Inflation and Debt - Term Paper Example

? Inflation and Debt Table of Contents I. Introduction 3 II. Fiscal Inflation 4 A. Fiscal Inflation 4 B. Fiscal Inflation and the Current Economic Environment 5 C. Fed Perceptions about General Inflations, Treating Fiscal Inflation 6 D. What the Feds, Other Concerned Private Economic Agents Should Do 8 III. Cochrane’s Key Claim 9 IV. Comments 10 Works Cited 12 I. Introduction This paper discusses the paper ‘Inflation and Debt’ by John Cochrane in the context of key questions relating to the concept of fiscal inflation, the reasons for worry relating to the impact of fiscal inflation to the present economy, how the Fed perceives or misperceives general inflations and whether or not fiscal inflation can be viewed in the same way as the general inflations, and what interventions private agents of the economy as well as the Fed can enact to avert the crisis that Cochrane discusses in the article. The paper also discusses Cochrane’s key claim and comments on that key claim. This paper asserts that on balance, there is some weight to the argument of Cochrane relating to the threat of inflation from sustained fiscal deficits and loss of lender confidence in American debt leading to the government needing to fund deficits by printing dollar, but that the threat is somewhat mitigated by the continued confidence of lenders in the US economy in the foreseeable future as well as by historical precedents from countries like Japan, where large debts did not necessarily end up in a monetary policy of printing more money and in inflation spikes as Cochrane feared (Cochrane). Cochrane basically talks about how budget deficits and large amounts of debt results in inflationary threats, or that those lead to heightened risks of what Cochrane describes as the “run on the dollar”. The gist is that deficits in the future impact current inflation rates upwards, and Cochrane asserts that the Federal Reserve is powerless to deal with this reality. The Fed view of inflation is basically anchored on Keynesian concepts, and Cochrane further asserts that this, together with monetarist inflation concepts, is incapable of dealing with the inflationary threats that deficits bring to the table. Cochrane notes that the fiscal situation is dire in several respects, chief among them is that the culture of entitlement that lies at the core of American society ensures that the deficits in the future will continue to be large, as the expenditures to fund the “entitlements” alongside other expenditures are poised to dwarf government revenues. This is a recipe for sustained deficits that need in turn to be funded either by debt or by printing more money. In the event that the public sees printing money as an inevitability, then the consequences include the greater likelihood of that “run on the dollar” (Cochrane). II. Fiscal Inflation A. Fiscal Inflation Fiscal inflation in gist is simply inflation caused by fiscal policy, as when the government spends more money than it has, leading to borrowing, and to the printing of money to fund the deficits. Fiscal inflation can be seen as the flipside of large government spending leading to deficits in the budget, and the literature finds support in the assertion that the inflationary effects of large amounts of debt and of budget deficits are beyond the control of the Fed, which operates under the assumption that there can be no lasting inflationary pressures from activities that do not introduce liquidity to the market via the printing of new money (Cochrane; Ferguson). Debt and deficits, according to the view of the Fed, is not similar to printing fresh money, and does not have the same inflationary effect as the latter. This contrary view is borne out by the thinking that as long as there is no new money printed, and where the government has the power to issue debt to finance deficits in the budget, then there is no threat of inflation. This notwithstanding the established correlation between increased government spending and the reduction in taxation to induce economic growth as increasing demand relative to supply, and therefore inducing inflation in the long term (Cochrane; Feldstein). To the key question therefore of whether deficit spending and large amounts of debt impact inflation in the long term and in the present, the camp is divided between those who see government spending through debt as leading to fiscal inflation, and those who say that as long as there is no new money printed then there is no threat of inflation from government financing spending with new and large amounts of debt (Cochrane; Bernanke; Bernanke (b); Krugman; Ferguson). Fiscal inflation, to take a step back, differs from the other types of inflation that are detailed in the literature. In fiscal inflation, as has been discussed above, excessive spending by the government can lead to higher prices down the line, for reasons that have been partially explained above and will be further explained in the following sections of this paper. Fiscal inflation also differs from other types of inflation because, in the hypothetical scenario of Cochrane where loss of lender confidence leads to a dollar run, monetary policy is helpless to correct the downward spiral of the economy, as opposed to other types of inflation, which traditional monetary policy can address (Satow; Cochrane; Feldstein). B. Fiscal Inflation and the Current Economic Environment As discussed in Cochrane, there is a risk that the large debts that the government is incurring right now to finance its operations