Saturday, January 31, 2009

Tax, Borrow and Inflate

Government can raise revenue in one of three ways: (1) tax, (2) borrow and (3) inflate.

Milton Friedman taught us that inflation is everywhere and always a monetary phenomena. Wage-pull, or cost-push inflation stories do not make sense. The oil shocks of the 1970s don't explain inflation, it would explain a relative price change, but not a change in the general price level. Money supply and money demand determine that.

However, as Tom Sargent has discovered in his work on hyper-inflation, Friedman's dictum is correct, but could be modified by simply pointing out that hyper-inflations are everywhere and always preceeded by fiscal imbalance.

In short, the natural proclivity of government has consequences. They want to spend more to meet electoral promises, they do so in the short run, and when the bill comes due they want to print more money to pay back in cheaper currency. When spending gets really out of control (is a national debt of $10 trillion out of control!?!), then they monetize at such a rate to threaten to destroy the currency through hyper-inflation. A broad definition of the money supply is MZM and it is kept by the St. Louis Fed:

Hyperinflation on the way?

Realistically, this worst-case scenario (hyperinflation) will likely be avoided by what will ultimately be a dramatic shift in policy once our leaders come to their senses. However, until then the dollar will likely lose a substantial portion of its value: i.e., the Dollar Index (USDX) will likely drop to 40 or so from its current 85ish position. The move to 40 will likely take a few years, but it effectively means you better ensure your salary increases by 45% over those same years just to maintain your current buying power.

Isn't economics fun?

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