28 May 2009

The Connection Between Government Debt and Price Inflation

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Back when I was a college professor, I would always drill home to my students that government budget deficits didn’t cause (price) inflation per se. For example, if the country were on a gold standard with 100% reserves in the banking system, then the total quantity of money wouldn’t have anything to do with how much the government borrows, just like it isn’t affected by how much Microsoft borrows in a given year.

However, in the real world the layman’s suspicion is justified. In our wacky system, the Federal Reserve ultimately is responsible for the CPI, in the sense that the Fed exercises a huge influence over the ultimate money supply. But if the government is running massive deficits year after year, this puts tremendous pressure on the Fed to inflate, because it (a) keeps interest rates down, making it cheaper to borrow and (b) reduces the real burden of previously accumulated debt.

But before today, I had never realized just how related the federal debt was to the general purchasing power of the dollar. Tom Singleton emailed me a chart from CaseyResearch, the gist of which I reproduce below using FRED:

In retrospect, I suppose you could argue the causality is the other way around: The Fed inflates for some other reason, which raises prices, which makes the government’s appetite for (nominal) debt go up. The chart above wouldn’t settle the direction (if any!) of causation. But I think the old-time wisdom is right: When the government runs massive deficits (and surely $1.8 trillion qualifies), just wait for the dollar to plunge.

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