How to keep away inflation in the future

Larry, a loyal MR reader, asks:

When the US government borrows and prints so much money in the coming
few years, how is the country going to keep massive inflation away?

Borrows and prints are different here.  The borrowed money is no inflationary threat, if the U.S. government is willing to raise taxes to pay it off.

As for the newly created reserves, in theory the Fed can suck them out of the banking system at will (and/or change the rate of interest paid on reserves, to influence demand to hold).  But will it hit the right timing in practice?  Let’s say the economy miraculously recovered tomorrow.  Banks would be very eager to make more loans than they are doing now and the broader monetary aggregates would go up rapidly.  However the broader aggregates take many months to influence the price level, so in the meantime the Fed would sell assets from its balance sheet and take reserves out of the economy.  These are uncharted waters and the trial and error factor likely will be significant.

It is the lags which give the Fed some chance to react but the lags also mean that the Fed will never quite know if it is proceeding at the right pace.  And will the contractionary open market operations be conducted with all the non-standard assets currently on the Fed’s balance sheet?

As I said, uncharted waters.

I give it a reasonable chance that we, in due time, have a secondary recession, resulting mainly from the Fed deflating at too rapid a pace as the economy recovers.


As far as I can tell, most of the Feds assets are commercial paper and loans to banks, all with maturities of 90 days or less, plus what looks like a huge amount of currency swaps with foreigners, or some such thing. Presumably, when they want to contract, they can just quit rolling over the loans, at some measured (ha) pace.

I have been concerned for months about the rapid expansion in reserves, and the potential for this to lead to huge price inflation if and when the financial panic subsides. It's true that Bernanke could drain the reserves out, but he will be hard-pressed to slam the brakes just as the economy begins emerging from the recession.

For those interested, here is a recent blog post where I did some back-of-the-envelope calculations to show just how much Bernanke has painted himself into a corner.

How is it possible to reconcile banks borrowing huge amounts from the Fed and then banks holding vast excess reserves? Banks pay a quarter basis point on the loans more than they earn on their reserve balances.

Isn't the most plausible scenario that some banks are borrowing from the Fed to finance loans, and _other_ banks are holding reserves at the Fed?

Consider the following scenario. Citibank was funding mortgage backed securities with uninsured deposits. Uninsured depositors move funds from Citibank, split the money into 250k bundles and deposit it in insured accounts at First Federal of Charleston, SouthCoast Bank, etc. Reserves balances shift from Citibank to those smaller banks. The smaller banks just leave the funds at the Fed. They even earn interest on them. Citibank borrows money from the Fed's term auction facility to continue to finance its portfolio of mortgage backed securities that had been financed by the uninsured deposits. The reserves the Fed created and lent to Citibank are held by the various smaller banks.

In this scenario, Citibank cannot pay the Fed back unless it can sell its mortgage backed securities.

If the banks that are currently holding the reserves choose to lend them out, collecting money from banks that are only solvent because the Fed is lending them enough money to finance their bad assets will not be an option.

On a more positive note, however, the U.S. Treasury's balance at the Fed is already financing a substantial fraction of Fed assets. While in the past, Fed assets and base money were more or less equal, that is no longer true.

If this were the situation, I would expect the Federal Reserve to be actively supporting a taxpayer bailout of insolvent financial institutions.

What do you know?

The chances that the current expansion of the Fed’s balance sheet will result in inflation in the future cannot be estimated in isolation from the fiscal deficits that are now being incurred and will likely be incurred in the next few years. A monetary contraction will result in a rise in interest rates and thus in the cost of servicing an enormous national debt. The temptation partially to repudiate the debt through inflation will be there. Realistically, the overall outcome may involve a combination of tax increases, entitlement cuts and inflation – possibly another recessionary dip, but policymakers may be very unwilling to risk this. In any event it will be nasty. I have given my views at:

Mario & Mike:

I'm afraid that you're both incorrect. The US Govt has no need to desire to repudiate debt through inflation. It can print dollars at will, why does it care how big the deficit gets? It cannot run out of money -- ever.

