Yesterday’s post focused on how the expansion of the Fed’s balance sheet may or may not translate into inflation.  But the Fed is not the only thing to worry about – there is also the growth of the Federal Government deficit.  The Obama administration has been spending a lot of money to fight the recession and prevent the collapse of several “too-big-to-fail” companies.

Here is a chart which the Washington Post put together to show the upcoming deficits:

The first point to make is that government debt per se does not add money to the economy.  The government borrowing is – as a first approximation – no different than say MSFT borrowing.  Somebody else had to have the money already to give it to the government in return for a promise of future repayment.  For instance, China which has bought over $1 trillion of US government debt did so with dollars that were already in existence.

The potential relationship between the creation of government debt and inflation is therefore an indirect one.  It is based on the fear that the government will eventually influence the central bank to create inflation to make it easier to pay off the debt!  For instance, this recent article in the Economist on government debt states:

The sheer scale of their fiscal burdens may tempt governments to lighten their loads by inflation or even outright default. Inflation seems increasingly plausible because many central banks are already printing money to buy government bonds. To fiscal pessimists this is but a small step from printing money simply to pay the government’s bills. Adding to their worries, many economists argue that a bout of modest inflation would be the least painful way to ease the financial hangover.

I believe that is a significant overstatement of what has been happening so far, but it describes a mechanism by which government debt could translate into inflation: central banks issuing new currency to buy the debt.  That is the mechanism that has fueled hyper-inflation episodes in the past, such as the one in the Weimar Republic.

Given the independence of the Federal Reserve and the folks leading it, such an outcome seems highly unlikely in the US.  An econometric analysis conducted in 2008 of post World War II data found fairly little evidence of inflation being used by industrial nations to alleviate federal deficits.  But the magnitude of the upcoming deficits takes levels of government indebtedness back to levels last seen at the end of WWII and we are unlikely to see a rapid growth period which would allow that debt to be paid down through rising tax revenues.  There is a real potential for pressure on the Fed in the future to allow for some meaningful inflation to help reduce that debt burden.  Bottomline is that between the need to shrink the Fed balance sheet and to resist this pressure, there will be a lot riding on cool, smart and independent heads running the Federal Reserve in the years to come!

Yesterday’s post focused on how the expansion of the Fed’s balance sheet may or may not translate into inflation.  But the Fed is not the only thing to worry about – there is also the growth of the Federal Government deficit.  The Obama administration has been spending a lot of money to fight the recession and prevent the collapse of several “too-big-to-fail” companies.

Here is a chart which the Washington Post put together to show the upcoming deficits:

The first point to make is that government debt per se does not add money to the economy.  The government borrowing is – as a first approximation – no different than say MSFT borrowing.  Somebody else had to have the money already to give it to the government in return for a promise of future repayment.  For instance, China which has bought over $1 trillion of US government debt did so with dollars that were already in existence.

The potential relationship between the creation of government debt and inflation is therefore an indirect one.  It is based on the fear that the government will eventually influence the central bank to create inflation to make it easier to pay off the debt!  For instance, this recent article in the Economist on government debt states:

The sheer scale of their fiscal burdens may tempt governments to lighten their loads by inflation or even outright default. Inflation seems increasingly plausible because many central banks are already printing money to buy government bonds. To fiscal pessimists this is but a small step from printing money simply to pay the government’s bills. Adding to their worries, many economists argue that a bout of modest inflation would be the least painful way to ease the financial hangover.

I believe that is a significant overstatement of what has been happening so far, but it describes a mechanism by which government debt could translate into inflation: central banks issuing new currency to buy the debt.  That is the mechanism that has fueled hyper-inflation episodes in the past, such as the one in the Weimar Republic.

Given the independence of the Federal Reserve and the folks leading it, such an outcome seems highly unlikely in the US.  An econometric analysis conducted in 2008 of post World War II data found fairly little evidence of inflation being used by industrial nations to alleviate federal deficits.  But the magnitude of the upcoming deficits takes levels of government indebtedness back to levels last seen at the end of WWII and we are unlikely to see a rapid growth period which would allow that debt to be paid down through rising tax revenues.  There is a real potential for pressure on the Fed in the future to allow for some meaningful inflation to help reduce that debt burden.  Bottomline is that between the need to shrink the Fed balance sheet and to resist this pressure, there will be a lot riding on cool, smart and independent heads running the Federal Reserve in the years to come!