Special Report

How to Save the Global Economy: Whip Up Inflation. Now.

The American and European debt crises have dragged on for years now. Yet none of the heavily indebted countries -- not the United States, not the peripheral eurozone borrowers -- has been able to use a traditional weapon to fight the debt crisis: inflation. This has been the crucial difference between the current crisis and similar ones in the past.

Recovery from a debt crisis is always painfully slow, for reasons both economic and political. Creditors need to rebuild their balance sheets and are unwilling to make potentially risky loans. Debtors need to boost savings to cover their debts and are unwilling to resume spending. At the same time, debt-ridden countries collapse into political conflict over the question of who will pay to get them out of the red: Should it be taxpayers, bankers, public workers, or investors?

A bit of inflation can help on all these fronts. So long as the debts are denominated in national currency and interest rates are kept low by monetary policy, inflation reduces the real debt burden. This is, to be sure, a forced restructuring that puts some of the onus on creditors -- but that is almost always the outcome of more explicit negotiations in any case. When most of the debts are household debts, as they are in the United States and parts of the eurozone, it is not really feasible to renegotiate millions of mortgages and consumer loans; inflation takes care of that for the whole economy. It mitigates some of the political conflict and lessens some of the economic burden.

So far, though, none of the major debtors has been able to make this option work. The most troubled eurozone debtors -- Greece, Ireland, Italy, Portugal, and Spain -- don't make their own monetary policy, so they cannot inflate away a share of their debt. Indeed, two-thirds to three-quarters of the foreign debts of Greece, Portugal, and Spain are owed to eurozone creditors, primarily in Germany and France. Even Ireland, which has strong financial ties to Britain and the United States, owes about half its debts to other eurozone countries. This means that if the European Central Bank decided to pursue inflation, it would be taking money out of the pockets of creditors that are also members of the eurozone -- and powerful members, too. As politically daunting as this might be, however, some such redistribution would almost certainly be part of any durable settlement of the eurozone debt crisis anyway -- and the apparent inability of Europe's leaders to arrive at such a settlement in anything near a timely fashion has only further confirmed that inflation may be the only politically feasible way forward.

For its part, the U.S. Federal Reserve has run a monetary policy appropriately focused on stimulating the economy, keeping interest rates extremely low, and engaging in "quantitative easing," whereby it twice increased purchases of long-term Treasury securities and mortgage-backed securities. This effort has not, however, been enough to raise prices by more than trivial amounts. The Fed policy should theoretically lead to an export-boosting depreciation of the dollar, but every attempt to moderate the dollar's value so far has been met by countervailing efforts on the part of the big surplus countries, especially China. These policies have also been countered by the dollar's continuing strength as a perceived safe haven in the midst of crisis: Domestic and international investors still think of Treasury securities as the most reliable place to park their money in uncertain times, a view that has maintained the dollar's value in spite of the Fed's interventions.

We're not proposing a lot of inflation -- just enough to reduce the debt burden to more manageable levels, which probably means in the 4 to 6 percent range for several years. The Fed could accomplish this by adopting a flexible inflation target, one pegged to the rate of unemployment. Chicago Fed President Charles Evans has proposed something very similar, a policy that would keep the Fed funds rate near zero and supplemented with other quantitative measures as long as unemployment remained above 7 percent or inflation stayed below 3 percent. Making the unemployment target explicit would also serve to constrain inflationary expectations: As the unemployment rate fell, the inflation target would fall with it.

Today our highest priority should be to stimulate investment, growth, and employment. Raising the expected inflation rate will lower real interest rates and spur investment and consumption. It will also make it difficult for the de facto dollar peggers, such as China, to sustain their policies. The resulting real depreciation of the dollar would stimulate production of U.S. exports and domestic goods that compete with imports, boosting American production. The United States would get faster growth, an accelerated process of deleveraging, a quicker recovery, and a firmer foundation upon which to address long-term fiscal problems.

Andrew Harrer/Bloomberg via Getty Images

Special Report

How to Save the Global Economy: Cut Defense Spending

Breaking out of the current frustratingly slow growth in the developed world requires a blend of short-term stimulus and longer-term restraint. Unfortunately, in Europe and the United States, we have been following these policies in reverse -- constraining public-sector spending in the near term while doing nothing effective to prevent deficits in the future.

