Monday, December 8, 2008

Will Monetizing the Federal Deficit Cause Inflation?

Only if we’re lucky.

I sometimes joke that the old dispute between the Monetarists and the Keynesians was resolved when the Keynesians conceded all the substantive points and the Monetarists agreed to be called Keynesians. Like most jokes, it’s not quite true. The one thing the Keynesians never conceded was the raison d’etre of the Monetarists, the Quantity Theory of Money – the idea that nominal national incomes, and ultimately prices, are determined (in some reasonably simple and predictable way) by the quantity of money. By the mid-1980’s, financial innovation had made the quantity of money in the US very hard to measure, and so the theory – whether right or wrong – became largely irrelevant. And in August 2008, it still seemed largely irrelevant.

But that has all changed in the past three months. While it is still quite difficult to measure the “true” quantity of money, it is easy to measure the quantity of base money –the money created directly by the Fed. When the quantity of base money shoots up in a way that dwarfs all prior experience, it’s fair to say that the “true” quantity of money – whatever that may mean empirically – is also rising more quickly than usual. And some monetarists, clinging to empirical relevance over the period since the 1980s, would argue that the quantity of base money is the true quantity of money.

If this latter group is right – both about the validity of the Quantity Theory and about using base money as the true measure – then we are in for one hell of an inflation. Fortunately (or, alas, perhaps unfortunately) they’re wrong. At least I’m convinced they’re wrong. But let’s examine what has happened. On September 1, the monetary base was $846 billion. On December 1, it was $1.483 trillion. As an annualized rate of increase, that would come to more than 800%. It’s an increase of $637 billion, enough to finance the whole federal deficit for fiscal year 2008, cut every household in America a $1000 check, and have plenty left over for everyone in Washington to spend on whores and liquor – and I’m talking Glenfiddich and Ashley Dupré here.

OK, I apologize to Miss Dupré (who I imagine doesn’t even like being called a “former sex worker,” let alone a “whore”), and for that matter, to everyone in Washington (many of whom are scrupulously monogamous teetotalers, and many of whom, indeed, are in categories to which the escort business doesn’t even market itself). I was using a conventional figure of speech to make a point: the Fed has created a huge, huge, huge amount of money in the past few months. And with T-bill rates already at zero and no danger of their going lower, it’s easy to imagine that the Fed will be able to finance the entire 2009 federal deficit, gargantuan though it is projected to be, and perhaps 2010 as well, without having much immediate effect on anything.

But in the long run, will it cause inflation? This is where I declare (in case you had any doubt) with the Keynesians. I’m not even sure that two years of fully monetized deficits would be enough to stop deflation, if it should happen, let alone cause inflation. In the textbook Keynesian model – the one in today’s textbooks, not the one Keynes would have put in if he had written a textbook – the case is pretty clear: there is a non-accelerating inflation rate of unemployment (NAIRU) – an idea, by the way, derived from the Natural Rate Theory associated with Milton Friedman, the leader of the Monetarist school. When the unemployment rate goes below the NAIRU, the inflation rate rises, and it keeps rising until unemployment goes back up. When the unemployment rate goes above the NAIRU, the inflation rate falls, and it keeps falling until unemployment comes back down.

One of the problems with the NAIRU is that nobody ever knows exactly what it is. But recent estimates have tended around 5 percent, and just about any economist will agree that it can’t be much higher than 6 percent. The unemployment rate for November was 6.7 percent, comfortably above anyone’s estimate of the NAIRU. A nearly universal consensus holds that it will rise from here, and some very reputable economists are talking casually about double digits. Moreover, the experience of recent business cycles suggests that, once it rises to its peak, it will come down only very slowly. So if you’re even just a little tiny bit Keynesian, you won’t be expecting much inflation for quite a while. If you take the textbook model as gospel and have confidence in recent empirical estimates of the NAIRU, you probably expect deflation, and you may be worried that the deflation could become quite severe.

I don’t take the textbook model as gospel, but I think it’s a pretty good way of looking at things, and I’m confident that the NAIRU – to the extent that the concept is valid – is not too far from 5 percent. Moreover, the 65 percent drop in the price of oil, which would have been considered wonderfully good news during most of the last 40 years, is not encouraging under today’s circumstances. Things could get quite ugly, and the ugliness will not resemble that of the 1970’s.

Now you might say, “So much for the short run, but in the long run, monetization today will cause inflation in the future.” When I start to see double-digit inflation in Japan, maybe I’ll believe you, but that long run is starting to look very, very long. Even if the US recovery comes fairly quickly (like the middle of 2009, rather than the end of 2010 or the beginning of 2015), the Fed will have plenty of opportunity to demonetize the federal debt before the unemployment rate starts to fall to a normal level.

