Wishful thinking

FT.com / Comment / Editorial - Inflation can and must be avoided

nflation can and must be avoided

Published: May 4 2009 19:04 | Last updated: May 4 2009 19:04

Is another period of high inflation inevitable? Is it desirable? The answer to both questions is: no. But resurgence of inflation is, alas, conceivable. Thus, even today, when policymakers are focusing on the need to avoid a deflationary collapse, they must also work out how to exit from high fiscal deficits and unconventional monetary policy.

When a credit bubble bursts, policymakers confront not only an immediate danger of deflation, as the financial system and demand collapse, but also a more distant risk of inflation, as government debt and central bank money explodes. That is precisely their predicament today.


Central banks have, rightly, become extremely aggressive: short-term interest rates are at very low levels; and, as a result of unconventional policy, the “money multiplier” – the ratio of commercial bank to central bank money – has almost halved in the US. Meanwhile, governments have emerged as borrowers and spenders of last resort. According to the International Monetary Fund, the ratio of government net debt to gross domestic product is set to rise by 27 percentage points in the US and 29 per cent in the UK, merely between 2007 and 2010.

For many, inflation is the unavoidable result of such huge rises in public debt and aggressive monetary policy. If governments found it hard to issue debt at “reasonable” interest rates, their pressure even upon notionally independent central banks to finance them directly might become overwhelming. Even without such pressure, the needed tightening might come too late.

Yet inflation is far from inevitable. With a real interest rate of, say, 2.5 per cent, the cost of financing net debt of 120 per cent of gross domestic product would only be 3 per cent of GDP. This is eminently affordable. What is needed is a credible will to close fiscal deficits as economies recover.

Inflation would also be highly undesirable. True, some view inflation as a clever way to eliminate the overhang of private- and public-sector debt. But it would also make another severe recession inevitable, this time to eliminate resurgent inflationary expectations. It would be crazy to add such inflationary insult to the deflationary injury.

Having lost control over economies, policymakers are forced to improvise. But the underlying aim is to restore stability now and then let their economies grow their way out of the excessive debt. That is far and away the least bad way to escape from the mess. We must chart a course that avoids both deflation now and surging inflation later. It will not be easy. But it can – and must – be done. The alternatives do not bear thinking about.

Copyright The Financial Times Limited 2009

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