Sunday, April 13, 2014

Money Myth 10: Persistent government deficits lead to high inflation.

FACT: There is simply no evidence that increases in the money supply and/or government "debt" cause hyperinflation. The propensity to save and a nation's underutilized productive capacity are two major mitigating factors to inflation.

The fear of hyperinflation (especially in the US) is a common theme behind the many "doom & gloom" authors, precious metal fund promoters, and other economists and investor newsletters that warn of the next dire economic crisis caused by too much government debt. The story usually goes that the US debt is reaching crisis proportions, and that we are one tragic financial crash away from the hyperinflation experience of Zimbabwe, Wiemar Republic, or more recently, Greece.

It should be clear by now that the currency of nations like the US function very differently than those of nations that don't issue their own currency (e.g. the Euro), peg to another currency (e.g. some countries promise to convert their currency on demand to the US dollar), promise to redeem in gold, or hold significant foreign currency-denominated debt. It was these factors that gave rise to hyperinflation in Zimbabwe and the Wiemar Republic, along with the destruction of those nations' productive capacity. In other words, they had promised to meet financial obligations in a currency they did not issue, and with the productive capability of their countries decimated, they had no ability to produce enough surplus to meet those obligations. The conditions for hyperinflation are extraordinary factors (often external) such as war, civil war, foreign denominated debt or other significant external obligations, or rampant corruption.

Inflation is a complex subject and there is no doubt that the fear of inflation has a significant influence on consumer and business confidence. Inflation is hard to measure since innovation and productivity gains make direct comparisons between products we use today and those of the past quite difficult. This, among other factors, has led to much debate (and mistrust) over the government methodology for calculating inflation-tracking statistics such as CPI. However, it is still reasonable to take the position that inflation has been consistently low for many years in many countries, despite consistent and even significant deficit spending. 

Too much inflation can certainly reduce the desirability of a currency for savers, and can have a disproportionate negative impact on the poor since a higher percentage of their income is spent on life's essentials. This is one of the areas where our monetary system, once properly understood, can be used for the public good (mitigating inflation's effects on the poor, promoting employment, and using tax increases only when necessary to cool a frothy economy.

So with this background, we can make some general comments about inflation.
  • For better or worse, modern economies seek to maintain a constant low level of inflation. This is generally viewed as positive in order to attract continued investment (deflation tends to cause the private sector to retract and stop investing since they can't see how new investment will produce financial returns).
  • Any inflation has its drawbacks and we should consider how to mitigate the impact on the poor in public policy and fiscal policy.
  • The job guarantee provides a framework for using employed labor as a buffer stock and a price control mechanism that would bring price stability with full employment. 
  • Inflation is NOT caused automatically by an increase in money supply. This dynamic has been evident in Japan for about two decades.
  • The conditions for hyperinflation do NOT exist in the US or other countries with a similar monetary system, and history seems to have borne out this distinction. 
  • We may see continued asset and commodity price inflation as investors chase yield. This dynamic has much to do with our financialized economy and the structural & tax incentives for pooling wealth under the control of the financial sector.
  • If the private and public sector desire to save and hold government securities at least equal to deficits and trade balances (which is very much the case with the US and many other developed countries today), the "not-yet-taxed government spending" (deficits) do not result in a rising rate of inflation. 
  • When a nation has high unemployment and its productive capacity is below maximum output, inflation is a very low risk as increases in deficit spending are absorbed by expanded output, hiring, etc.
  • There is little evidence that inflation levels higher than what we typically experience (even double digit inflation rates) cause significant negative economic effects. Unfortunately, our fear of inflation has kept us from implementing the very policies that could help those in need the most. Read chapter 7 in Modern Monetary Theory, and this Levy Institute working paper for a more detailed treatment of this topic.
  • If full employment is reached, the economy is booming, and the rate of inflation truly does start to increase above a desired level, higher targeted taxation is an appropriate fiscal policy move (the government removes excess money from the economy, cooling demand).
In conclusion, the fear of hyperinflation is unfounded and is causing much harm. Refusal to increase deficit spending when it is needed the most leaves millions unemployed, perpetuating deficits as the economy languishes, tax receipts fall, and the government safety nets fill up.

We can and we should direct our elected officials to end unemployment now. 

Additional reading

Rob Parenteau has provided an excellent succinct summary of the unique dynamics of hyperinflation, showing why extreme conditions must exist in both demand and supply.

Also read Mythologies: Money and Hyperinflation by Arun DuBois.

Check out the series of posts on the topic by Cullen Roche of Pragmatic Capitalism, especially Hyperinflation - It's More Than Just A Monetary Phenomenon

Bill Mitchell's billy blog has a thorough overview of inflation from the perspective of modern monetary theory in two posts. Part 1 and Part 2