Whether or not the larger deficits cause inflation depends on whether the federal deficit becomes larger than the private sector's demand to save. Inflation comes from too many dollars chasing too few goods, and dollars sitting in a bank account are not chasing anything.

A combination of "tax increases, entitlement cuts and inflation" will 1) decrease aggregate demand, and 2) decrease aggregate demand. Falling aggregate demand directly opposes your #3 -- inflation. Higher taxes and cuts in government spending reduce aggregate demand. Reductions in aggregate demand create deflation, not inflation.

MIKE: The value of money comes from it's ability to extinguish tax debts and keep yourself out of jail, not from what it's backing. If the Fed gives money to someone for nothing, and runs up a deficit doing it, then the person who gets something for nothing (banks selling crap assets for $>0) are up, and everyone else loses.

You are 100% correct in thinking about both Fed assets and bank assets in a balance sheet context. The key difference is that the Fed can issue currency, ie. increase its' balance sheet at will, and banks cannot, they can just use money, like the rest of us. Banks have a direct line to the Fed, which we do not, but they are not the Fed and are still currency users. I think this is the distinction that's confusing Mario.

"The borrowed money is no inflationary threat, if the U.S. government is willing to raise taxes to pay it off."

Yep. But this minor fact is the difference between Democrats and Republicans and choosing wrong over the last few decades is the reason Europeans now enjoy a higher standard of living than Americans while also exporting a higher standard of living to the developing world than Americans. What taxes to raise? Carbon? A VAT (called GST in Canada when we flirted with high debt as a result of right wing government 15 years ago)? Target the 0.1%? The 1%? Tobin Taxes? Follow NY (and maybe Europe?) and start taxing unhealthy foods?
More importantly? How to make sure biggest taxer if threat of debt default, wins election? If there's anything the last Canadian election taught me it is that facts and honesty don't work and patriotism and fear and personality-scripting works. I'm an advocate now of encouraging ethical traders to short the weakest right-wing media companies; Canwest Global here in Canada (sob, from my hometown). Who is the weakest right wing media in USA?
Sweeping the hardest part of the question under the carpet. It took an inability of Palin to memorize a handful of talking points and a global recession to finally usurp Republican machine. Without a perfect storm again or some better voter education strategies it's going to be hyperinflation and debt default by default.

Tyler, you're wrong. These are not uncharted waters. I recommend you to study the history of Argentina's public finances--whatever the differences with USA, you will find there all the examples you need to understand what may happen once people start to distrust government to have the ability or the willingness to raise taxes (and cut expenditures) enough to pay back debt or to avoid hyperinflation.

Philip Huggan,

Your memory fails you. The GST in Canada was introduced by a right-wing government, to counter the high deficits incurred by the previous small-L and capital-L Liberal government. It was also introduced as a revenue replacement for the longstanding but economically-suicidal-under-globalization tax on manufacturers.

The Liberal party of the day regained power easily by promising to abolish the GST and then immediately broke that promise; the Conservatives' reward for recklessly doing the right thing in the higher interests of the country was electoral annihilation and near extinction as a political party; Canada, on the other hand, enjoyed a decade of large budget surpluses, unique among Western countries, which only the recent global economic crisis will bring to an (abrupt) end.

Don't count on anything like the GST or VAT being introduced in the US; political gridlock makes it impossible. Americans seeking to understand the Canadian political system should imagine no Senate and no President, just a House of Representatives whose speaker automatically becomes the chief executive of the country, and whose members of Congress almost always vote straight party line. Things get done quicker under such a system.

this minor fact is the difference between Democrats and Republicans and choosing wrong over the last few decades is the reason Europeans now enjoy a higher standard of living than Americans while also exporting a higher standard of living to the developing world than Americans.

And how those clever Euros export a higher std of living to the under-developeds? Could they export that high std to us in the poor old USA?

