Last night on Kudlow, three out of five of the people talking wanted the Fed to raise interest rates to head off inflation and defend the dollar. On these very pages, I am regularly castigated for saying any of the following:
- A "strong dollar" doesn't mean a strong economy
- The government is going to have to pay for its debt, not inflate it away
- Some inflation is all right
- The gold standard won't solve any of the problems people think it will
For someone who hangs out with libertarians a lot, announcing that you're okay with a small amount of inflation to relieve the sticky price problem, and that you think the Fed mostly does a good job, is akin to announcing that you've decided to take up human sacrifice to fill those lonely weekend hours. Nonetheless, I stand by the sentiment: inflation is not the big worry that our economy faces.
To explain why I think the risks lie in the directions of fiscal crisis rather than hyperinflation, I turn to Tyler Cowen, who elegantly summed up the government's problem at a conference I attended last week: inflation only works on stocks of debts, not flows. You can inflate away the value of debt you've already issued, but especially in these modern times, bondholders will rapidly ratchet up the interest rate they charge you. They will increase it by more than the rate of inflation, to compensate them for future inflation risk. Losing your credibility is costly.
To this, my excellent former co-blogger Winterspeak responds that since the United States has a monopoly on the currency it issues, it can't default--it can just keep running the printing presses. There are a couple of problems with this. In some sense, I think it confuses cause with effect: the government gets to borrow in a currency over which it has a monopoly, because it has been a fairly credible steward of that currency. If it inflated away its debts on the scale of, say, a Latin American nation, it would not be able to borrow in dollars any more. And since it needs real goods and services, not little green pieces of paper, that matters.
For his point to be right, you need to believe that the government can end up financing the entire debt by seignorage, which is the revenue that the government gets from issuing currency. In the case of the United States, that revenue is currently pretty considerable, because so many people overseas use dollars as their emergency bank account; essentially, they give us goods and services in exchange for dollars, and then stash those dollars under their mattresses. But that's because we don't inflate the currency.
In the case of a hyperinflation, essentially, the government gets a slight discount, based on the fact that it knows how much money is in existence, and you don't. It prints the dollars, and uses them to buy goods, and then the oversupply of dollars pushes up prices still further. But the discount is actually pretty small, and hyperinflationary seignorage turns out to be a very inefficient way of generating tax revenue, especially in a world where there are modern financial markets monitoring government behavior. The much maligned Laffer Curve is actually a pretty effective model at describing hyperinflation; it's very easy to get on the wrong side, where inflationary expectations and deadweight loss start killing the revenue you can raise. It is possible to end up in a place where, as with the Zimbabwean dollar, your monopoly right to print your currency becomes worthless, because the demand for that currency is essentially zero--no one will give you goods and services in exchange for your paper.
If you're talking about a past stock of debt, it makes some sense to talk about it solely in terms of dollars--really, accounting entries. But of course, the reason the government borrowed the money is that it needed to secure real goods in the economy, and its citizens didn't want to reduce their consumption enough to pay for it all with their taxes. Sometimes that's a one time event, like a war, in which case inflating away your debt looks quite attractive (immoral, possibly--but then, lots of attractive things are immoral, n'est ce pas?)
But more often it's an ongoing problem. In which case, it's hard to aggressively inflate, because within a very short period of time, your ability to borrow in your own currency at attractive rates will fall off. So if you're going to hyperinflate, you need to be prepared to quickly close the gaps between the real goods and services you want to consume, and the real goods and services you want your citizens to give up in order to pay their taxes. In other words, you need to be prepared to stop running a budget deficit--or to resort to increasingly desperate tactics like Argentina's nationalization of its private pension regime in order to loot the accounts.
In the US, the problem is even more complicated because so many of its mandatory payouts are inflation-indexed; it doesn't do you any good to inflate your debt away if half the debt is owed to inflation-linked Social Security accounts.
I am the last person to ascribe any towering wisdom to our nation's political class. But they do (most of them) understand this calculus. Moreover, the US has an unusual degree of continuity, and power, in our legislature; to do something this drastic, you'd need to secure the assent of a number of congressmen who are planning to be working at the Capitol for several more decades, and thus have an interest in not seeing the fiscal mechanism by which they distribute goodies to their constituents entirely break down. If interest rates start accelerating on our debt, or treasury auctions fail, I think they're more likely to take some sort of drastic step then to either default, or hyperinflate.
The key word is "drastic"--I expect they will let us get into quite a pickle before they finally reign things in. But there are really quite a few institutional checks that will prevent things from going the way of Latin America, not least that we have a central bank with a lot of political independence. For all the complaints about Greenspan and Bernanke's inflationary bias, neither were prepared to countenance even high single-digit inflation, and I doubt Bernanke's successor will be, either. The first step to hyperinflating would be some sort of radical step to curtail the Fed's power--and that radical step would, as noted above, make it very hard for the government to borrow new money.
I think the much bigger worry is that we are going to drive ourselves into a corner where the bond markets will force us to slash benefits to people who have planned their lives around them, making those people worse off than they would have been if the program had never existed. And also, of course, that they will raise taxes by enough to produce serious, painful deadweight loss. But until Ben Bernanke starts looking much more inflation-friendly than I've so far seen, any kind of effort to totally inflate away our national debt is pretty low on my list of potential problems.
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