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If we can’t cure the economic cold, maybe we should bring on economic pneumonia.

You remember the old joke to that effect?  We know how to cure pneumonia?

Blackhedd recently provided an explanation of how “a zero nominal interest rate might correspond to a real interest rate that is hundreds of basis points higher” if expectations are for a deflationary period.

I took it to mean that since the original principal must eventually be repaid, even a zero interest rate has an effective rate of plus “something” because it must be repaid with dollars that are more valuable than the ones that were borrowed. That implies the “something” is the positive equivalent of the expected rate of deflation (by definition, a negative rate). If the borrower has no confidence in his ability to earn a growth rate greater than “something” plus his desired profit margin, there’s no reason for him to borrow in the first place. And if the lender doesn’t believe it either, he has no incentive to put dollars that will become more valuable just by sitting in his vault at risk by lending them out.  This logic rests on the idea that there are generally deflationary expectations taking hold throughout the economy.

IF that’s correct, it seems there are a couple of consequential actions that could be taken to turn things around. First, the crisis of confidence, which is what this is, needs to be put to rest. It may be that it will take some observable inflation to make people believe that there will be no prolonged deflationary period.

What is so hard about that? We know exactly how to create inflation–we do it by printing money without any wealth to back it up. I keep hearing “experts” who say that “We can’t just ‘print money,’ we have to borrow it by selling government securities.” My sincere question is, “Why is that true?” I say sincere, because those same experts never explain why, they just state it as an Axiom of modern governmental finance. I’d really like to know, “Why?” South American republics have no problem printing money by the railroad carload, nor did Germany not so long ago. They just fired up the presses and printed the darn stuff. We could use that money to buy those currently un-priceable mortgage securities at whatever price is necessary, rather than at whatever price is fair. Or pay Social Security benefits with it. Or Medicare. Even pay governmental salaries and Congressional expenses with it.  That would put the cash directly into circulation.

Maybe the answer lies in the belief that we must keep INflation in check, but again I’d have to ask, “Why?” We already have the beginnings of a stagnant economy and inflation is negative. “Stagflation” that combines stagnation with DEflation is far worse than the kind we had in the ’70s. Add some INflation to our current situation and not only do we have some incentive to spend money, raise interest rates, and invest in business expansion, we have a situation which we know how to deal with. So creating that situation is the second action. We would then be able to fight the new war with the right weapons, rather than try to fight the current war with the weapons that should have been used in the Great Depression. If we don’t let the inflation get out of hand (as it was in the ’70s), it should be relatively painless.

We even have the former Stagflation Fighter himself, Paul Volcker, conveniently ensconced as an Obama advisor. He should remember that the solution was higher interest rates and lower tax rates. I’m not sure how the higher interest rates helped, but lower tax rates are obvious. Throw out the idea of The Obama’s gigantic government spending program, and the economy will right itself as individual citizens make those everyday decisions to buy what they need and invest for the future.

I know there must be something wrong with my scenario, but some implementation of the ideas of changing expectations from deflationary to inflationary, and of printing money rather than borrowing it seem to be necessary before we can turn things around.

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