Government debt to be monetised?

Read our article in the Cayman Financial Review Magazine, eversion 

Almost certainly the “unlegislated tax”1 of inflation will be the consequence of the debts that the governments of Europe, Japan and the US have accumulated. Inflation is a very regressive tax and it is dishonest and divisive, but it usually is more politically popular than the alternatives of cutting spending or raising explicit taxes.  

In recent years we have heard more frequently the dangerous recommendation that monetary policy should target higher inflation by allowing prices to rise, on average, by more than the conventionally accepted 2 per cent.

Inflation “doves” acknowledge that debasing the currency is a form of taxation, yet they defend higher inflation by saying that it is no worse than other forms of taxation.

Some advocacy of greater tolerance of inflation reflects a defeatist outlook with regard to the prospects for returning to adequate fiscal discipline. But, even if one is resigned to long-term fiscal irresponsibility, public editorialising and blogging about the desirability of greater inflation – at least compared to the alternative policy options – dilutes their own case.

We know that it is unanticipated inflation that is an effective tax, so denying the intent to re-inflate – while actually pursuing inflationary policy actions – would more effectively achieve their purpose.

We also know that a theoretical fully anticipated inflation can never be achieved – especially because of the very large stock of non-interest-bearing currency that is held by someone.

However, the degree to which individuals and businesses can take actions to protect themselves from greater expected inflation reduces the effectiveness of this type of taxation.

In the 1960s, the US deliberately chose inflation as the expedient way to transfer resources to the government because President Johnson did not want Congress to debate the merits of the Vietnam war versus the Great Society programmes. For the president, the “tax no one has to vote for” was a way to avoid the constitutional requirement that taxes had to originate in the Ways and Means Committee of the US House of Representatives.

Today, one motivation for advocating the inflation tax is that it is a way to impose taxation on the very large share of the population that is exempt from the income tax, while at the same time asserting that a political pledge of “no tax increases for low income people” has been kept.

This cynical cop-out will be successful in forestalling fiscal disaster only to the extent that the public at large is surprised by the timing and extent of the acceleration of inflation.

Proponents of higher US inflation are either unaware or unconcerned about the effects of debasement of the world’s primary reserve currency on other countries.

As we saw in the highly inflationary period of the failed presidency of Jimmy Carter in the late 1970s, the persistent appreciation of currencies that seek to maintain low inflation compared to the United States creates political problems in those other countries, especially the smaller open economies that are heavily dependent on international trade.

No doubt some advocates of higher inflation recognise that current foreign holders of longer-term government debt will suffer both capital losses as interest rates rise and an erosion of purchasing power through inflation, the same as domestic holders. I doubt that troubles them.

They may not understand that the resulting depreciation of the international value of the dollar also will impose exchange translation losses on foreign holders, both private and official. They might even welcome such a tax imposed on foreigners – clearly a case of taxation without representation.

Those economists who advocate inflation as a way out of recession assume that monetary policy works solely, or at least primarily, through interest rates, and they fret about the “zero boundary problem”.

The argument is that since nominal interest rates can’t go below zero, the Federal Reserve should target inflation at more than 2 per cent to ensure that nominal interest rates include a larger inflationary premium so that the Fed has more latitude to cut rates when necessary.

The central idea is that if aggregate nominal demand for output declines for any reason, a judicious reduction of interest rates by monetary authorities will spur consumers and businesses to spend more, thus sowing the seeds of recovery.

The claim is that if the crisis is severe it takes larger cuts in interest rates to reverse the contraction in aggregate demand, so higher interest rates to begin with – the result of higher inflation – gives the policymakers a bigger weapon.

In the case of the Great Recession of 2008–09 and the subsequent anaemic expansion, this policy prescription is misguided; it is the result of a faulty diagnosis. The error stems from having concluded that the trigger for the crisis was a contraction in the financial sector – credit availability shrank, so household and business demand for output fell. Policy activists want more powerful monetary and fiscal tools to address such conditions.

That diagnosis fails to consider that what has been characterised as a “housing bubble” was not sufficient to cause the economic damage we have seen. Neither the dotcom bubble of the 1990s nor the rapid increases of house prices in Canada or other countries were followed by widespread declines in output and employment as well as banking failures.

The key to the differences is what was happening on the other side of the balance sheet. Asset price increases need not be accompanied by debt increases, but when they are then the subsequent declines in asset prices have much broader implications.

Some 20 years ago, mortgage-equity-withdrawals (MEWs) during refinancing had been only 1 to 2 per cent of personal disposable income. However, by the 2004-06 period MEWs reached 9 per cent of disposable income, which was enough to drive consumption spending in the national economy from about 65 per cent of GDP to 70 per cent.