But I’m skeptical as to whether much if any demonetization will even be necessary. Back in the old days, the four decades after World War II, we used to have sharp recessions – mostly the manufacturing sector would contract quickly, then turn around and expand quickly. That doesn’t happen any more. Today’s service economy doesn’t expand and contract quickly. Recessions begin more slowly, and recoveries are painfully slow. Even in a best-case scenario, the unemployment rate is likely to be above the NAIRU for quite some time. It strains my crystal ball to try looking ahead to the time when any demonetization at all will be necessary.

No, we won’t have to give back the $637 billion (or even the trillions that may follow). It was a Christmas present from the Weak Economy. The biggest Christmas present the US has ever gotten. Unfortunately, it’s not the one that was at the top of my wish list.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.


Mark said...

ok, I just read Mr. Mankiws blog which sent me here and the first entry I read wasn't all that comforting. The last thing the world needs is another Keynesian. So I have some things I'd like to point out.

1> For a general deficit fiscal policy, where the government issues treasury securities in exchange for money as stimulus, we must account for who the money comes from. This is (in my opinion) the problem with the Obama plan. Think of the lender of a fiscal stimulus as acting like the Fed. If the government sells the Treasuries to Americans, it takes cash out of the system and then redistributes it accordingly. This represents money that was in the US and available for sonsumption that is instead saved, and will be consumed by others. However, if the lender is a foreign nation, the matter is entirely different. No money is taken out of our system and new dollars are brought online. Increasing the supply of dollars will increase inflation, no?

2> While one can generally use the monetary base to judge inflation, (I hate to say this) this is because one is *assuming that this monetary base is being used. Right now, the base is not being used, banks are instead hoarding the capital. Obviously, one day is will be used, and when it is the next question is....what will be quicker, the *signs of inflation or the velocity of money?

Lance said...

Is the rise in reserves a truly accurate picture though? Previously the reserve amount was a good gauge of how much money was in the economy, since it represented an opportunity cost of earning interest.

However, just recently, the Fed announced plans to pay interest ( on deposits. So, the true figures are quite muddled.

This paper from the New York Fed talks about it:

save_the_rustbelt said...

This color scheme is impossible to read for those of us in the bifocal crowd.


G in Berlin said...

I agree. White on black is not readable and I don't need glasses (yet). Please change your theme.

THEGAP said...

I have a question. Is your theory working for all countries? If so why not spending a huger amount of public money all over the world to have better results?
A part this question I would like to stress that you never compare the creation of money by the FED with the US GDP and its growth. As far as I know and as huge is the spending it is less than one year of GDP. Which is less than the creation of money in Europe by the ECB. According to you does it matter? Can we say that this creation of money is an anticipation of the creation of wealth and if it will be equal or superior and only in this case it will not be painful or inflationist?

Foodie said...

Like a few others -- my eyesight is decent but white on black is not conducive to a text heavy blog. If it was just pictures, then maybe

JG said...

Ye olde MV=PQ?

Looking at Fred I see the monetary base is shooting straight up while the money multiplier is plunging straight down, by just about offsetting amounts.

Though as the multiplier gets back to normal (we hope) it seems there'll be plenty of time to get the base back to normal too.

NAIRU seems persuasive enough as cause of inflation/deflation -- but as to it trumping the money supply's effects on prices, perhaps it is so only within the limited range of our experience? (Happily limited.)

I.e., if the govt started paying its bills with freshly printed cash, like Weimar or Mugabe's Zimbabwe, do we doubt that it could lift both unemployment and inflation, a lot, together?

Let's not test that thought.

Ben said...

OK, non-economist here, so forgive my ignorance - how does one demonetize debt? In other words, I can see that the Fed has printed massive amounts of money to deal with our crisis situation. You contend that inflation is not an immediate concern because other, deflationary forces are more powerful and thus it is okay to print all this money.

But when the economy recovers and the deflationary forces subside, how does demonetization occur? If there was previously 1 trillion dollars outstanding and now there is 2 trillion, it seems that each dollar will be worth half as much. The Fed/Treasury could buy back some of the money, I guess, but it seems like this would have serious repercussions as well.

M said...

Learn to trust your own intuition again. Go to for more details.

Andy Harless said...