In the United States, cuts in public-sector spending have caused the loss of 550,000 public-sector jobs -- think teachers, police, and firefighters -- since January 2009, adding to the raw unemployment numbers and removing the multiplier effect that takes place when employees spend their paychecks. The result: Despite gaining private-sector jobs every month for the past 21 months as of November, we have been badly hurt by reduced public-sector spending, which has cut jobs and economic growth.

Yet my Republican colleagues have insisted on retaining all of George W. Bush's tax cuts, thus all but guaranteeing that future revenues will continue to fall far short of what is necessary to reduce U.S. debt and create the conditions for a strong recovery.

One major change that can reverse this: a substantial reduction in America's military spending. In the current fiscal year, the United States is spending upwards of $650 billion on its military, including the costs of the wars in Iraq and Afghanistan. This is far more than it spends on Medicare and, more importantly, considerably in excess of what is required for America's legitimate national security needs.

The United States should and will be the strongest country in the world. But it can achieve that status for significantly less than it is now spending. An early withdrawal of U.S. troops from Afghanistan over the next six months would save hundreds of billions of dollars. In addition, we could reach savings of more than $100 billion annually by adopting strategic concepts appropriate to the current world situation, rather than continuing to rack up bills fighting threats that no longer exist. We could also save tens of billions of dollars a year by curtailing our commitment to the defense of Western Europe -- which was perfectly sensible when President Harry Truman made it but is wholly inexplicable now that Europeans are wealthy, strong, and threatened by no one -- as well as by reducing our military presence in Japan and forgoing the new proposal for stationing U.S. Marines in Australia. We do not need to maintain the fighting capacity we had during the height of the Cold War to engage the Soviet Union in an all-out conflict. Terrorists are terrible people who should be confronted, but they are not a thermonuclear-armed Soviet empire. Fighting them, though in many ways more complicated, should be less expensive.

Reducing excessive military spending -- my proposal cuts approximately $900 billion in the next 10 years -- would allow us to provide the short-term economic stimulus needed to continue the progress we are making in breaking out of the recession. Ironically, many of my conservative colleagues have opposed the idea of reducing our military budget on grounds that I refer to as "weaponized Keynesianism." They claim that government spending doesn't create jobs -- unless it is for the military. Many opponents of cuts in military spending now argue against them not in terms of national defense, but on the grounds that they would cause job losses. In fact, economists tell us, reductions in military spending will have far less negative impact on jobs than comparable reductions in medical care or infrastructure.

If America's extensive worldwide military engagements were proving effective at bringing stability to troubled countries, I would feel conflicted in noting that these impose a terrible drain on our economy and interfere with what we need to do to resume economic growth. But in fact, such interventions rarely work. Heavily armed young Americans are an excellent fighting force, but a U.S. military presence is rarely the best way to resolve long-standing ethnic, religious, or other social tensions.

If we commit to reducing military spending to a rate of approximately $430 billion a year over the next decade, with suitable inflation adjustments, it would do a great deal to reassure people that we had our deficit problem under control, that the long-term drain this puts on our economy would be diminished, and that we could then afford the near-term economic stimulus we need to help accelerate our currently sluggish growth.

Defense Secretary Leon Panetta recently said further cuts would "hollow out" the U.S. military. This is a surprising complaint from someone who cited the post-Cold War period as one of those times when we "hollowed out" our military -- he was, after all, President Bill Clinton's budget director when the United States reduced military spending in the way he now decries. But Panetta is unfair to his younger self. The reductions in the military budget begun after the collapse of the Soviet Union by President George H.W. Bush and continued by Clinton -- along with other spending constraints and tax increases on the wealthy -- resulted in balanced budgets in the late 1990s. No one I have spoken to has ever presented any convincing evidence that there was any damage to U.S. national security because of it.

Returning to the sensible defense policies of George H.W. Bush and Bill Clinton would in no way damage America's security. It would help us get the United States' job engine going again and revive economic growth around the world. Let's bring the troops home.

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