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.
A simple way to look at this is in total dollars. The US economy produces about $22 trillion in goods and services. If we grow on average at 2%, that is $440 billion per year in new output. So a $440B increase in the money supply would not bring about inflation; there is $440B more cash wanting to buy $440B more in goods and services. In our case, $3T in 2020 government stimulus plus another $2T this year will spike inflation.
There are two complications to my simple balance between money and supply of goods: savings and who has the extra cash. As David points out, if the consumer gets largess from the government and saves it, then there is no extra cash out there cashing a limited supply of goods and services. People save money when concerned about the future economy and spend it when confident that their jobs are secure. During this pandemic, people are concerned, so they save the excess payments rather than spending them or pay down debt. There is no real stimulus from savings or debt reduction.
Who gets the excess cash is also important. If individuals as is done with much of the pandemic stimulus, there will be high inflation if the consumers feel confident enough to spend. If the money goes to corporations or as bank reserves at the Fed, as has been done with some past excess government expenditures, then it does not result in consumer demand and inflation.
The current federal spending spree will cause high inflation as soon as the consumer feels comfortable spending. Perhaps enough Americans are intuitively wise about personal finance to be warry about the huge federal deficits and so they save and pay down personal debt rather than spend.
OK David and George, you have made a complex subject understandable.What should us older guys do to help our children and grandchildren ? Increase savings? Distribute our assets? Or is there a way to play both sides against the middle? What do you plan to do?
Just a reflex as to what to do for our children and grandchildren:
Those of us who: 1) grew up during the 1930’s, 2) have parents who grew up during the 1930’s, or 3) endured the 14.5 % inflation rate of 1980… we understand the following:
A) We need to educate our offspring that easy financial times have never endured unabatedly.
B) Saving and postponing consumption can be a virtue.
C) That fiat currencies have always failed in the past.
D) Self-sufficiency, hard assets and talents that produce the necessities of life are what kids need in focus.
E) Teach children to know the difference between Facts (News) and Opinion.
As lovely, as a major in English poetry may be…. it won’t likely keep them fed.
I would say marry a farmer that is debt-free.
Full Disclosure: I have 3 granddaughters-ages 11-5-4, if you know any young farmers.
One response to the commenters asking what to do is simple and obvious: Borrow money if able at today’s historically low interest rates, and pay off the debt in far less valuable dollars (this would a bet for inflation). Similarly, if it is an affordable option, consider investing in something that will keep pace with inflation; this might be better bet than “saving.” If “saving” means putting funds in a bank account, a safe, or under a mattress, the dollars will decline at the inflation rate. If confused about what to do (as I am) maybe diversify available funds sufficiently not to get swamped by inflation, and think hard before paying off any 2-3% mortgages “early.”
This is not investment advice.
I had no idea what market makers you folks are. In the week after this article was published, the return on ten-year treasuries jumped from 1.1157% to 1.344%/ How about letting me see your economic articles in advance of your publishing them on line.