Welcome to another edition of The Mueller Report!
I am more pressed for time than normal this week, so I apologize if its a bit clunky.
For those of you not following economic news very closely, inflation numbers came out this week and they were bad. Producer prices (raw materials, inputs, etc. in production) were up over 8% from a year ago. Consumer prices were up over 6% from a year ago; a rate of inflation not seen in over 30 years in the U. S.
Of course, if that were all, we wouldn’t have much to worry about. But it is quite likely that this level of inflation will remain and/or rise over the next six months at least. And there are even bigger dangers on the horizon.
Monetizing the Debt
High levels of national government spending funded by large amounts of borrowing tend to create inflation. Let me walk you through how:
In 2020, the federal government spent about $6.6 trillion. But it only raised about $3.3 trillion in taxes - which means it had to borrow over $3 trillion to cover its expenses. U. S. national debt grew from about $26 trillion (or a little less) to about $29 trillion.
In one year.
Normally, such a huge amount of borrow would cause interest rates to rise, which would crowd out some private borrowing because fewer people want to borrow at high interest rates. At the same time, higher interest rates would encourage people to cut back on their consumption and save more money.
BUT, the Federal Reserve operates by targeting/setting short-term interest rates. They adjust their target interest rate based on macroeconomic conditions (presumably) to try to steady the economy. So they would rather not let interest rates rise the way they should when the federal government adds an addition $3 trillion of demand for borrowing money on top of private demand to borrow money.
So, to maintain their target interest rate, the Federal Reserve has to increase the supply of available money to borrow in the economy. That is, in addition to what people save, the federal reserve has to add an additional $3 trillion dollars. That extra money prevents interest rates from rising above their target.
It also funds the federal government’s $3 trillion dollar deficit.
This is what we call “accommodative” monetary policy; that is, the Federal Reserve is accommodating the increased demand for borrowing created by Federal deficit spending. In the process, they create new money in about the amount the Federal government borrows (well, not quite the same amount because there is private demand to lend money to the government in “normal” times - so they really create new money to fund “unusually high” or increased amounts of government borrowing).
That’s what “monetizing the debt” looks like: the U. S. government issuing large amounts of debt and the Federal Reserve buying it (essentially) with new money.
But as everyone should know, increasing the amount of money in the economy, all else equal, reduces the value of that money leading to higher prices (i. e. inflation).
If the Federal Reserve wants to slow or reverse inflation, its primary means of doing so is raising interest rates and pulling money out of the economy.
Now for the bad news.
In 2020, the Federal government paid about $330 billion dollars in interest on the national debt. That comes out to a roughly 1% effective interest rate. The debt is larger now, so that will increase the amount we pay in interest if the effective interest rate doesn’t change. But what if that interest rate does change?
Remember, if inflation continues to be high, and especially if it increases even more, the Fed’s only real option to combat it is to raise interest rates. But doing so could change the federal budget dramatically.
Suppose the effective interest rate the U. S. government pays on its debt rises to 2%. That will mean $660 billion in interest payments a year (plus a little more for the higher principle/debt amount).
What if the effective rate of interest we have to pay on U. S. debt rises to 4%?
Now the U. S. government would have to pay ~$1.3 trillion in interest on the debt, making it the single largest budget item - bigger than social security, bigger than national defense spending, bigger than Medicare. That would be bad…And borrowing more to pay for it is not a particularly good strategy, especially if interest rates are high and/or rising.
Although 4% would be a four-fold interest, which seems pretty extreme, it is not a particularly high interest rate by historical standards (and if you account for the falling value of money at 6%, it would constitute a negative real interest rate).
So the main danger we face is that the Federal Reserve will be reluctant to raise interest rates (hence allowing inflation to grow) and when they do raise interest rates, we will almost certainly see significant problems in U. S. government budgeting and spending.
But there are more things to be concerned about. As the cost of everything rises, federal spending does not go as far as it used to. For every trillion dollars of the federal budget (of which, alas, there are more than one), they are losing approximately $60 billion dollars of purchasing power to rising prices at our recent annual rate of inflation (and probably more if they buy resources like in the producer price index). And as inflation rises more, that decreased real spending power will increase.
So we see government spending not going as far in terms of what it can buy as inflation rises. And if interest rates rise as the Fed attempts to combat inflation, the national government could enter a budget crisis of fairly epic proportions.
So grab your popcorn - we will have a front row seat for some pretty spectacular political and financial fireworks over the next couple years.
Even more bad news
On average, the cost of living is increasing at a faster rate (just over 6% in the last year) - which means our dollars are not going as far as they used to go. This is another nasty element of inflation that I’ve been talking to my students about recently: seignorage.
Seignorage refers to an implicit tax on currency. In olden days, when currency consisted primarily of minted coins, various political authorities that wanted to spend more than they raised in tax revenue would often engage in fraud by shaving coins and melting the shavings down into new coins (thereby increasing the number of coins they could spend).
This was fraudulent because the coins were supposed to represent a certain quality and certain weight of precious metal. Governments would spend the coins as if, for example, they were one ounce silver coins when in fact they may now be .95 ounce silver coins after being shaved.
Another fraudulent trick governments would pull was melting down their coins and mixing the silver or gold with other less costly metals. They could mint more coins than they received, but the purity was diluted.
Either way, the result was the ability to spend more money (in the short term) by creating more/new currency, which then reduced the value of money (i. e. caused inflation). As a result, the value of the currency held by citizens declined. That’s effectively a tax. Consider this example:
You have $100 and the price of a cup of coffee is $4/cup. You have purchasing power worth 25 cups of coffee. The government could tax you $20 - meaning you write a check for $20 to the government and are left with $80. Now your purchasing power is worth 20 cups of coffee - the government has effectively taken 5 cups of coffee worth of purchasing power from you.
Of course, no one likes writing checks to the government, so politicians are often hesitant to raise taxes - especially if they can increase their spending by borrowing and/or creating new currency. Suppose that the government increases its spending by creating new money. You get to keep your $100, but the price of a cup of coffee rises to $5/cup due to an increase in the quantity of money. You have the same amount of money as before, but your purchasing power has fallen to 20 cups of coffee.
You’ve been taxed.
So how will all this government spending be paid for? Well, if not through income, corporate, or capital gains taxes, then through inflation. The American people have just paid the equivalent of an additional implicit 6% tax on top of their other taxes last year. I wonder what our implicit tax rate will be next year…
Talk to you next week!
P. S.
If you’re wondering what to do, look into inflation hedges like commodities such as gold and silver, cryptocurrencies (though they are more risky and volatile), and/or real estate. The price of all these things will rise as the value of the U. S. dollar falls. I wouldn’t rush to put all your money there, but if you are worried about inflation, I encourage you to think about hedging it somehow.
A little bit to add on inflation at 6% and what negative real interest rates mean for the economy. What 6% inflation does is if you can get long term fixed debt, say a 30 year mortgage at 3%, you are actually being *paid* 3% to take on debt, and that debt which is normally a liability, actually becomes an asset. Since people respond to incentives, this profit rewards them when they take on debt and buy housing, as they have a fixed debt repayment cost that is below inflation and each year they pay back this fixed debt cost with increasingly worth-less dollars, as they likely see their incomes and asset prices rise from inflation. This is yet another reason why the housing market is currently not in a bubble, and would likely only become one if rates were to rise considerably and/or inflation dramatically decreases.
Good post. Agree. The real excitement and economic challenges are just beginning.
Shalom. — Duane