The current turmoil in Washington, DC over the federal debt has drawn a lot of laughter and ridicule from other countries, especially in Europe. The Europeans should refrain from laughing too hard at us. They are themselves playing a very dangerous welfare-state debt game, with steadily rising debt levels despite years of attempts to get deficits under control. In some EU countries the debt crisis is so bad that the European Central Bank has (ECB) pledged to pump out whatever amount of money they think is needed to avoid debt default among euro-zone states.
The money pump is hooked up to a bond buyback program where the ECB promises to buy every single Treasury bond issued by a troubled welfare state, anytime, anywhere. In plain English, this means that wherever investors lose confidence in a European Treasury bond they can always sell it to the ECB, no matter how high-risk the bond happens to be. In practice, this program has cemented high interest rates for troubled welfare states and could even push international rates up over time: after all, why should you buy a Swiss Treasury bond at little over one percent interest when the ECB gives you an ironclad guarantee for a Greek bond at ten percent interest. The price for those high interest rates will be paid by Europe’s already struggling private businesses, as they see their investment costs rise.
But the Europeans have an even more serious problem to deal with, namely inflation. In order to finance budget deficits across the euro zone, the ECB is pumping out new M-1 money at a rate close to eight percent per year. Long story short, the cash goes toward buying Treasury bonds from troubled EU welfare states. But at the same time, the euro-zone economy is stuck in zero GDP growth, which means that there is no growth in transactions demand for money. Government absorbs the newly printed money and uses it to pay its bills, including entitlements to private citizens.
Funding the welfare state with printed money is a recipe for high, lasting inflation rates. Venezuela is an example of sorts, but a better one is Argentina, where entitlement spending, paid for with runaway money supply, has driven inflation up to a socially and economically explosive 30 percent. Needless to say, this inflation rate is crushing the Argentine currency, just as runaway inflation always does.
So far, the euro zone has not had to pay the inflation price for its irresponsible combination of a welfare state and endless money printing. That does not mean though that they cannot end up being a new Argentina within a few years. But even the United States should take notes here. We are not where the Europeans are – not yet. We have a smaller government, higher growth, lower unemployment and a more resilient political system than the Europeans. If any economy in the world can avoid a new encounter with inflation, it is ours. But none of this matters if Congress and the Federal Reserve continue to make irresponsible decisions.
While I do believe that our political system will actually be able to handle the budget deficit problem, I would not bet on the right solution unless I knew for sure that the Federal Reserve would see the dangers in pumping more newly-printed dollars into the federal budget. Ben Bernanke was a disappointment, and I have serious questions about his designated successor, Janet Yellen. She has been quoted as an “inflation dove”, i.e., as someone who is willing to keep feeding the Treasury even at the expense of higher inflation.
Normally a person in her position would meet fierce resistance from established economists and people in Congress. After all, Americans in general harbor a clear hostility toward inflation, and even Democrats detest it – almost as much as they hate Sarah Palin. But there seems to be a change in tone in the public debate when it comes to inflation. A good example is a story from Moneynews.com back in August:
The economist whose research foreshadowed the unusually long slog back from the 2008 financial crash is calling for the unlikeliest kind of central banker to lead the Federal Reserve: one who welcomes some inflation. Harvard University Professor Kenneth Rogoff, whose influential 1985 paper endorsed central bankers focused more on securing low inflation than on spurring employment, is highlighting the benefits of a Fed led by either Janet Yellen or Lawrence Summers precisely because they fail his old litmus test.
In endorsing a looser inflation target for U.S. monetary policy, Professor Rogoff is playing with fire. The old notion that inflation is a monetary phenomenon, caused by too much money supply, has been thoroughly proven wrong. You can flood an economy with all the liquidity you want – if there is no real-sector activity to put all that liquidity to work, there won’t be any activity that can drive up prices. In other words, the transmission mechanisms from the monetary sector to the real sector are weak and slow.
