Many economists are worried about inflation. But others say they’re looking the wrong way.
By Heidi N. Moore, contributor
The national knowledge is creeping in that the good times of the stimulus may soon be over. The United States is running an 11% deficit and our gross debt is 83% of our GDP and may rise to 100% in as little as three to five years.
So when we saw a recent note about the “Keynesian endgame” from Scott Minerd, the chief investment officer of Guggenheim Partners, we decided to pay attention:
“At its core, the Keynesian theory says governments should be called on to prime the economic pump as needed. This works as long as the government has the ability to borrow money. But what happens when a government can no longer borrow money?”
The “Keynesian endpoint” is a time when so many governments are overextended with their own debt that they will refuse to float any more money to each other. This is particularly problematic for the U.S. because we generate debt of $1.6 trillion a year but savings of only around $500 billion, Minerd notes. The remaining money comes to us by borrowing from foreign governments, including China, which owns just over $900 billion of U.S. Treasurys; in total, foreign governments own a $4 trillion piece of us. Usually, when governments can no longer borrow, they turn to their central banks; but many central banks across the world seem to be acting oddly and hoarding cash.
Unsustainable? Yes. But Minerd argues that what will bring us to the point of trouble will not be inflation, as the Federal Reserve seems to think. The Fed has kept interest rates low partly to curb the threat of inflation and partly to encourage lending. We all know the risks of inflation: Rising prices make products unaffordable and drive down consumption.
But the real problem we should be wary of, says Minerd, is deflation. (He’s hardly alone; economists including Paul Krugman and several of the regional heads of the Federal Reserve have warned against the same).
“It would take an unemployment rate below 6% to get the inflation rate to become a concern,” Minerd tells Street Sweep.
Deflation is dangerous because it causes debt to balloon compared to real asset prices. For instance, in a deflationary environment, everyone will owe more in mortgage debt than their homes are actually worth. All household debt, in fact, is likely to be much larger than the value of the assets behind it — which would make it harder for people to pay off their debt, push down consumption and spending, and generally create a toxic economic environment. Deflation can lead to a depression, or extend the current recession to unbearable levels, far faster than inflation can.
Even seemingly cautious moves, like requiring banks to hold more capital, could encourage deflation by encouraging banks to lend less. The Bush tax cuts are set to run out at the end of 2010, and costly healthcare reform is set to kick in next year, which adds additional pressure. Minerd believes that the declines in the Consumer Price Index over the past two months show that we’re already starting the deflationary cycle.
The only way to get out of this, he tells Street Sweep, is to boost job growth; his suggestion is to repeal the payroll tax, which would encourage businesses to hire people and would encourage those who are employed to spend. It’s not an idea that has been kicked around in Washington too much, and it may have many flaws — but, as the economy shows few signs of true recovery, having the discussion can’t hurt.
–Heidi Moore is Sweeping the Street while Colin Barr is on vacation.
