Where is the hyperinflation? Can we just print our way to growth?
December 20, 2011
Why isn’t the US suffering from hyperinflation as predicted by so many Austrian economists?
In this year’s political debate there are a number of pundits and candidates talking about impending hyperinflation. Despite tough talk and innumerable predictions, inflation continues to be absent from the radar, or is it? In truth, many people feel the bite of inflation because of higher fuel prices or higher food prices, however, these higher prices have been offset by lower housing prices. That’s one of the reasons why this year’s inflation has been so pernicious. On the one-hand, people are faced with higher food and energy costs but cannot lower their rental or mortgage payments to reflect the lower housing costs. Knowing that the Federal Reserve has engaged in massive quantitative easing programs over the past several years, shouldn’t that money come back to haunt us?
According to recent Federal Reserve reports, most of that money went back to the FED in the form of deposits. For the first time, the FED has offered interest on deposits for banks that keep money at the FED. How exactly does that work because the local bank is not paying money on deposits? It’s a fair question because essentially, the FED is printing money to pay interest on money it issued to buy back bonds to reduce interest rates to zero. Should the FED engage in additional quantitative easing in January as expected, then most probably, banks will simply put the money back into the FED and earn interest on the deposits. Instead of lending this money to small businesses, banks have chosen to lend back to the FED. Quantitative easing is not about creating jobs or supporting bank lending, it is only about keeping interest rates at zero.
As long as interest rates remain near zero, the US government will not have to pay much for its debt. This way, the US can tell the world that the deficit is falling and that we don’t need to raise taxes or cut spending more. This is a false reality because interest rates can only be maintained at zero artificially and not forever. Once interest rates move back to their long-term average over the past 40 years of 4 to 6%, the deficit is going to explode. When that happens there will be more calls for austerity and another round of budget cuts. During this time, bank lending is restricted and if interest rates rise, the economy will shrink as well. This explains why Republicans and Democrats do not have a reasonable jobs plan. To create jobs, they need banks to lend so the FED would have to stop taking deposits and interest rates would go up, shutting down the economy. This is why we call this a jobless recovery and pretend that things are getting better.
The Austrian’s are wrong because they are just looking at total money in the system and not looking at what it is doing. The Keynesians are wrong because they are looking at low inflation and declaring victory suggesting that we let the printing presses fly with no ill effects. The neo-classicists are wrong because they believe they can cut spending without a negative effect on the economy. Eventually, sooner rather than later, Bernanke is not going to be able to keep interest rates at zero. Right now, he is being helped by the European crisis, however, as the Eurozone crisis deepens, China will begin to readjust its portfolio of currencies and may decide that there will be a negative impact on the US banking sector precipitating a crisis in the dollar. China may decide to begin dumping bonds into the market place and Bernanke will have to find a way to scoop up those bonds by raising interest rates. It would be a mistake to think the Chinese do not realize the precarious position the US is in financially.
One model proposed by Ron Paul is to cut government spending by $1 trillion eliminating the deficit in one year. That is very appealing to the Austrians who feel there needs to be an adjustment to all the cash in the market place. Ron Paul says he will soften the blow by employing the $2.5 trillion the FED is holding in government bonds. That is Ron Paul talking out of both sides of his mouth, either government debt is good or it is bad but it is not both at the same time. He could just cancel that debt and reduce the debt overnight by a significant amount but then that debt would not exist for reissuance to sop up the excess cash that is going to come out of the Federal Reserve. Further, he will raise interest rates a few percentage points which could be good but will cause more job losses in addition to jobs lost when he cuts economic activity by 7%, after all government spending is economic activity. The problem with the Paul plan is that it is deflationary requiring structural adjustments in areas that do not adjust very well, like wages. Ron Paul overcomes this by removing all wage controls with the expectation that wages will fall very quickly along with costs. The sticking point is that housing expenses are not going to fall very quickly, nor will prices on imported goods. That sets up the potential for a new housing crisis as foreclosures mount and housing prices continue their decline.
On the other side of the table are the Keynesians who demand big stimulus packages. In the Keynesian world inflation will not take hold until workers demand higher wages to cover rising costs. With 20 million potential workers in the economy there is a reasonable expectation that wage increases will be muted over the near term. By stimulating aggregate demand, jobs will be created and economic activity will pick-up, however, by absorbing all the cash in the market place, the stimulus plan will limit the amount of funds even more that banks have for lending, shutting down banks as a source of funding for business. This will push up interest rates necessitating more quantitative easing by the FED with the expectation that the FED will try to buy up much of these assets to maintain the zero rate policy. Hence, while people will have government supported jobs, private industry will be unable to expand to provide jobs when the stimulus ends returning us back to where we started. This is the problem Japan faces.
What we need to do is to first, stimulate the economy, then, drop the zero interest rate policy allowing the deficit to expand. Once we move beyond a zero interest rate policy and let interest rates climb, it will free up cash reserves held at the FED and investors will want to put that money to better use. Instead of worrying about the deficit, one should be worried about job creation. Eventually, the excess cash will work its way into investments providing sufficient stimulus from the private sector eliminating the need for government support. At that point the nation can begin to focus on ways to cut the deficit without pushing the nation back into recession. America cannot solve its problems by cutting spending without causing new greater problems and it cannot simply spend its way out of this crisis. It needs to abandon Bernanke’s zero rate policy, embrace deficits, and create jobs.
Most neo-classicists would call this crazy because the nation risks bankruptcy by increasing its deficit. The newsflash is that the nation is already bankrupt, it spends more than it takes in and covers the difference by printing money. The stimulus package takes the existing money held by banks and puts it to work by investing it. It then accepts the resultant inflation and higher interest rates as part of the cost of solving the problem. The higher anticipated deficit can be adjusted through targeted spending cuts and tax increases to maximize their effect without shutting down the nascent economic growth. This of course would require real solutions instead of political posturing and a dedication by both Republicans and Democrats to craft a workable program to our problem instead of the impending disaster quickly sailing across towards us over our horizon. In a nutshell we are doomed.
Here is one solution, it needs some fine tuning, but don’t we all.