Sunday reading

John Cochrane has written an excellent, though very long, article ("Inflation and Debt") on why the risk of inflation we face comes not from the Fed's monetary policy, but from our projected federal deficits. (HT: Greg Mankiw)

For several years, a heated debate has raged among economists and policymakers about whether we face a serious risk of inflation. That debate has focused largely on the Federal Reserve — especially on whether the Fed has been too aggressive in increasing the money supply, whether it has kept interest rates too low, and whether it can be relied on to reverse course if signs of inflation emerge.

But these questions miss a grave danger. As a result of the federal government's enormous debt and deficits, substantial inflation could break out in America in the next few years. If people become convinced that our government will end up printing money to cover intractable deficits, they will see inflation in the future and so will try to get rid of dollars today — driving up the prices of goods, services, and eventually wages across the entire economy. This would amount to a "run" on the dollar. As with a bank run, we would not be able to tell ahead of time when such an event would occur. But our economy will be primed for it as long as our fiscal trajectory is unsustainable.

Needless to say, such a run would unleash financial chaos and renewed recession. It would yield stagflation, not the inflation-fueled boomlet that some economists hope for. And there would be essentially nothing the Federal Reserve could do to stop it.

Cochrane's central point—one that I have missed—is that it is the dramatic shortening of the average maturity of Treasury debt that creates so much risk of inflation today:

... our government is now funded mostly by rolling over relatively short-term debt, not by selling long-term bonds that will come due in some future time of projected budget surpluses. Half of all currently outstanding debt will mature in less than two and a half years, and a third will mature in under a year. Roughly speaking, the federal government each year must take on $6.5 trillion in new borrowing to pay off $5 trillion of maturing debt and $1.5 trillion or so in current deficits.

As the government pays off maturing debt, the holders of that debt receive a lot of money. Normally, that money would be used to buy new debt. But if investors start to fear inflation, which will erode the returns from government bonds, they won't buy the new debt. Instead, they will try to buy stocks, real estate, commodities, or other assets that are less sensitive to inflation. But there are only so many real assets around, and someone has to hold the stock of money and government debt. So the prices of real assets will rise. Then, with "paper" wealth high and prospective returns on these investments declining, people will start spending more on goods and services. But there are only so many of those around, too, so the overall price level must rise. Thus, when short-term debt must be rolled over, fears of future inflation give us inflation today — and potentially quite a lot of inflation. 

We have no choice but to put our fiscal affairs in order, and as soon as possible. Fortunately, the problem is still relatively easy to solve. Cochrane's solution is familiar to all serious students of what ails our economy today. What we need is 1) real entitlement reform, since "our largest long-term spending problem is uncontrolled entitlements," 2) more revenues, which can be achieved by a pro-growth lowering of tax rates, and 3) a reduction in regulatory burdens.

Cochrane's article is extensive, but written in a manner that should be accessible to just about anyone. He does a good job of explaining, from a monetarist's perspective, the mechanics of how inflation happens. Read the whole thing.