That increase in a $14 trillion economy fuelled an extraordinary boom in auto sales, furnishings, appliances, consumer imports of all kinds, as well as remittances to other countries.

Between 2001 and 2007, Americans extracted several trillion dollars from the equity of their homes during refinancing. For far too many families, the expression, “my home is my ATM” had real meaning.

Consumption spending was being financed by debt. Then, quite suddenly, in the summer of 2008, it was no longer possible to refinance, house prices plunged, and there was no more equity to withdraw.

What followed were misguided policies of government to maintain the bubble-level of household consumption spending through transfer payments – distribution of the proceeds from the issuance of massive amounts of new government debt. New borrowing by government replaced borrowing by households; total national debt continued to grow while household balance sheets shrank.

Fiscal policy actions became part of the problem, not the solution, and monetary policies cannot correct the mistakes of the rest of government.

Instead of greater latitude for discretion in the use of monetary and fiscal policies for “pump-priming” nominal demand, we would have been better off to allow real estate and other asset prices to adjust to the underlying supply and demand conditions without the issuance of massive new claims on future taxpayers.

The inherent resiliency of a market economy would then have begun to restore prosperity based on economic fundamentals, not bubblenomics. Instead, the lack of fiscal discipline has undermined confidence that policymakers will succeed in maintaining monetary discipline.

Because monetary policy is ultimately a fiscal instrument – a way to finance government – the explosion of government spending financed by the issuance of debt, together with further increases of unfunded promises of future payments for retirement and medical services, signals an end to the “great moderation” of the previous two and one-half decades.

The combination of high real growth of output and employment together with sustained low inflation for much of the 1980s and 1990s was during a period of declining fiscal deficits and debts, and even occasional budgetary surpluses. Regrettably, those couple of decades were the exception to longer historical experience of economic volatility and turbulence.

Now we are facing an extended period in which the “fiscal dominance hypothesis” will be tested; that is, a society that is unwilling or unable to maintain fiscal discipline will prove to also be unwilling to maintain monetary discipline.

Economists use the term “fiscal drag” to describe the situation in which government debt is a high and rising share of national income.

Contrary to the common idea that deficit spending by governments ‘stimulates’ economic activity, substantial historical experience has shown that the opposite is the case. Persistent deficit spending and the resulting accumulation of debt have been accompanied by slow economic growth.

Part of this phenomenon may reflect the fact that larger shares of the economy’s resources are controlled by the less productive government sector rather than the more productive private sector.

Part may reflect the effects of actions that businesses and households take in anticipation of higher rates of taxation.

Part almost certainly reflects the effects of actions that businesses and households take in anticipation of higher rates of inflation and interest rates resulting from expected monetisation of the debts.

The slow growth of national output and employment and the associated stagnation of standards of living have historically given rise to political pressures to stimulate more rapid economic growth.

These political pressures all too often have been brought to bear on the monetary authorities to take actions – lower interest rates, greater credit availability, more rapid monetary growth – to prime the pump of economic growth. Any resulting expansion of employment and output growth will prove to be temporary.

Before too long the lags of monetary policy actions will begin to show up in actual inflation and expectations of further inflation. The depressing effects of high real interest rates that accompanied the increased indebtedness will be augmented by an “inflation premium” causing nominal interest rates to rise further.

The resulting “stagflation” is characterised by simultaneous high unemployment and inflation.

We are at a fork in the economic highway. One route involves continued monetary and fiscal “stimulus to aggregate demand” in an attempt to borrow, print and spend our way to prosperity. It did not work in the 1970s and will not work now. In fact, no place on the planet has ever spent its way to prosperity.

The other route requires deficit reduction along with tax and regulatory reforms to provide a more fertile environment for private investment, innovation, and ultimately greater demand for a more highly skilled and better compensated workforce.

Parts of this essay draw on a longer article, “Honest Money,” published in the Fall/Winter 2011 Cato Journal.

Endnotes:

1.  Milton Friedman referred to inflation – the deliberate debasement of fiat monies – as an unlegislated tax.

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Michael Klein
Michael Klein Editor Pinnacle Media Group Ltd. PO Box 1365, Grand Cayman, KY1-1108, Cayman Islands T: 345-326-1720C: 345-815-0064 E: mklein@pinnaclemedialtd.comMichael is a financial journalist and copywriter.  In the past he has been responsible for the Risk Management and Corporate Finance sections of a British monthly Corporate Treasury publication.  He has written various financial handbooks, notably on European Banking and Cash Management and the Debt Capital Markets.   In addition he has worked as a copywriter for banks and investment funds and served as corporate communications consultant to US and European blue chip companies.   Michael holds an MA in Political Science and International Law from the University of Bonn in Germany. 

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