You might consider dragging your sorry ass over to Europe. When you do you will find that grass is not very green on another side of Atlantic, with possible exception of 3 or 4 small countries.

Trudeau's 1970s debt built schools for boomers. Mulroney's nearly equal debt just gave us richer rich people. Trudeau first $250B debt didn't threaten bankrupcy, Mulroney's did. No comparison. Just look at Schreiber. The guy was Mulroney's closest aide and dedicated to bringing about Right Wing governments across the world. Sickening, at least among countries are forced to sacrfice good public spending programmes (Harper killed daycare in 2006 and carbon tax in 2008). When AGW toasts this civilization Liberals will have had nothing to do with it.

I depends an what your definition of inflation is. If you're looking at just nominal value, fed borrow-and-spend policy is neutral or deflationary. But if you're looking at erosion of the meaning of money, government spending is almost always inflationary.

A piece of paper that entitles its bearer to claim 1 oz. of gold is worth 1 oz. of gold. If I have taxes to pay in any country, I can sell that gold anywhere and get local currency to pay those taxes--and historically, many countries have accepted gold directly.
A BofA dollar is also known as a checking account dollar in BofA. People pay their bills with BofA dollars all the time. They are valuable. They are also acceptable for taxes, but they would be valuable even if they weren't, since BofA stands ready to convert them to paper dollars any time. Also, I sometimes pay my mechanic with my IOU--a Mike dollar. He accepts them because he knows I'll pay him Fed dollars soon enough. But he could also pay the salary of his driver, because his driver rents a house from me, and I accept Mike dollars for rent payments.
Convertibility is one thing, and backing is another. Over the weekend, when banks are closed, BofA dollars are inconvertible into paper dollars, but they are still backed by BofA's assets. On Monday morning, BofA dollars are both backed and convertible. The US dollar is physically inconvertible, meaning the Fed will not buy back its dollars with gold on demand. But the US dollar is financially convertible, meaning the Fed will buy back its dollars with bonds. This implies that the US dollar is not fiat money, as you claim. The US dollar is backed by the Fed's assets, but physically inconvertible.
If Zimbabwe's central bank does not meet your definition of bankrupt, then you need to change your definition.
"a dollar has value because it's backed by something, you are free to believe that, but it is simply not true. You are in excellent company, however, as every academic economist I have met believes the same thing"
Every academic economist I've ever met, and every textbook I've ever read, says that the US dollar is not backed, and that its value is maintained by the forces of supply and demand.

Schreiber was not Mulroney's "aide" at all. That's like saying Tony Rezko was Obama's closest aide.

You have a very creative perspective on the historical record, but let's leave it at that since this isn't the time or place to hijack the thread and talk about Canadian politics.

A VAT or GST would indeed be a useful way to sharply cut the US federal deficit, it certainly worked wonders in Canada. But in the US context it's pretty much a straight political impossibility, akin to herding cats and convincing them all to do a synchronized jump off a cliff.

BILL: You are actually pretty close in your analysis.

"The notion that inflation depends on the budget deficit and saving is incomplete. Once one includes investment, net capital flows and the likc, then this analysis is ignoring how changes in interest rates can bring these things to equilibrium without inflation."

But I am including all of that. Remember, by definition, Y = G + C + I + NX


Y - I - C - T = (G - T) + NX

It's all there, and Y - I - C - T is, by identity, net private savings.

You'll note that interest rates play no role in this. I could generate inflation and deflation with a zero Federal Funds rate if I was the Fed, and do it all through fiscal policy if I wanted. Not that I recommend this.

"Like everything else, the value of money depends on supply and demand." Yes, and Govt can create the demand by setting taxes. A small modification, the Fed cannot create money, it can just set the price. Quantity is set through spending, either fiscal, or through banks. So yes, supply and demand matter, but you have the same actor controlling both.

