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Sunday, April 19, 2009

Feldstein: Inflation is Looming

Martin Feldstein is worried about inflation

Inflation is looming on America’s horizon, by Martin Feldstein, Commentary, Financial Times: ...The unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation. According to the Congressional Budget Office, the president’s budget implies a fiscal deficit of 13 per cent of gross domestic product in 2009 and nearly 10 per cent in 2010. Even with a strong economic recovery, the ratio of government debt to GDP would double to 80 per cent in the next 10 years.

There is ample historic evidence of the link between fiscal profligacy and subsequent inflation. But historic evidence and economic analysis also show that the inflationary effects can be avoided if the fiscal deficits are not accompanied by a sustained increase in the money supply and, more generally, by an easing of monetary conditions. ...

A fiscal deficit raises demand when the government increases its purchase of goods and services or, by lowering taxes, induces households to increase their spending. ... If the fiscal deficit is not accompanied by an increase in the money supply, the fiscal stimulus will raise short-term interest rates, blocking the increase in demand and preventing a sustained rise in inflation.

So the potential inflationary danger is that the large US fiscal deficit will lead to an increase in the supply of money. This inevitably happens in developing countries that do not have the ability to issue interest-bearing debt and must therefore finance their deficits by printing money. ...

[T]he large US fiscal deficits are being accompanied by rapid increases in the money supply and by even more ominous increases in commercial bank reserves that could later be converted into faster money growth. ...

The link between fiscal deficits and money growth is about to be exacerbated by “quantitative easing”, in which the Fed will buy long-dated government bonds. While this may look like just a modified form of the Fed’s traditional open market operations, it cannot be distinguished from a policy of directly monetising some of the government’s newly created debt. Fortunately, the amount of debt being purchased in this way is still small relative to the total government borrowing.

The Fed is also creating a massive increase in liquidity by its policy of supplying credit directly to private borrowers. Although these credit transactions do not add to the measured fiscal deficit, the unprecedented Fed purchases of more than $1,000bn of private securities have led to the enormous $700bn increase in the excess reserves of the commercial banks. The banks now hold these as interest-bearing deposits at the Fed. But when the economy begins to recover, these reserves can be converted into new loans and faster money growth.

The deep recession means that there is no immediate risk of inflation. ... But when the economy begins to recover, the Fed will have to reduce the excessive stock of money and, more critically, prevent the large volume of excess reserves in the banks from causing an inflationary explosion of money and credit.

This will not be an easy task since the commercial banks may not want to exchange their reserves for the mountain of private debt that the Fed is holding and the Fed lacks enough Treasury bonds with which to conduct ordinary open market operations. It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation.

The government budget constraint is:

(Government spending including interest on the debt) - (Taxes) =
      (Change in the Money supply) + (Change in the Bond supply)

Or, more simply:

G - T = ΔM + ΔB

The left-hand side, government spending (G) - taxes (T), is the government deficit (surplus if the value is negative). The right-hand side shows the two ways of paying for the deficit, printing new money, ΔM, (the change in the money supply can raise prices) and borrowing from the public by issuing new bonds, ΔB (the change in debt can raise interest rates and lower growth).

Let's start with Feldstein's comments about developing countries. Suppose you are a developing country and you want to improve your country's growth rate, and you think the key is infrastructure spending. You run a deficit to accomplish this, fully intending to pay it back out of higher future growth (which may not actually happen).

But how will you pay for that spending on new infrastructure? You, as the dictator, could raise taxes but you are a poor country and the wealth and income base just isn't there to support a higher tax level. You could borrow the money, but once again the wealth level in your own country isn't high enough to allow that, so if you borrow, it will have to be from foreigners. But, unfortunately, there are some defaults in your country's recent past and the international community won't lend to you without restrictions that you just aren't willing to take on.

So once international credit dries up, becomes prohibitively expensive, or comes with too many restrictions, and if taxes cannot be raised enough, there is but one choice to pay for the infrastructure spending and the deficit it causes, print the money, and it's a choice developing countries often find themselves making. The result of these persistent deficits, then, is persistent growth in the money supply - month after month more money has to be printed to cover government operations - and the result is inflation.

Feldstein's point about quantitative easing monetizing debt can also be explained in terms of this equation. Under quantitative easing, the Fed prints new money, and uses it to purchase long-term government bonds. Thus, the right-hand side of the equation above is unchanged overall, but the money component gets larger while the bond component gets smaller as the Fed purchases government debt. (Note that the money supply also goes up if the Fed purchases private sector bonds rather than government bonds since new money has to be printed to pay for them, another one of Feldstein's points.)

Once we begin to recover, there are three ways to reduce the inflationary pressures from the growing money supply. First, we could simply reduce the money supply. How do you do that? By selling bonds to the public. Feldstein's worry is that the Fed has bought so many private sector bonds (and traded for government bonds in the process) that it won't have enough government bonds to reduce the money supply by as much as needed, and nobody will want to purchase the private sector bonds unless the price is very low, or, saying the same thing, the interest rate is [excessively] high. But high interest rates are undesirable so reducing the money supply may be difficult.

The second choice is to raise taxes. It might happen, but my inclination is to say good luck with that. But I hope I'm wrong, and maybe we can make some headway here. Third, we could reduce government spending. I don't know what the administration's goals are as to the size of government over the long-term, so I can't say for sure how much of the stimulus spending is considered to be temporary, and how much is intended to be permanent, e.g. for health care reform. But much of it was sold to the public as temporary, and I expect the administration to make good on that commitment (though "good luck with that" comes to mind again, but I'm still hopeful). If it doesn't, other goals such as health care reform could be compromised.

And speaking of health care reform, that's where the focus needs to be. The budget worries twenty years from now have little to do with the temporary stimulus measures we are taking today, going forward health care costs are the most important issue by far in terms of the budget, and everything else revolves around solving that problem.

So am I worried about inflation? Somewhat, particularly when I hear that the Fed's independence is likely to come under review by congress. Whatever doubts you have about the Fed's commitment and ability to keep inflation low in the future, I have little doubt that congress would choose to monetize the debt when faced with tough choices about how to solve a deficit problem (would congress have done what Volcker did?). I still have faith in the Fed, but as you can see from the government budget constraint above, what the Fed can do is dependent upon the actions of congress. If deficits persist, it could come down to a choice by the Fed to monetize the deficit - and risk inflation - or allow government debt to pile up and risk high interest rates. Volcker chose low inflation over high interest rates when confronted with a similar choice, but it's not completely clear to me at this point what this Fed will do in the same situation, and how much cooperation they can expect from congress in terms of reducing the deficit.

    Posted by on Sunday, April 19, 2009 at 01:08 PM in Economics, Fiscal Policy, Inflation, Politics | Permalink  TrackBack (0)  Comments (46)

          

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