The Coming Inflation Nightmare

By W. David Montgomery

Many alarming executive orders have been issued in the first days of the Biden Administration, but today I want to discuss a central feature of its economic policies.  That is the implicit, and by some loudly shouted, belief that it is possible to pile up ever growing deficits by borrowing from the Federal Reserve.  This belief must be spiked.

A sub-cult in economics that likes to refer to itself as Modern Monetary Theory, or MMT to the insiders, holds that the amount of borrowing by the Federal government is meaningless. It can always be accommodated, according to this cult, by the Federal Reserve creating money[1] that it lends to the Federal government.  All policymakers need to do is keep watch on inflation, and if it appears all that money is beginning to cause price levels to rise, the solution is to increase taxes high enough to siphon off the excess money being spent by consumers.  As long as inflation is stubbornly low, despite zero interest rates, the Federal government can spend all that Democrats dream of and really has no need to raise taxes.  Members of Congress, whether Democrats or Republicans, love it.  The Democrats love to spend the money; the Republicans love to cut taxes. It seems like a free lunch for everyone.

Despite the facts that the originator of this theory, Warren Mosler, was a Wall Street trader with negligible training in economics, and that even the rabid anti-Trumper Paul Krugman debunks it, economists in Bernie Sanders’ camp and AOC use it as their excuse for unimaginably expensive programs (while Republicans go along with the game since it can “justify” tax cuts). . 

Economists like Mickey Levy, a member of the Shadow Open Market Committee, reject the theory, but they grant that some of the claims of MMT are consistent with recent economic data.   Inflation has remained extraordinarily low despite the massive increase in the money supply created by the Fed to fund extraordinarily high deficits.

But a reckoning is coming.  We can cut through the puzzles of banking and finance by concentrating on two things: 1. the capacity of the economy to produce goods and services and 2.  the resources available to households and business to purchase those goods and services for investment and consumption.  If households and businesses have the resources to purchase more goods and services than the economy (and this includes foreign exporters to the US) can produce, prices of everything rises and we have inflation.  If they do not have the resources or want to save rather than spend, the reverse happens.

Even as some businesses grew, like online sales and supporting infrastructure, others declined even more rapidly so that total output fell and unemployment grew.  As a result of extended unemployment compensation and stimulus payments in the Trump Administration, the drop in personal income was less than the drop in output. However, due to unemployment and concern about the future, saving by households and businesses increased. 

The deficits run up during the Trump Administration to provide “stimulus relief” should have produced inflationary pressures with lockdowns constraining output increases, but because of increased savings, aggregate spending stayed roughly within the capability of U.S. businesses (and exporters to the U.S.) to supply. 

The major factor preventing trillions of dollars of stimulus money (and paper profits in the stock market) from producing inflation has been the unwillingness of US households to spend the windfall that they received from stimulus payments.  But that saving has also created an overhang of financial assets that could be spent whenever households choose.  This overhang will only be made worse if the Biden Administration follows through on its promise to forgive student debt.  Loan forgiveness will give a massive increase in net worth to indebted college graduates, waiting for those wealthier middle- and upper-class graduates to use their windfall.

If Democrats get their way, these government transfers will continue growing far faster than the real productive capacity of the economy, so that the overhang will grow.  The more slowly lockdowns are removed (or if they are tightened), the more sluggish the economy will be in responding to increased demand and the greater the danger will become. 

The question then is when the added purchasing power created by unspent government transfer payments will be released into the economy, relative to the amount of idle capacity that could respond to the surge in demand.  If consumer spending increases while lockdowns are still in place, there would be the perfect storm.  The lockdowns would constrain increases in output, aggregate demand would exceed available supply and inflation would surge.

The danger is only a little less if lockdowns are removed, because that is likely to increase consumer confidence and trigger spending of hoarded stimulus payments.  Removing lockdowns would allow some increase in output, but the risk of inflation would still be there.  Increasing output creates additional income for workers and owners, over and above the hoarded purchasing power from stimulus payments.  Thus additional productive capacity is used up by additional spending from increased income.  The overhang of savings will remain, ready to drive demand over available supply when its holders start to spend. The perfect storm of rising income and use of accumulated savings will still push aggregate demand well above the capacity of the economy to produce. 

There is only one possible result: rapidly increasing inflation, at least to the point at which the financial assets built up with stimulus checks are destroyed.  In one sense, MMT is right.  The only sure way to reduce the pressure is to raise taxes and cut spending to drain off the excess purchasing power that was built up during the period of stimulus payments.  But that takes concerted action to do what members of Congress will not do – face up honestly to the problem and tell their constituents that they must tighten their belts.

Many are concerned that by building up huge deficits, we are shifting the burden of our current policy mistakes onto our children and grandchildren.  My opinion is that the day of judgment is much closer.  The classic operations of supply and demand are most likely to hit us, not our grandchildren, with massive inflation and its consequences. 


[1] I use the word “create” rather than “print” money to dispel the misconception that the Federal Reserve runs printing presses to expand the money supply.  Few transactions involve paper money today, what the Fed does is purchase Treasury securities and create bank deposits that the US Treasury can draw down.  Since those securities constitute assets for the Federal Reserve and its member banks, those banks can then loan more to everyone.  That keeps interest rates close to zero and lets the government send out stimulus checks and spend in excess of the taxes it collects.

5 Comments