Research Affiliates' Jason Hsu warns about too much nominal weath and two few goods
As the Federal Reserve persists in its quantitative easing program and Congress temporizes over the debt ceiling, it seems worthwhile to revisit the macroeconomic links between monetary policy, fiscal policy and inflation. Writing as a macroeconomist who favors the fiscal theory of inflation, I will argue that QE, by itself, largely does not change public or private sector balance sheets.
Rather, QE enables more unchecked governmental spending on potentially unproductive (negative net present value) projects. This fiscal channel significantly degrades the government's balance sheet through debt-financed public spending, which drives inflation. Spending financed by QE has not resulted in material inflation thus far, but the conditions are clearly in place.
Exacerbating the risk, in response to massive deficit spending — dominated by welfare transfers from future taxpayers to the current generation — U.S. households are more likely to consume with abandon (and entitlement) instead of investing for the future. I offer a pessimistic prognosis that Americans will imitate southern Europeans, not the Japanese, in reacting to irresponsible policies. In this scenario, inflationary pressure would only be magnified.
First, the facile phrase “printing money” misleadingly suggests that creating “reserve credit” and “paper money” isn't the same thing as issuing debt. In fact, both reserve credit and cash are forms of government debt — one interest-bearing, the other not. It is important to understand that the Fed's issuing reserve credits to buy public debt on the open market changes neither the government's nor the investor's balance sheet. In its sterile form, without fiscal coordination, QE can be seen as an asset swap in which the public sector induces the private sector to hold shorter- rather than longer-term government debt. The primary effect of QE conducted by the Fed is to pin the short rate near zero and then, through aggressive asset swaps, to flatten the yield curve so as to reduce overall government financing cost. This activity is not and has not been inflationary.
Why, then, is there so much chatter about the risk of inflation from printing money? It is a popular misconception that inflation is a monetary concern. Since the late 1990s, the view that inflation is primarily a fiscal issue and can't occur without expansive fiscal action has gained acceptance.
What connects monetary policy and the Fed's activities so centrally to inflation? When a government can issue substantial debt at zero interest — which is what QE or printing money accomplishes — it will spend more freely than if it had to roll over the debt at double-digit interest rates. Rates on sovereign bonds are supposed to serve as a signal to citizens on government financial strength and to help enforce discipline on deficit spending. Bond investors are the vigilantes who ensure that fiscally conservative politicians are not brushed aside by voters and populist leaders willing to finance today's welfare with tomorrow's liabilities. Once that market control mechanism is lost, the public sector will slide down the slippery slope of excess spending, crowd out the private sector and cause the economy to become increasingly less productive. If not for the debt ceiling, which acts as the last control against unsustainable deficit spending, the Fed would enable unbounded U.S. debt issuance by serving as the lone eager buyer of Treasuries at negative real interest rates.
Ultimately, inflation arises from too much nominal wealth chasing too few goods. Nonetheless, even this traditionally monetary formulation (too much nominal wealth) has a real dimension (too few goods). As the last century's disastrous experiments with central planning proved, government is generally bad at producing things that consumers want. In a productive economy, the private sector does that. But government can easily create nominal wealth by paying people for make-work. The expansion of the state in the Western world in the last two decades has led to more and more people working for the government or not working because of the government, and evidence supports the statement that big government has had negative effects on growth and productivity. When money is printed to facilitate deficit spending, inflation follows, as wealth creation driven by stimulus and welfare is followed by insufficient production of goods and services.
One extreme example illustrating the impact of fiscal policy on inflation: war. Economists and historians widely accept that war causes inflation. In its most stark interpretation, war is the state crowding out the private sector to produce weapons and death, neither of which is highly desired by consumers. (They want protection from invasion and other threats, but that's another matter.) The state issues massive debt to finance war, creating significant nominal wealth. But that cannot be converted into consumption, because production is severely cut as a result of state-driven activities.
If that analysis is correct, why doesn't Japan have high inflation, despite years of QE to help finance a massive public debt of 200% of GDP? Two reasons: The Japanese economy has remained incredibly productive, and, rather than borrowing and spending, households have saved for retirement. In other words, they undid the increase in public spending with aggressive private belt-tightening. The result is a continual strong trade surplus and net foreign assets of nearly 60% of GDP. Contrast that with the average southern European country, which runs a large trade deficit and a net foreign debt of 80% of GDP. Japan has remained hardworking and productive in spite of its own government's sustained attempt to undermine it through waste and inefficiency.
If the U.S. pursues quantitative easing without letup, however, it may not be able to bank on the Japanese outcome. Americans are not likely to save enough to buffer the immense rise in public debt. As the government spends more, the number of public employees and beneficiaries will expand. At the same time, the private sector will make less — and this is before we attempt to adjust for the decline in labor productivity related to an aging population. And with the rapid rise in their household income and consumption, the Chinese won't always sell their labor and resources to Americans cheaply.
This causal chain ends in inflation: The government creates nominal wealth without creating real output; households, whether failing to account for the consequences of government debt or responding rationally to negative real interest rates, spend readily and save little; and too much “wealth” pursues too few “goods.”
Jason Hsu is the chief investment officer of Research Affiliates. This commentary originally appeared on the firm's website.