MIKE: "A piece of paper that entitles its bearer to claim 1 oz. of gold is worth 1 oz. of gold." Sure, but you are not talking about the US$ any more, as it does not entitle it's bearer to any quantity of gold. All it entitles its bearer to do, for sure, is extinguish $1 of tax liability.

You seem to be denying that the US$ is not a fiat, non-convertible, floating FX fiat currency. You also seem to be making a distinction between FDIC backed US$ account at a bank, and a US$ in any other sense (including in a Treasury bond). Maybe you think Zimbabwe would not have inflation problems if it paid in Zimbabwe T-notes instead of Zimbabwe currency. You're not only denying that the sky is blue, but you're denying that the sky is the sky. We're done.

WOOLSEY: I am never one to deny the law of supply and demand. But surely you recognize that one actor -- the Govt -- can take control of both sides by controlling the Fed Funds rate, spending itself, and taxing (to extinguish money supply). Please tell me what supply and demand means in this context when a single entity can control both supply and demand.

MIKE: I want to see this wondrous menagerie of currencies you claim exist. Please share with us all a Federal Reserve note promising a weight, or mass, of gold, or of anything else. Also, please show me a BofA buck, and no, a Federal Reserve note kept in a BofA account does not count, any more than a dollar bill in my pocket is anything other than a dollar bill. It is not a "winterspeak pocket buck".

Please also tell me why a Federal bond is any different from a Federal reserve note. Maybe Zimbabwe would not have experienced hyperinflation of the Government had paid people in bonds instead of notes? The distinction, saying that one is inflationary and the other is not, is simply garbage.

Hussman makes this point clearly:

"Inflation occurs when fiscal policy creates more government liabilities (either money or debt) than people are willing to hold at existing prices. If investors are scared about credit risks, they generally seek government liabilities as a safe haven, so you typically get deflationary pressure during credit crises. In contrast, if the government produces a lot of liabilities in an unproductive economy (as the Germans did in the 1920's, paying striking workers in the Ruhr even though they weren't producing anything), you get high inflation. It would not have mattered had Germany paid workers with bonds instead of money – bond prices would have declined, raising interest rates, lowering the willingness of people to hold non-interest-bearing currency, and causing a hyperinflation nonetheless. Inflation is first a fiscal phenomenon, tempered by economic activity and credit conditions, and affected only at the margin by “monetary policy.† The government budget constraint (spending = taxes + debt + money creation) ensures that monetary policy cannot be independent of fiscal policy. All monetary policy does is to vary the mix of debt and money within that equation."

I don't agree with everything Hussman says, but on this point he is very clear.

I sympathize with your desire to believe that US$ are backed by something, but it just ain't so. Fiat is fiat.

The massive fiscal and monetary stimulus packages are designed to ward off the risk of deflation 1930's style. The tangental risk is that the stimulus cure causes hyper-inflation as experienced by the Weimar Republic in 1920's. Is this a worse disease?

USA is currently funding its expansionary policy by foreign borrowing. If the Chinese etc decline to continue to fund this then the dollar will collapse and hello Weimar. Unless of course domestic savings increase to replace the foreign money flow.

Domestic saving is showing signs of improving and may well cover the future borrowing needs. Jim O'Neill, Goldman Sachs economist believes it will (source Bloomberg)

The effect of this forecast turnaround, by the private sector from profligate spenders to savers will, however, tend to neutralise the effect of the governments expansionary policy and allow the deflationary spiral to play out. Not a happy outcome.

The hope of those pulling the economic levers appears to be to manage a controlled, say 10%, inflation which will over time pull asset values and borrowing ratios back into line without cripling the economy.

The losers in any high inflation environment will be the savers. The irony is that the savers who stand to lose if the plan suceeds have the capacity to ruin the govenments plan by over saving such that the economy goes into a depression like spiral.

Isn't tis what occurred in the Great depression?

We live in interesting times

US does not declare how much money it prints. So, where does that effect the inflation. Moreover, there are lots of factors which account for inflation.

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