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The following is taken from an email to my good friend Mish in response to his blog post today "Inflating Away Debt". It goes to the core of the "inflation vs. deflation" debate, contrasting the "inflationist", "deflationist(a)", and something more like iTulip's "ka-poom theory" view.
Provocative piece, and I agree the outcome will not be as "hyperinflationary" as many people seem to expect, but, I don't expect it to be "deflationary" either. It already is not: we are seeing increasing CPI inflation while debt markets collapse/deflate (for the purposes of this discussion I think we can agree that only CPI decreases constitute true "deflation". Fine).
Importantly, I disagree that we can assume government "has the credit" to re-finance debt (hence preventing inflationary pressures). We've already been doing that. The situation is now changing: non-Federal municipalities are no longer included in the able-to-cheaply refinance group, as of the last couple weeks (which you've extensively reported). These municipalities, incidentally, have over an additional $2 trillion of public debt (which is never reported). What makes you think the Federal government isn't next?
The Federal government is the next shoe to drop. The Federal government will turn out to be simply another "immune" backer that is anything but. In fact, if you don't think the government will hyperinflate, then they're a horrible credit risk. I believe Moody's already recently warned that the US Federal government was at risk of losing AAA status "within a decade". So that means in reality it's in serious jeopardy right now, and might actually get downgraded in 1-2 years.
But both the Fed rate and Moody's ratings are something of a farce anyway. As capital flight out of the US pressures short-term Treasury/funds window rates above the Fed target rate (which is now transitioning from being artificially high to artificially low), this market rate will become the de facto cost of borrowing for the Federal government.
If the Fed is forced to continue defending a lower funds target rate than the actual trading level (to save face and help the banks), it will be forced to directly monetize the Federal deficit. That is a dramatic departure from the "business as usual" of getting others to lend, and it is very inflationary. If government spending continues to be driven by Fed borrowing as opposed to selling Treasuries on the open market, you effectively have money printing. That will simply be the only way for the Federal government to continue functioning (they sure can't meaningfully raise taxes).
And while the government may not seem like a good "vector" for cash injection into the broader economy, remember that government makes up a huge chunk of the overall economy (probably over half, when counting defense contractors and such). So if the current trends continue, and the Fed is forced to monetize debt, we will definitely see more price index inflation. And this will happen as the housing market and credit markets continue to deflate, a seeming paradox, but not really.
Frankly I think you are conflating logical arguments "for or against" inflation, as a policy choice, with what is likely to happen, as more of a "non-choice". Yes, inflation won't help unfunded liabilities. It won't help with jobs. It won't help with consumer spending. But no one cares; certainly government least among them. All the Fed cares about is (1) enabling the government, and (2) enabling the banks.
I suggest looking at what government has tended to do in response to worsening economic conditions: more of what it is already doing (deficit spending), growing bigger, and making more promises. That means more inflation, not less.
A significant miscalculation that seems to underlie your deflation theory is the assumption that financial economy collapse in the US equates to a global increase in the value of the dollar. But that is prima facie oxymoronic: collapsing dollar-zone markets means less foreign demand for dollars, not more, even as domestic citizens might begin to prize them. This is inflationary -- less foreign willingness to help refinance private and public US debt, and more expensive imports.
We might thus find ourselves in an awkward situation where both inflation and the public debt accelerate at the same time. This is in contrast to the other two typical outcomes:
a) the government prints its own money to spend it, instead of borrowing. Inflation gets out of control until/unless the economy gets back on a track of real growth. (Otherwise, you get hyperinflation.)
b) the government borrows all money needed and spends it. Borrowing conditions are favorable (interest rates stay the same or go lower). We come out ahead if the economy actually improves in short order, so we can "grow our our way" out of the debt in real terms.
We have been invoking plan B but have now fallen short of the necessary financing, and thus are sliding back towards plan A. However the borrowing-based financing mechanisms for B are still in place, acting as a brake on hyperinflation (higher interest rates will ultimately bring funds to market). Therefore we are moving towards all of: (1) massive borrowing, (2) Fed monetization creating additional inflation, (3) increasing interest/interest rates on the debt, AND (4) a shrinking economy.