and to basically keep the economy on a growth path can fuel inflationary pressures and result in large inflation over the long term. This is true, for instance, where the government decides to print more money in the future, to pay debt, which in effect is a form of inflation. In the case of the United States, where there is always the threat of the US eventually printing more money to finance its spending or else resort to more debt via bonds, the risk of inflation is there. Cochrane summarizes a state of affairs where if there is enough consensus among bondholders that the government will resort to printing more money to pay its maturing debts, then that is a clear sign of inflation in the future, and the result is that there could be a “run on the dollar”, where bondholders junk the bonds, get away from holding US dollars, and the overall effect is that prices for all goods and services in the economy will go up. The bank run is something of a sword that hangs over the head of the American economy and the American consumer, as this sword is put there by the non-sustainability of the American fiscal policy (Cochrane). The proposition that lenders will stop believing in the American economy and ditch US debt and currency is a big if to be sure, given that according to Krugman for instance, historical evidence from countries such as Japan indicate that governments did not resort to printing more money even as they amassed large amounts of debt at some point in their economic history, and that the result of large debts for these countries is a lowering of the inflation rate or the keeping of it at an even keel over time (Krugman; Feldstein; Cochrane). C. Fed Perceptions about General Inflations, Treating Fiscal Inflation The general view of the Fed with regard to fiscal inflation is that it is the direct result of printing more money, and that here the thinking too is that there is no direct or indirect impact to inflation arising from incurring more debt to finance government operations and to also finance deficit spending. Its general view moreover of monetary policy in general hews closely to Keynesian views. In the Keynesian school, the key tool for effecting monetary policy is the short-term interest rate or what is called the overnight interbank interest rate. This tool has a domino effect on other rates, including long-term interest rates and rates of mortgages, as well as a slew of other rates for other consumer and business loans. Where the overnight rates are low, the demand for loans goes up, and this in turn brings down the overall level of market slack, meaning the levels of money available for loans. In the long run, the higher demand results in inflation from higher salaries and prices for goods and services. On the other hand, where interest rates go up, demand goes down, and the inflation is tamed. The balancing act for the Fed is in making sure that growth is maintained while not driving up inflation to unacceptable levels from an overheating scenario (Cochrane; Satow). Moreover, the thinking of the Fed is that just by manipulating the interest rate, the slack or tightness of the general monetary state of affairs can be controlled, effectively reining in the rate of inflation too in the same way as a horseman does with a steed. To put it another way, interest rates are the key to controlling all the general inflations. The main thing according to the Feds is in controlling the supply of money (Satow; Krugman). On the other hand, Cochrane and others argue that there are alternative channels that can result in higher inflation, such as the incurring of large debts that can result in a spike in inflation owing to the people factoring in a future devaluation of the money from the government printing more money at some future point to finance debt servicing. In other words, the current available tools for the Fed, grounded on controlling interest rates, cannot effectively deal with the dynamics of inflation fueled by incurring large debts (Cochrane; Bernanke, Krugman; Feldstein). To put it another way, fiscal inflation should not be viewed in the same way as the other kinds of general inflation, because in the case of fiscal inflation there are factors outside of the control of tweaking the interest rates that can bring about fiscal inflation. For instance, in the scenario that Cochrane paints, there is a probability that people may read the future and see that down the road government may have to print money in order to finance maturing debt, and that in effect the general investing public may come to a point where it is no longer to finance US debt with bond purchases, in which case the government will have no other recourse left but to go ahead and print money. In this scenario, the public may deem that current debt instruments may not be worth investing in, which may drive up prices in the near term too, for a confluence of inflationary factors (Cochrane; Krugman). Cochrane further argues from historical precedence that the view of the Feds with regard to inflation is too limited, based on the performance of the American economy after the war, and excluding the evidence from the 1970’s, when America experienced what is known as stagflation, for stagnant growth and spikes in the rates of inflation. This was a time when there was a slack in the resource level in the overall market, and that in theory with such a slack there should be no pressure on inflation and that money could be easily had. Moreover, in the case of fiscal inflation, fears of the government eventually