Sunday, April 21, 2013

Are we heading for shoal waters?

Source: "Unemployment and Inflation" by Paul Krugman in The New York Times
Krugman writes:
(W)hat the Phillips curve with expected inflation implied was “clockwise spirals” in unemployment-inflation space. Suppose you came into a recession with, say, 10 percent inflation. This inflation rate would fall in the face of high unemployment — and expected inflation would eventually fall too, so that when unemployment fell again inflation would remain lower than it was pre-recession   (until the next boom). 
Both the slump of the mid-1970s and the slump of the early 80s fitted this pattern, but the recent slump has not.
The great recession is appears to be a "balance sheet recession" where banks and firms have seen a large decline in their balance sheets due to falling asset prices and bad loans. It is different from those in the 70s and 80s in that the U.S. and European central banks have been pumping huge amounts of money into the economy. The infusions of cash into the economy have kept inflation relatively constant as unemployment increased and started to increase again.

One of the members of my book club holds that the bad loans made during the housing bubble are largely still on the books of existing firms and there will have to be foreclosures and fire sales of the collateral. He also suggests that we don't know how the central banks will unwind their monetary policies nor how the national governments will unwind their fiscal policies that were put in place to deal with unemployment and lack of economic growth. We may be heading not only into uncharted waters, but dangerous ones.

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