Pretty ugly, but neither hyperinflation nor deflation.
Provocative piece, and I agree the outcome will not be as "hyperinflationary" as many people seem to expect, but, I don't expect it to be "deflationary" either. It already is not: we are seeing increasing CPI inflation while debt markets collapse/deflate (for the purposes of this discussion I think we can agree that only CPI decreases constitute true "deflation". Fine).
Importantly, I disagree that we can assume government "has the credit" to re-finance debt (hence preventing inflationary pressures). We've already been doing that. The situation is now changing: non-Federal municipalities are no longer included in the able-to-cheaply refinance group, as of the last couple weeks (which you've extensively reported). These municipalities, incidentally, have over an additional $2 trillion of public debt (which is never reported). What makes you think the Federal government isn't next?
The Federal government is the next shoe to drop. The Federal government will turn out to be simply another "immune" backer that is anything but. In fact, if you don't think the government will hyperinflate, then they're a horrible credit risk. I believe Moody's already recently warned that the US Federal government was at risk of losing AAA status "within a decade". So that means in reality it's in serious jeopardy right now, and might actually get downgraded in 1-2 years.
But both the Fed rate and Moody's ratings are something of a farce anyway. As capital flight out of the US pressures short-term Treasury/funds window rates above the Fed target rate (which is now transitioning from being artificially high to artificially low), this market rate will become the de facto cost of borrowing for the Federal government.
If the Fed is forced to continue defending a lower funds target rate than the actual trading level (to save face and help the banks), it will be forced to directly monetize the Federal deficit. That is a dramatic departure from the "business as usual" of getting others to lend, and it is very inflationary. If government spending continues to be driven by Fed borrowing as opposed to selling Treasuries on the open market, you effectively have money printing. That will simply be the only way for the Federal government to continue functioning (they sure can't meaningfully raise taxes).
And while the government may not seem like a good "vector" for cash injection into the broader economy, remember that government makes up a huge chunk of the overall economy (probably over half, when counting defense contractors and such). So if the current trends continue, and the Fed is forced to monetize debt, we will definitely see more price index inflation. And this will happen as the housing market and credit markets continue to deflate, a seeming paradox, but not really.
Frankly I think you are conflating logical arguments "for or against" inflation, as a policy choice, with what is likely to happen, as more of a "non-choice". Yes, inflation won't help unfunded liabilities. It won't help with jobs. It won't help with consumer spending. But no one cares; certainly government least among them. All the Fed cares about is (1) enabling the government, and (2) enabling the banks.
I suggest looking at what government has tended to do in response to worsening economic conditions: more of what it is already doing (deficit spending), growing bigger, and making more promises. That means more inflation, not less.
A significant miscalculation that seems to underlie your deflation theory is the assumption that financial economy collapse in the US equates to a global increase in the value of the dollar. But that is prima facie oxymoronic: collapsing dollar-zone markets means less foreign demand for dollars, not more, even as domestic citizens might begin to prize them. This is inflationary -- less foreign willingness to help refinance private and public US debt, and more expensive imports.
We might thus find ourselves in an awkward situation where both inflation and the public debt accelerate at the same time. This is in contrast to the other two typical outcomes:
a) the government prints its own money to spend it, instead of borrowing. Inflation gets out of control until/unless the economy gets back on a track of real growth. (Otherwise, you get hyperinflation.)
b) the government borrows all money needed and spends it. Borrowing conditions are favorable (interest rates stay the same or go lower). We come out ahead if the economy actually improves in short order, so we can "grow our our way" out of the debt in real terms.
We have been invoking plan B but have now fallen short of the necessary financing, and thus are sliding back towards plan A. However the borrowing-based financing mechanisms for B are still in place, acting as a brake on hyperinflation (higher interest rates will ultimately bring funds to market). Therefore we are moving towards all of: (1) massive borrowing, (2) Fed monetization creating additional inflation, (3) increasing interest/interest rates on the debt, AND (4) a shrinking economy.
Pretty ugly, but neither hyperinflation nor deflation.
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