Who's Afraid of the Inflation Temptation?

There is not much about the US economy today that gives off the whiff of inflation. Unemployment is near 10 percent, and consumer confidence is at a year-low. Banks are holding enormous excess reserves, which holds down the money supply. The Federal Reserve has injected more than a trillion dollars into the economy, but core inflation still declined in January. Producers prices are down today. All evidence suggests that inflation fears are a dream.

And yet...

The US government is projected to run a $1.6 trillion deficit in 2010 -- the largest nominal deficit in history. Even as the deficit number falls in the next few years, US borrowing to pay the difference between revenues and outlays plus interest will grow to $2 trillion by 2012. As the debt burden grows -- the CBO projects that Obama's budget could add $10 trillion to the debt in 10 years -- the feds' options fall into three buckets. The government can raise taxes, but that will be politically poisonous. The government can cut spending, but that could strangle a weak recovery. Or the Federal Reserve can let inflation seep into the economy, which could erode the value of our debt without the government so much as cutting or raising a single tax dollar.*

We've tried this dirty magic before. As Michael Kinsley recounted in The Atlantic this month:

In 1979, for example, the government ran a deficit of more than $40 billion--about $118 billion in today's money. The national debt stood at about $830 billion at year's end. But because of 13.3 percent inflation, that $830 billion was worth what only $732 billion would have been worth at the beginning of the year. In effect, the government ran up $40 billion in new debts but inflated away almost $100 billion and ended up with a national debt smaller in real terms than what it started with.

Perfect? Painless? Plausible? Possibly. But there are dangers. First, inflation doesn't just chew up the debt. It also swallows the value of non-inflation-indexed savings. For savings tied to inflation, like Social Security, inflation would in nominal terms cost tax payers more money down the line.

Second, inflation at a level high enough to quickly reduce fiscal deficits could spiral out of control back home. If you're setting prices in an economy where future prices are expected to rise, your temptation is to set prices higher. In this way, inflationary expectations can outrun the Fed's target.

Third, there's a decent chance that inflation won't actually reduce our deficit in the first place. If inflation begins to creep up, investors will demand higher interest rates on US debt to beat expected inflation in the future. As Anne Vorce, director for the Fiscal Roadmap Project of the Committee for a Responsible Federal Budget at the New America Foundation, told me this morning, "Our creditors would go nuts. The Chinese premier specifically said he was concerned about inflation in our debt. Inflation is tempting in the short run. In the middle or long it has costs."

Vorce says we have every reason to expect that that the Federal Reserve will avoid the inflation temptation. "In the end, there will be recognition that it will be counter-productive."
*Here's a good explanation of one theory suggesting that inflating away the debt flat-out does not work:

The fundamental obstacle to governments eroding their debt through inflation is the duration of the government debt portfolio. If all outstanding debt had ten years before it matured, then governments could inflate their way out of the debt burden. Inflation would ravage bond holders, and governments (with no need to roll over existing debt for a decade) could create inflation with impunity, secure in the knowledge that existing bond holders could do nothing to punish them. In the real world, of course, governments roll over their debt on a very frequent basis. As a result, governments are vulnerable to higher debt service costs if market interest rates change. If markets move to price in the consequence of higher inflation by raising nominal interest rates, then the debt service cost will rise and increase the debt. Thus a period of high inflation will tend to raise both the numerator and the denominator of the debt:GDP ratio.