On September 20 I explained the welfare-state debt game, noting that Europe’s welfare states have put themselves in a very dangerous situation. Their debt levels are rising steadily, despite years of attempts by the EU to get budget deficits under control, and the European Central Bank has decided to pump out whatever amount of money they think is needed in order 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, any time, anywhere.
In the short term, this program is theoretically going to prevent a “run on the bond” where investors lose confidence in the Treasury bonds from one country and dump them onto the market. 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.
Over time, though, another threat looms, namely inflation. The ECB is already pumping out new M-1 money at a rate close to eight percent per year; since the euro-zone economy is not growing there is no growth in transactions demand for money. In short: people’s spending is at a standstill, so they can do with the same amount of money every month. Instead of feeding a need among the general public for liquidity, the M-1 money pump is going toward purchases of Treasury bonds from struggling welfare states. The ECB is using its monetary printing presses to cover budget deficits across the euro zone.
Europe’s welfare states are refusing to structurally reform away their entitlement programs. Instead they have entered a dangerous alliance with the ECB to keep funding spending programs their taxpayers are chronically unable to pay for.
In the end, 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.
The combination of a welfare state with persistent budget deficits and a central bank willing to fund those deficits until the next Big Bang is basically a ticket for the high-speed train into a macroeconomic disaster zone. So far the “new” Europe has withstood inflation – their latest fight with it was in the late ’70s – but that could also be the reason why the leaders of the EU do not see where they are heading.
To make matters worse, the same could be said about the United States. 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 that holds true only for as long as we make responsible decisions, on Capitol Hill as well as in the board room of the Federal Reserve.
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. So far Ben Bernanke has been a disappointment on this matter, 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. … What qualifies them in Rogoff’s view is their dovishness, a refusal to place too much weight on stable inflation at a time when unemployment is far above its longer-run level. Rogoff is espousing aggressive monetary stimulus, even at the cost of moderate price increases. At a time of weak global inflation, higher prices may even help the U.S. economy by lowering real interest rates and reducing debt burdens, he said.
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.
Under the old monetary notion of inflation it would be “easy” for the central bank to keep inflation at a desired level by matching that level with appropriate money supply. But in order for prices to rise as a result of a money supply increase, someone has to spend that new money on a product whose price then rises. That is where the transmission mechanisms come in; had those mechanisms been working as implicitly assumed in monetarist inflation theory, the expansion of the U.S. money supply over the past few years (ten percent in the last year alone) would have caused an explosion in consumer prices. That has not happened, precisely because the private sector is not spending the money. Consumers, bankers and businesses are too uncertain about the future to absorb the enormous amounts of liquidity that the Fed has created.
The one sector that does spend money regardless of the future outlook is – you guessed it – government. 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 is in effect giving Congress a blanket endorsement to continue to deficit-spend, and to the incoming Fed chairman to continue funding that spending with newly printed money.
In an article in April, the Huffington Post quoted Yellen as sharing this 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. Yellen, who is seen as a potential successor to Chairman Ben Bernanke, says she looks forward to the day when policymakers can abandon unconventional tools like asset purchases and return to the conventional business of lowering and raising interest rates, currently set at effectively zero. But she made that clear that time is not near, saying eventual “normalization” of policy by the Federal Open Market Committee is still far in the future. “Progress on reducing unemployment should take center stage for the FOMC, 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 continued monetization of the federal budget 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 did caution that Janet Yellen’s inflation dovishness may not be as unequivocal as some might suggest:
She might prove him and other investors wrong. Her economic framework and communications strategy show little tolerance for higher prices. She led a subcommittee of the Federal Open Market Committee that produced an explicit inflation target of 2 percent, a topic the panel debated for more than a decade. Her policy approach uses models and rules that view stable prices as a necessary condition to try to move the economy toward full employment while holding interest rates near zero. “The market does have it wrong if they think she is going to be soft on inflation,” said Stephen Oliner, a resident scholar at the American Enterprise Institute in Washington and former senior adviser at the Federal Reserve Board. “She has very little tolerance for inflation above the 2 percent target.” As the FOMC subcommittee put together a strategy document published in January 2012, Yellen stood behind a phrase that said anchoring the public’s views on inflation “enhances the committee’s ability to promote maximum employment in the face of significant economic disturbances.”
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, while the Fed may have been able to pump galactic amounts of money into the federal budget – and the global economy – during the QE years, without paying any price in the form of inflation, that should not be taken as a guarantee that inflation is not on the horizon now. As the Argentine example shows, there comes a point when a central bank’s faithful funding of a welfare state’s budget deficit turns from a benevolently misguided attempt at stimulating the economy into being 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:
a) end QE,
b) stand firm on the 2-percent inflation target, and
c) 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.