Inflate out of Deflation?

Suppose you were the Vice President of Sales for the Coastal Region of Acountrylah of Crazy for Coconuts, a cafe specialising in offering refreshing drinks. Acountrylah has a tropical climate, though the coastal regions are exposed the monsoon season periodically. As it is now a monsoon season, your sales have been plummeting and demand for your drinks has fallen. In order to narrow the gap in sales caused by seasonal variation, you have decided to issue vouchers to stimulate sales.

Even though your vouchers are trading at 10 cents over the Ringgit (So in this case a RM50 voucher costs only RM5) – sales are still not picking up. Perplexed by this response, you spoke to your QC manager and even employed the service of a consultation firm to see if there is something wrong with your product. The customers surveyed assured you that your product is fine and tastes as good as they are accustomed to. So again, you remain confused. If the vouchers are picked up by customers, why isn’t anybody using them?

A little bit of investigation shows that most customers are hogging the vouchers so that they can use it when the monsoon season ends. To your greater annoyance, there is a “carry trade” going on where people buy the vouchers from your coastal region and sell it to people in the non-coastal region at a higher price, but still less than the face value of the voucher. (This exploitation of arbitrage opportunity is profitable to those who are exploiting it). Essentially you are trying to sell your drinks for “free” (vouchers can only be used when there are purchases of a certain amount on a single receipt of course). This outcome has stymied, even rendered your efforts to stimulate sales futile. Even though there is a huge amount of vouchers circulating around, nobody is using it and thus your little economy is in caught in a “liquidity trap.” (Liquidity Trap = plenty of money around but little transaction)

In a stroke of genius, you decide to choose one of these two options. First, you can declare that vouchers that are worth RM50 will be worth, say only RM5 at the end of the monsoon season. Two, you put an expiry date on the vouchers, and will no longer acknowledge it when it is not a monsoon season. As a result, sales are picking up again and people are using the vouchers. Your cafes are selling drinks and you have successfully narrowed the gap in sales due to seasonal variation.

Of course, the parable above is an exercise in theory on what to do with the US economy. With the Federal Reserve Bank’s recent revision of outlook from “moderate” to well, a more gloomy outlook and unemployment rate at an obstinate 9.5%, the Federal Reserve Bank has decided to maintain its monetary base with a $2 Trillion by buying more Treasury Securities with the proceeds from its mortgage backed security that has matured. With deflation now a major source of concern, and that the expansion of monetary base (which must be said, is substantial by historical standards) having no impact on inflation (and spending), it seems pretty likely that the US is now caught in a liquidity trap. The drop in productivity and fall in consumer spending suggest that this is highly likely.

So recall the two options the VP of the Coastal Region of Crazy for Coconut in Acountrylah faced. Option one is essentially a form of inflation (when a voucher worth RM50 is worth only RM5), and what this tells us is that inflation can potentially lift us out of a liquidity trap. So perhaps printing more money (quantitative easing) to induce inflation can help stimulate the economy once again as people will spend now(if they spend later their money becomes weaker because of inflation) instead of hogging it for fear of their money losing its value? Inflation also helps to reduce the real value of debts the US currently holds in addition to paying off some of the outstanding debts.

As sound as this proposal might seem in a hypothetical world, it could lead to serious negative repercussions in the real world, especially when applied to the context of present day US. Inflation and quantitative easing spooks investors and bond-holders. If a inflate-us-out-of-here policy is in place, bond-holders will likely demand higher interest rates to protect their investments (and also a high premium to compensate for the risk assumed). In addition, it is hard to quantify how such a policy will negatively impact on market confidence on the US government’s ability to implement and coordinate sounds fiscal policy and how it casts doubt on the Federal Reserve Bank’s ability to exercise sound monetary policy. A currency crisis is very likely and a feedback-loop inherent in such currency crises might exacerbate the problem more, provoking a crisis as severe as that of Argentina,Mexico or even the Asian Financial Crisis of 1997.
This sounds like too huge a risk to run.

So now we have option 2. Slightly unlike the parable, I do not suggest pulling out the Greenback out of circulation. Instead, a sub-money can be introduced to the economy in coordination with the tax cuts enacted under the fiscal stimulus programme (American Recovery and Reinvesment Act 2008). Yes,various studies have proven that tax cuts can be more effective than government spending, but this recession is unlike any other and the uncertainties it entails makes it more sensible to many to hold on to their money in lieu of spending. (To be fair I have no empirical data to back this up, though intuitively speaking it seems like this is the case. Perhaps a study on the spending and saving habits of those who received their tax cuts could be useful).

Instead of granting citizens Tax Credits, perhaps the citizens can be made to pay the full amount of taxes they owe, and the tax cuts they are entitled to be given in the form of spending vouchers. Such vouchers should be stripped of their function as a store of value by law (so banks and other financial institutions will not pay interests on it) to prevent an incentive of hogging it. However it must be indexed to inflation by having the government guaranteeing the real value of the voucher when it is pulled out of circulation and transferred into cash to ensure that people will use it as a form of money (but without its function as a store of value). An expectation of inflation in the future and the fact that this sub-money is non-interest bearing is likely to build up the momentum to escape from a liquidity trap, though I will not go as far as saying that this is guaranteed. In short, this sub-money is a medium of exchange and an instrument of accounting. If it were me, since I get no interest in saving this sub-money and that things are relatively cheap (because of deflation), I’d spend/invest right now and get ready to reap rewards in the future.

On whether or not the government has the right to force people to spend their money indirectly (as in introducing a sub-money that cannot function as a store of value to force spending) is beyond the scope of this post.
I must also say that I have not given it thorough politico-economic thought so I am in no position to elaborate on that side of it. Though it must also be mentioned that isn’t the Federal Reserve empowered by law to do whatever it takes in extenuating circumstances to prevent a downward spiral of the economy. If that were the case doesn’t that also apply to a government trying to veer the economy to recovery?


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