Wednesday, August 31, 2011

Spend it or Lose it

In a recent column, Paul Krugman described what policies the Fed should have taken (which, coincidentally, he prescribed for Japan a decade ago). The Fed should promise to keep short-term interest rates near zero. At the same time it should buy up long-term debt in the hope of igniting inflation. Krugman never gets around to explaining what he hopes to accomplish with this so I will. He wants to take your savings.

For the last couple of years it has been a matter of faith that the only thing hindering the recovery is a lack of spending. Businesses are "hoarding" cash and individuals have been saving and paying down debt instead of spending. Krugman's solution is to penalize people for not spending.

The idea is to raise the rate of inflation enough that money left unspent will lose value. He may be hoping to force businesses to spend more of their cash holdings but they have investment options available that regular people do not. So the ones who will be hit the hardest are the ones who behave responsibly. If you are trying to save money you will see its buying power decline. If you put $100 in the bank, it will only be worth $96 this time next year. Given this, the only way you can get anything out of your savings is to spend it as fast as possible. In fact, with inflation running above interest rates, you might as well borrow as much money as possible since the cost of borrowing will be less than zero. Krugman hopes that this will provide the spark that the economy needs.

There are problems with the strategy. The first is that it discourages responsibility. You should be saving for retirement and emergencies. Our nation's long-term fiscal health depends on a majority of people behaving this way. If we force people to spend rather than saving then we will make them more dependent on the government in the future (which might please Krugman).

A second problem is that once you start up inflation it can easily get out of control. Inflation changes people's spending habits. Krugman is counting on this to stimulate the economy but the expectation of further inflation can turn into a self-fulfilling prophecy.

But the biggest problem is that this has been tried before. In 1933, FDR decided that the problem with the economy was that people were hoarding gold. He did away with gold coinage and had all existing gold coins melted into bars and shipped to Fort Knox. Then he inflated the currency. Obviously, that did not end the Great Depression.

In the late 1970s the country suffered from stagflation - stagnant economy and high inflation. Krugman's suggestions will likely bring a return to those times rather than lead to a recovery.

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