price of stuff is 6% higher, you go to your boss and ask for a raise to cover inflation (being the good boss he/she is, he/she concedes), now the portion of your income going to stuff (food, clothes, ipods, etc) is the same as a year before, however, your mortgage payments haven't changed, they stayed the same as last year. As such, your ability to your debts increases, and now you can spend a greater portion of your money buying stuff or saving your money.

Not to mention, a higher inflation relative to other countries, affects your terms of trade (conditions under which you trade). Higher inflation causes your exchange rate with other currencies to drop (depreciate) as long as they don't change their inflation rate. A depreciated currency effectively makes it easier for foreigners to buy stuff made in your country. This can encourage export business.

It just so happens that this could help alleviate the US trade deficit. Which seems to be reaccumulating since April 2009 when the balance of trade started to decrease again.

To come back to the article's point, monetary "debasement" is not at all like buying a "debased" product. Entirely because the point of money is that it isn't a "real" thing. Its a place holder to represent purchasing power. And while inflation decreases the total power your money has, it also has other effects. The problem with a lot of purely classical and liberalist traditions is that they tend to neglect the reality of the system in which any economic policy works. While I won't concede to suggest that Mr. Mankiw and Mr. Rogoff are expressly correct in their prescriptions and I certainly don't see this as a total solution for the uncertainty in the US economy, there seems to be a good reason why higher inflation may pay off in the short run (I certainly think there could be problems with a sustained policy that incorporates this level of inflation, long term but I sincerely doubt that this is what either of these economists are suggesting). From my perspective, a lot of neo-liberal economic theory gets thrown around in both the academic world and the media, without much understanding behind it. There's a conditioned response that many have towards "inflation" and "deficits" that may not be helpful in finding an objective, best policy solution to the current context.

Please note 2 final things:
1. I may have something wrong in my understand above. If this is the case, please mention it in the comments below.
2. Most economists like the word "good" instead of "stuff"..."Stuff" just sounds better to me.

Development as problem-solving systems

This entry is in response to Bill Easterly's recent blog entry,

http://aidwatchers.com/2010/07/the-answer-is-42/

I whole heartedly agree with what Professor Easterly has to say in this article. It is really a part of how we redefine the way developmentalists look at their subjects and the work they are trying to do. By framing development as the emergence of a problem-solving system as opposed to a series of solutions, it sets apart the expectations that so many people have. Processes emerge gradually and, while they can be informed by developmentalists, they cannot be imposed all at once. We've seen this in cases of Afghanistan and Iraq where the imposition of western-style democracies have been resisted. On the other hand, the "solutions" that this discipline comes up with, have to be seen in with a more even handed perspective. That they are solutions to specific problems in specific contexts, not panaceas.

One twitter correspondant replied to Prof. Easterly's article "Isn't this tautology?" (@aneldagrove)

Maybe, for those who are in the field and have been working on the ground. But for outsiders this reality is not so clear...especially when we have misleading institutions that express a sense of "catch-all" like the World Bank and the International Development Bank.

However, these instutitions are, generally, our best hope for real development inasmuch as their studies and projects combine both prescriptions for problems as well as subtle changes that affect systems. And, they carry the legitimacy of being big, knowledgable (not to mention well-funded) sources of "development".

What am I saying? I think I'm saying that the best hope for system change on the level that Prof. Easterly alludes to, is through the subtle systemic changes that have occured within countries that adapt to the advice of development agencies and institutions. Might it be that development is a case of being as shrewd as serpents and as innocent as doves?