The fact of the matter is that a central bank cannot “manage” inflation the way traditional monetarist theory stipulates. Inflation occurs when someone spends the new money on a product whose price then rises. This has not happened despite massive growth in money supply during the the past few years (ten percent in the last year alone). The reason is that the private sector is too cautious to spend, and therefore too cautious to lend and borrow money. In effect, the free market keeps tabs on inflation despite the Federal Reserve’s irresponsible monetary policy.
By contrast, government does not abide by the rules of the free market. It spends money regardless of the future outlook. Since most of what the federal government spends money on happens to be entitlements, the welfare state is a perfect venue for work-free money to make its way into consumer markets – i.e., circumvent the normal transmission mechanisms from the monetary sector to the real sector. As a result, entitlement spending could drive inflation in the U.S. economy almost as easily as it has done so in, e.g., Argentina.
Therefore, when Professor Rogoff advocates a higher tolerance toward inflation he inadvertently gives Congress a blanket endorsement to continue to deficit-spend, and to the incoming Fed chairman to continue funding that spending with newly printed money.
This would be the end of the story if Janet Yellen was an inflation “hawk”. But according to an article in the Huffington Post in April, Yellen shares Rogoff’s dovish view of inflation:
The Federal Reserve should focus its energies on bringing down an elevated U.S. unemployment rate even if inflation “slightly” exceeds the central bank’s target, Fed Vice Chair Janet Yellen said on Thursday. … “Progress on reducing unemployment should take center stage … even if maintaining that progress might result in inflation slightly and temporarily exceeding 2 percent,” Yellen told a meeting sponsored by the Society of American Business Writers and Editors.
There is another factor at work here, in addition to the Fed’s continued money printing for the federal deficit. International investors have become cautious about buying U.S. Treasury bonds, up to a point where a ten-year T-bond issued by the U.S. government pays a higher interest rate than the same bond issued by the French Treasury. If at this point the Federal Reserve continues to massively expand the U.S. money supply, the effect could easily be a combination of currency depreciation and considerably higher interest rates.
Currency depreciation quickly creates inflation.
This scenario has already been picked up by international investors. In September, a Bloomberg news report explained:
Inflation expectations in the U.S. are rising in financial markets, and hedge-fund manager Mark Spindel sees Janet Yellen’s candidacy to be the next Federal Reserve chairman as a catalyst. “If it is Janet, I think you have to price in some tolerance for higher inflation,” said Spindel, head of Potomac River Capital LLC, which manages $570 million, and former manager of $15 billion at the World Bank’s private-sector lending unit, the International Finance Corp.
The report also cautioned that Janet Yellen’s inflation dovishness may not be as unequivocal as some might suggest. That may very well be so, but this all happened under Bernanke’s chairmanship, which technically means that he had the last say on inflation policy. But more importantly, our economy may now be at a point where it can no longer keep inflation at bay under the pressure from a rapidly growing money supply. For several years now, the Fed has been able to pump galactic amounts of money into the federal budget – and the global economy – under its Quantitative Easing program. But that does not mean we won’t reach a saturation point. On the contrary, this is precisely what international investors are pointing to: the world is simply not big enough to absorb any more dollars.
At the same time, the federal budget continues to send newly printed, work-free dollars into the pockets of entitlement recipients. The more entitlement payments are funded this way, the less of consumer spending will be matched by work and production. This creates an inflation spiral which – eventually – takes on Argentine proportions. When that happens, the central bank’s faithful funding of a welfare state’s budget deficit turns from a benevolently misguided attempt at stimulating the economy into an inflation monster.
Once deficit-caused inflation takes charge, it won’t go away until the deficit goes away. To make the deficit go away, Congress will resort to panic-driven spending cuts combined with equally panic-driven tax hikes.
Greek austerity, for short.
I don’t see that point waiting around the corner. But we are moving in its direction. The best contribution at this point would be a clear and unwavering statement from Janet Yellen that she will:
- end QE,
- stand firm on the 2-percent inflation target, and
- will not give in to pleas from either the president or Congress to keep funding their deficit.
What are the chances of this happening? Not huge, but not remote either. If, that is, common sense prevails.