26 October 2015

How deflation can become a boon to solve the current economic malaise?

We saw two weeks ago that the global economy is getting mired in the spiral of deflation, in spite of, (or rather, as a side effect of) unconventional monetary policies followed across the developed world for better part of the last decade.

It is becoming clear that cheap money can pull the string of keeping inefficient producers in the business, but it cannot push the string of generating demand for all the productive capacity in the economy.

Now for more than a generation, the overall debt to GDP ratio across the world has continued to increase, driven since 2008 largely by public sector debt, funded in part by balance sheet expansions of central banks, as a result of printing of money.

At the current juncture, while, we are facing deflation, the efficacy of further unconventional monetary policy is under grave doubt. However, there is a simple solution to the problem, given the current unusually large ownership of public debt by central banks.

It may be prudent to write off the public debt held by central banks, recognizing the fact that most of the fiscal deficit has gone into unproductive social welfare programs. This write off will not create any negative impact either on the private sector or on the confidence in the functioning of the public sector. On the other hand, it will create significant headroom in the perceived future capacity of the developed world sovereigns to service the debt, as the new debt/GDP ratio will be magically lower.

This would allow the governments to run fiscal deficits of higher magnitude. Since this increase in deficit financing is not as a result of automatic balancing, the governments can decide the allocation into productive sectors such as building railroads (say for USA) or investing in ultra energy efficient technologies.

This maneuver should be coupled with administrative actions to prevent run-away built up in private sector debt, by limiting size of banking sector and bond markets. Just as some countries are pricing carbon emissions through market based auctions; we should recognize that excessively large banking and bond activity is harmful and any growth in that activity should be auctioned away by selling limited permits for bond issues and credit growth.

So, in one stroke, we would be able to solve the short term problem of lack of demand by activating fiscal policy, and start making process towards tackling the modern day scourge of run-away increase in the debt to GDP ratios of capitalist economies.