1. I’m not sure I follow what you’re saying, but it sounds like you’re talking about a wealth effect, where the Fed would buy bonds back from the foreign nation, which would bring the dollars back to the US, giving Americans more wealth, so that they would spend more and bid up prices. In any case, I don’t think it matters, because the Fed is almost certainly buying most of the Treasury securities from Americans. In fact, I would guess that it’s buying “more than all” of them from Americans: that is, when the Fed increases the money supply, it weakens the dollar, inducing dollar-peg countries (particularly China) to use their currency to buy more dollars, which they then invest primarily in US Treasury securities, so on net, even though the total supply of Treasury securities is reduced, the quantity held abroad increases.

2. The Fed can monitor aggregate bank lending with a very short lag (a week or two IIRC), and the direct result of that lending will be increases in more broadly defined measures of the money stock, which are known to be leading indicators. The Fed will monitor these along with other leading indicators for signs of strength that could eventually lead to inflation, and it can contract the monetary base whenever it thinks necessary. You may want to second-guess the Fed on how it does this (e.g. argue that it should give more weight to monetary indicators or that it should react more quickly to early signs of strength), but I see that as a separate issue. Possibly the Fed will make judgment errors about when and whether to contract the monetary base, but there’s no question in my mind that it would have a chance to do so before inflation became a problem.


You have a point, but for the moment, I think the Fed is paying so little interest that it doesn’t make much of a difference. I must say, though, there are some strange things going on that are difficult to interpret, like when the federal funds rate goes below the Fed’s reserve interest rate, so that banks would apparently have an incentive to stop lending to other banks, and the excess demand would drive the funds rate back up (all of which should happen so quickly that we would never observe the inversion in the first place).

It hadn’t occurred to me that in the longer run (once the interest rate starts to rise again), if the Fed is paying interest on reserves, it substantially reduces the fiscal advantage to having monetized the debt. I’m not sure what to think about that. I always thought that paying interest on reserves was a bad idea, which maybe I’ll talk about in a later post.

I should also point out that, whatever the reason that bank reserves have risen, that still counts as monetizing debt, although subject to my previous paragraph. But it’s true that a monetarist could make a case for agreeing with my conclusion even if he/she disagrees with my Keynesian analysis.


I do think that, right now, for large countries with well-respected currencies, spending a lot of newly created money would be a good idea. (For this purpose, I’m thinking of the Euro Area as a single country.) Unfortunately, for smaller countries with less-respected currencies, it might end up being very inflationary, because of a couple of things: (1) if people have little confidence in the currency to begin with, they may react to a rising money supply by selling the currency and driving down its value, and (2) small countries depend more heavily on imports for what they consume, so a currency depreciation would have a dramatic effect on consumer prices. (Also, even internally, inflation can be a self-fulfilling prophecy, which is more likely to happen if people don’t trust the currency to begin with.)

Regarding the ECB, I hadn’t looked at the statistics before, but they look very odd to me. It seems that in the Euro Area, the monetary base is close to GDP, and M1 is about twice GDP, whereas in the US, both the base and M1 are only about 12% of GDP. It seems implausible to me that the difference could be so extreme. There must be something I don’t understand about the data. (Can anyone explain this?)


I agree that the government should not make a general practice of funding deficits with money, but I also think that the mechanism by which the money supply affects prices has to involve actual demand (unless it is just a self-fulfilling prophecy, that people raise prices because they see the money supply going up, irrespective of actual demand). I do think the Fed should (as it does) use monetary indicators as one of the things it uses to forecast demand, but ultimately it’s going to be the supply and demand for actual goods and services that determines prices, and that’s what the Fed has to have its eyes on, with unemployment (relative to the NAIRU) being a coincident (or slightly lagging) indicator of demand that the Fed tries to anticipate. (Supply is a tricky issue, I admit, because it depends on expectations, which aren’t easy to measure or anticipate.)


Demonetization would consist of, as you say, buying back some of the money, or more precisely, selling on the open market some of the Treasury securities that the Fed has accumulated. I don’t think it would have serious repercussions (at least not major negative ones) unless it happened very quickly, which I doubt would be necessary, because recovery is a gradual process. (It would, of course, mean that the Treasury would have to pay real interest on the securities once again, instead of paying interest to the Fed and having it end up back in the Treasury.)

A.N. Guzman said...


the fact that nobody agrees on the nairu and that people have changed it to fit data makes the entire theory a bit cooked.

it is true that the US can get away with creating money out of thin air without much impact on inflation (thought not as true if we measured inflation by the same standards all throughout, instead of introducing changes in the way we measure the CPI every now and then).

but i hope you are not thinking that a real economy can get away with such measures. having your currency as world reserve is a must if you want to get away with 'printing as much money as you want'.


