April 2009 

Between a rock and a hard place  
Jean Pisani­Ferry 
 
Some are secretly calling for it. Others want to banish it for good. Only a few are venturing to announce
its return. Even fewer are daring openly to advocate it. What if inflation were to come back? What if this
crazy sequence of uncontrolled debt, financial collapse, recession and stimulus ended up in a return to
good old price increases?
There are two versions of this story. The first is based on the quantity theory of money. It is a long-
established fact that when too much money is chasing too few goods, prices go up and for six months
now, central banks have been creating money at a frantic pace. Their balance sheets have ballooned: those
of the Federal Reserve and the Bank of England have doubled in size, the European Central Bank’s has
grown by half. This is unheard of outside periods of hyperinflation. Just wait until the banks’ new liquidity
feeds into an expansion of lending, so the story goes, and inflation will take off.
Yet the immediate risk is precisely the opposite one. The liquidity supplied by central banks has been used
not to increase lending to businesses and households but to replace that which banks were no longer
supplying each other with. It is not a case of too much credit but too little. Demand for goods is not too
high but too low. And there is not too much inflation, there is too little. The IMF’s most recent forecast
speaks of a drop in global production in 2009 and, in the developed world, near- zero inflation until 2010.
In Europe, Spain has just announced a one-year decrease in prices, others will do likewise. The real short-
term risk is that inflation will be negative and therefore that anyone borrowing today will have to pay back
the debt tomorrow at a time when its real value will be higher.
Ultimately, of course, when the situation has normalised and banking systems have started to work
properly again, the appetite for spending will return and money created during the troubled period will
pose a threat of inflation. But central banks are more alive to this than anyone else and are already making
plans to mop up the excess liquidity. They all have the tools to do this.
It is here that the second version of the story comes in, and it is more interesting. Unlike the first version,
it is not based on a mechanical calculation but on the possibility that the public, governments and, like it
or not, central banks will deliberately choose the inflationary route in order to reduce the debt. After a
quarter of a century in which lenders, i.e. holders of capital, have thrived, borrowers will have their day,
whether they be private - households borrowing to buy a house and businesses - or public - countries
whose GDP will have shot up by 20-30 points within the space of a few years and which will
simultaneously have to face the cost of an ageing population. For a borrower paying down debt at a fixed
rate of interest, inflation does not look such a bad thing.
It is hard to think that tomorrow we will be prepared to put up with double-digit inflation as we did in the
1970s, and whose harmful effects still remain etched in the mind. But there will be considerable
temptation to increase the inflation target by a few points.
This choice would not be cost-free. After two decades spent anchoring low-inflation expectations – at the
cost of tough monetary policy – frittering away this investment would mean a loss of credibility and thus
higher real interest rates.
Central banks are clearly aware of this possibility. They know, even if they are partly in denial, that their
legitimacy has taken a hit as a result of long being perceived as closer to financial markets than to
government or to the public, and that after proving how imaginative they can be in the financial crisis, it
will be no easy job to resist pressure by insisting on their customary conservatism.
The danger – and a real one in Europe – is that, fearing impotence tomorrow faced with pressure to allow
inflation, central banks will today be more hesitant to get to grips with deflation. In a nutshell, they could
be so afraid of a potential risk that they fail to act decisively to tackle an immediate one.
It is up to governments to head off this risk, as they are the ones who hold the key to solving the problem.
Even if they are unable to determine social preferences, they can at least influence their own future
inflation incentives by acting today to set the rules for reducing the deficit resulting from their stimulus
packages. This will not be straightforward, because it will mean saying that, in order to pay for the crisis,
people will need to work for longer, pay higher taxes and/or spend less. But one thing is clear – the more
governments manage to establish credible disciplines for the medium term, the more margin they will
have to act in the short term, and the more they will be able to count on parallel action by central banks.