printing more money can have an upward effect on inflation in the present (Feldstein; Cochrane; Krugman; Ferguson). D. What the Feds, Other Concerned Private Economic Agents Should Do The implication from the arguments of Cochrane is that large debts and running government operations by incurring large deficits, and incurring deficits to fund expansion of the economy and to keep inflation and stagnant growth at bay, leads to problems down the road in terms of pushing up inflation and causing damage to the economy in the long term. In other words Cochrane argues that current monetary policy that pays maturing debt with fresh loans is unsustainable and a recipe for present and future disaster. Given this, the Fed’s role must be to rein in those contrary forces that push inflation upward, by not printing more money, and removing the reasons for needing to print more money. That means reducing and ultimately erasing the budget deficit, and inducing government to spend within its means, one, and/or improving its fiscal performance so that it is able to fund its operations from surpluses (Feldstein; Cochrane; Krugman; Bernanke (b)). This state of affairs removes incentives for government to issue debt, and to make it enticing for investors to purchase debt. In other words the cure that Cochrane implies is to reverse the current state of affairs and to shore up government finances to a point where it is able to pay off debt not with more debt but by either restraining spending or finding ways to raise revenues so as to finance on-going operations with revenue surpluses rather than with additional debt (Cochrane; Krugman; Ferguson). III. Cochrane’s Key Claim Cochrane’s key claim is that the Fed has it wrong with regard to fiscal inflation and the dynamics of monetary policy being able to completely account for the dynamics of fiscal inflation, which can be caused also by concerns over the ability of the government to continue funding maturing debt with more debt, and the possible emergence of investor consensus that government will ultimately pay off maturing debt with newly printed money down the line. This vote of no confidence, once it occurs, can have catastrophic consequences on inflation in a very short period of time, affecting current inflation and interest rates in a short span of time within the short-term horizon. The run is not a guaranteed event, but a likely probability that can have serious and unpredictable long-term consequences. Moreover, Cochrane asserts that the government will be unable to do anything about this run and this potential financial cataclysm, being confined to just tweaking interest rates and having put faith in the soundness of the market dynamics and its own view of what causes inflation (Cochrane). IV. Comments The key premise in Cochrane is that the present fiscal policies that favor sustaining growth through borrowing and financing government with debt is unsustainable, and that the faith of the Fed in the power of the interest rate lever to control the rate of growth and inflation of the economy is misplaced, given that fiscal inflation can occur from a sudden loss of confidence in the ability of government to continue to sustain its expenditures with debt, and to sustain this state of affairs without resorting to printing large amounts of money n the future. This is a big if, given that historically, Krugman and others have noted that precedence from other nations have shown that large debts did not necessarily translate to printing more money and to higher inflation. Moreover, given the complex nature of the American and world economies, and given the cyclicality and inevitability of financial crises, one cannot in the end rule out the possibility that the Fed can infuse liquidity into the market as its mandate is to be precisely that. Historically this role of the Fed to be a last resort provider of liquid funds to the market, which can include printing new money, has not deterred investors from lending to the US government via bond purchases. The final take is that there is something to the large deficit that is a bane to the long-term prospects of the American economy, as recognized by proponents from both sides of the debate with regard to the impact of large deficits on inflation, and that it is prudent in the end to try to fund future government expenditures with growth in revenues rather than with more debt. Meanwhile, the warning from Cochrane cannot be dismissed, and calls for more prudent fiscal and monetary policy that moves away from more deficit spending and towards a more sustainable fiscal policy (Cochrane; Bernanke, Krugman; Feldstein; Bernanke; Bernanke (b); Ferguson). Works Cited Bernanke, Ben. “Financial Reform to Address Systemic Risk”. Board of Governors of the Federal Reserve System. 10 March 2009. Web. 17 November 2013. Bernanke, Ben. “Achieving Fiscal Sustainability”. Board of Governors of the Federal Reserve System. 27 April 2010. Web. 17 November 2013. Cochrane, John. “Inflation and Debt”. National Affairs 9. Fall 2011. Feldstein, Martin. “Inflation is looming in America’s horizon”. Belfer Center for Science and International Affairs, Harvard. 19 April 2009. Web. 17 November 2013. Ferguson, Niall. “History lesson for economists in thrall of Keynes”. Financial Times Opinion. 29 May 2009. Web. 17 November 2013. Krugman, Paul. “The Big Inflation Scare”. The New York Times. 28 May 2009. Web. 16 November 2013. Satow, Juile. “Anna Schwartz: 'The Fed is Inviting Inflation'. New York Sun. 8 February 2008. Web. 17 November 2013. Read More