Will It Be Stagflation?

by Crocker on July 1, 2009, 11:06 am

in Economics,Politics

In keeping with the ongoing debate about whether our fate is inflation or deflation, here’s a piece from today’s Washington Times that predicts 1970s-style stagflation due to massive government spending and increases in the money supply. But the real kicker is the government’s stated policy – discussed numerous times here at BBL – to keep asset prices high to help both consumer and bank balance sheets:

Inflating asset prices in support of Wall Street, the banks and consumers who are upside-down on their mortgages is, presumably, a major, if unstated, goal of Fed policy. The Japanese proved in their “lost decade,” however, that artificially propping up asset prices with cheap credit and government spending while failing to recognize losses and moving on is a recipe for stagnation.

Interest rates are low because of the massive credit and money creation. But as it dawns on investors that significant future inflation is virtually certain, long-term rates are starting to creep up. Long-term Treasury bond rates already have risen from 3.5 percent to 4.5 percent over the past eight weeks. They will continue to rise as investors demand larger premiums to compensate for inflation and the tax on purely inflationary gains.

The real measure of the federal economic footprint is not the tax burden, but the spending level. Right now, federal taxes barely pay for half of federal spending. It is frightening when one considers that the taxes paid by the taxpaying public would have to double to pay for the current level of spending.

The rest of the federal government’s spending is paid for by borrowing (which is money not available to the private sector to spend or invest) or by creating money to buy federal bonds (which devalues everyone’s assets and salaries with inflation). The dead-weight loss to the economy of a 34 percent increase in federal spending is quite large and will serve as a continuing drag on economic performance, as can be seen in the decades of poor performance in most European economies. Substantial George W. Bush-era spending increases, while not as dramatic as recent spending increases, are also part of the reason for lackluster economic performance over the past several years.

According the the authors, the train-wreck is coming unless the government takes the very steps that we’ve been urging here at BBL:

The first thing policymakers need to do is to stop doing harm. The Fed needs to immediately raise the federal funds target interest rate and slow money growth to normal levels. Congress needs to return federal spending to a more normal 19 percent to 23 percent of gross domestic product. It should reduce the U.S. corporate tax rate, currently the second-highest rate among industrialized nations, and, if possible, reform the tax system to promote work, savings and investment. Finally, it needs to control rather than exacerbate federal entitlement spending.

Read it all. I’ve been going back and forth over the inflation-deflation conundrum. Anyone else care to weigh in?

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