Bob Goodwin said...

I have been debating (and losing) with Yves Smith, who has consistently said that Ben can helicopter away deflation, and she periodically says 'bye-bye dollar'.

It is my theory (I am a not an economist) that there is a maximum practical rate of monetization, and that rate is currently exceeded by the actual rate of deleveraging.

Of course I do not know how to measure either, but that is not stopping me from making bets on future deflation.

Thanks for the wonderfully wonkish posts with a sustained story line.

wp. said...

NAIRU is a concept by Edmund Phelps (Nobel prize in economics 2006) not Milton Friedman. The whole inflation-unemployement thing you described derives from keynesian orthodoxy, however it is originally thought to work exactly the other way round...

Andy Harless said...


Just a semantic point, but I what I said was that the Natural Rate Theory is “associated with Milton Friedman,” which I do think is true, even though it was first published by Edmund Phelps.

When you say, “it is originally thought to work exactly the other way round,” I take it you are referring to the real balance effect, whereby rising prices reduce demand by reducing the real value of the money supply. Naturally this doesn’t apply when we have a heavily managed money supply, but one could argue that the Fed’s reaction function produces a positive relationship between unemployment and inflation. Then it becomes a matter of how the Fed’s reaction function interacts with an underlying Phillips curve relationship, the same kind of issue as with the standard supply-and-demand paradigm. This would argue that, in order to estimate the NAIRU, we need some kind of instrument to identify the Fed’s reaction function and distinguish shifts in that from shifts in the Phillips curve.

A.N. Guzman,

For the US at least, even a simple fixed NAIRU model fits the data pretty well (despite the ostensible identification problem that I mentioned just above). I got a NAIRU of 5.8% for a fit from Apr 1953 to Mar 2006. As a first cut I would just take that and run with it. Economists can debate what refinements would improve the theory or the fit. (Should we control for supply-shock variables such as oil prices and exchange rate changes? To what extent should we attribute serially correlated residuals to shifts in the NAIRU? Etc.) I think the consensus is that the NAIRU does shift somewhat and that, in the past decade or so, it has been below the long-run average.

I don’t think the dollar’s reserve currency status per se is all that important. It leads to a greater absolute demand for dollars, but it doesn’t necessarily have much effect on how the dollar’s value will change in response to things such as changes in the money supply. More important, I would say, is the world’s comparative confidence in dollar-denominated assets, and the overall size of the US economy. The same thing would work for the Euro Zone, I think, and has worked for Japan. For smaller countries, creating a lot of money is dangerous, because inflation can be a self-fulfilling prophecy, both internally and externally, because businesses will start to raise prices when they fear inflation, and because, if investors don’t trust the government’s intentions, the currency will depreciate, and for a small country that (necessarily) consumes a large fraction of imports, the depreciation has a dramatic effect on the general price level.

There is also the fact that much of the world has come to depend on US import demand and therefore will often support the dollar, thus cushioning any inflationary impact of dollar creation on the US. But that’s actually part of the same story that I’m telling: not only won’t creating a lot of dollars produce inflation in the US; it also won’t produce inflation in China. The fact that China’s inflation rate is falling now is evidence that even a less venerable economy can get away with creating a lot of money if it hitches on to a well-respected currency like the dollar.


I see the source of my confusion. I was using annual GDP data for the US but quarterly GDP data for the Euro Zone. If I’d thought about the numbers, I would have caught that, since $2 trillion annual GDP is obviously too small. So the European monetary base is about 25% of annual GDP, which is not too unreasonable compared to 12% for the US. Apparently Europeans (or Euro users in general) like to hold more money for a given amount of national income than Americans (or dollar users in general) do, for reasons that aren’t immediately clear. Perhaps the US financial system makes it easier to hold “near moneys,” that are close substitutes for money. (Now that I think about it, the fact that the US has a single issuer of government debt, which issues a lot of short-term debt, might be part of the explanation, since US Treasury bills are a fairly close substitute for dollars, and there is no clear European analogue.)

THEGAP said...

What is quite interesting is the fact that 3 years and a half after our discussion we do not have in the eurozone any improvement in the low competitive economies and a mild improvement in the US economy. My opinion is that "this time is different" and keynesian or neokeynesian tools are weakly efficient. But as anyone can see at least in Europe inflation is beginning to be a problem.
I read recently in Foreign Affairs a paper by Rajan who explain more precisely why this time is different and how to get out of this trap.
Thank you for this discussion and I saw lately your explanation about Eurozone which is obvious we hold more money but too much is too much we were wrong about the references. Bravo to find it first !

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