Should we debase the currency?

You might wonder if this question is a misguided satire of Keynesian proposals like the ones in this Institute one-pager for boosting employment in a time of weak economic growth. The question is not meant as a satire, though. In a time of increasing recession fears, policies specifically aimed at reducing the value of the dollar have gained some supporters. Many scholars see a deliberate weakening of the U.S. dollar and/or a moderate increase in the U.S. inflation rate as something to be sought after in itself, not just as an unfortunate side effect of monetary or fiscal stimulus.

Kenneth Rogoff, for example, recently reprised the classic argument that the burden of debt falls when prices rise across all industries. (Rogoff’s Financial Times article is here. The New York Times discusses his views here.)  To wit, moderately higher prices obviously allow firms that have debt in dollars to more easily meet their debt-service obligations. Furthermore, increases in prices often bring higher wages, albeit with a time lag, making it easier for consumers to pay off their debts on time. In the United States, this is a very salient point, in light of high debt levels in nonfinancial business and the household sector, which we documented in this recent post.

Meanwhile, on the other hand, John Plender skeptically reminds Financial Times readers (and perhaps proponents of modern monetary theory [MMT]) of the possible dangers associated with policies that intentionally or unintentionally invite a spurt of inflation.

He somewhat ruefully notes that yields on the debt of some euro nations have been increasing, owing to high levels of default risk. In part, yield spreads have been rising because individual members of the Eurozone, including those that are now tottering on the brink of default, do not control their own monetary “printing presses”, as the United States, for example, does.

Insightfully, Plender points out what an irony in the resulting situation, in which investors have crowded into the U.S. Treasury bond markets–even as federal deficits soar.  He certainly finds nothing wrong with the current view of the bond markets (and MMT theorists) that

no country defaults on its domestic bonds if it retains the right to set the printing presses in motion

But to Plender,

….it seems counter-intuitive that bond markets, with their traditional fear of inflation, should punish a country for not being able to debase its currency.

As strange as it might seem to those who follow the staid and conservative bond markets, fixed-income investors seem to have adopted the MMT view as their philosophy, at least for now.

This seems no less and no more ironic to Plender than overt calls by economists such as Rogoff for policies that intentionally raise or create inflation.

In contrast to our own benign views of sovereign currencies (an example of which can be found here), Plender argues for what may seem like a more balanced assessment of the investment risks associated with bonds denominated in unbacked national monies. Of course, such risks include the risk of devaluation, or “currency risk.” Countries adopting sovereign currencies and open capital markets have to be willing to tolerate changes in their exchange rates in return for greatly enhanced freedom in using macro policies to control unemployment and inflation.

In Plender’s opinion, the U.S. central government should be more concerned than it has been about the effects of such exchange-rate fluctuations on investors’ willingness to hold their debt and hence on bond yields. Indeed, he argues that a deliberate attempt to increase inflation and devalue the dollar, as advocated by Rogoff and others, might prove disastrous for the bond markets and the economy as a whole, instead of averting a debt deflation.

(Raghuram Rajan offers his own critique of the pro-inflation argument in another subsequent FT piece; Krugman blogs Plender’s post here.)

Like Rogoff, we strongly support expansionary macro policies at the present time, though mostly for reasons different than his. In support of our position, we have argued many times (for example, in this brief)  that in the United States, inflation risks pale in comparison to the risks and realities of a very unhealthy labor market. Here we only wish to add a reminder about a third form of investment risk, not explicitly mentioned in Plender’s column: that of recessions or depressions in countries that issue debt, or where private borrowers seek to earn income. This “recession risk” is far greater where governments cannot or do not run deficits as needed to fund policies that maintain high employment, as long as inflation and exchange rates remain at reasonable levels. This is no irony at all.