Federal Budget Deficit: How Big a Problem?

Many of my friends are losing sleep over our federal budget deficit and accumulating debt burden.  The level of discourse is usually simple:  "We're going bankrupt!"  In a short series of posts I want to look at the possible problems caused by our large debt burden, covering inflation, debt crisis, and high tax rates.  This post is about the potential for higher inflation due to the deficit and debt.

Back in the 1970s I taught my students that if I asked on exam whether deficits caused inflation, a "B" answer would be, "Yes, they always have."  However, an "A" answer would be, "They always have in the past, but they don't need to cause inflation.  They are only inflationary if the central bank accommodates the deficit by pumping up the money supply."

The 1980s proved that a country can have high deficits and falling inflation, if the central bank will limit money supply growth.  Why did the Fed limit money supply growth?  I think the key issue was a change in attitude among professional economists.  We abandoned the old Phillips Curve idea, that inflation could only be reduced by accepting high unemployment, for a new idea: that an economy paid a temporary price in the form of unemployment for a permanent gain against inflation.  Furthermore, economies with low inflation tended to be more stable, and also had higher long-term growth rates.  (For more detail, read the best book about economics and business, pp. 96-100.)

The crucial question is whether the folks at the Fed will stick with the anti-inflation doctrine or whether they will help the Treasury by inflating the currency.  Inflation helps the Treasury by lowering the real (inflation-adjusted) amount of the debt.  This is typically done in countries where the central bank is controlled by the government.  Our Federal Reserve, in contrast, has substantial independence.\

Is the Fed's recent behavior proof one way or the other?  They have radically increased the monetary base, which is also called high-powered money.  This is the raw material out of which regular money is made.  However, the linkage between the monetary base and the money supply is looser than historic norms.  Think of a car with a slipping clutch.  The motor is revving up, but the axle is moving slowly.  One fear is that the clutch will suddenly take hold, and then we're off on a wild ride.

Recently the Fed has flattened out the level of the money supply:

Even though the money supply has been flat in recent months, the Fed is slowing the growth rate of its monetary stimulus.

The Fed has communicated that it will one day have to actually tighten to prevent inflation.  If they do it at the right time, they can prevent inflationary pressures.  I'll concede that they have to do it just right, in terms of both timing and magnitude.  However, I think it very unlikely that they will go on willy-nilly letting inflation accelerate as high as ten percent.  Five percent I could see, as a result of error on the Fed's part, but not much higher.

What if I have not convinced you?  Then think inflation hedges.  Gold is the classic, but it might be worth reviewing what would have happened had you bought an inflation hedge back in 1980–just as the Fed was shifting to an anti-inflation stance.  In January 1980 gold sold for $675 per ounce.  If you had bought back then, you wouldn't have broken even until April 2007.  Even with the recent run-up in gold, you still would not have kept up with inflation since 1980.

However, I'd buy gold if I thought we were headed into a long bout of inflation.  Mining companies are also a good inflation hedge, as is real estate.  I'd also own more foreign stocks if I were worried about inflation (and I have a large portion of my investments in foreign stocks now).

What are the business planning implications of higher inflation?  First, do not lock yourself into fixed prices for your products.  However, try to lock in supplies at fixed prices.  (Just keep in mind that if a long-term contract ends up heavily disfavoring one party, that party will work hard to find a way to break the contract.)  Along with inflation expect more of a roller-coaster ride, with wider price fluctuations than we've had over the past 25 years.  That means more attention to hedging and contingency planning.