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Worries about Budget Deficits and Inflation: Let's Avoid Repeating Our Mistakes

There is a lot of concern about the future course of the economy, and there are two separate worries that are getting confused. The purpose of this post is to distinguish between the two sets of worries, and to discuss whether the worries are justified.

The confusion comes from the failure to distinguish between the policies implemented by the Fed and Treasury in an attempt to bailout and stabilize the banking system, and the policies passed by Congress and signed into law by the president in an attempt to jump start the economy. Many people think of these two separate polices as one large government bailout program, but the policies and the worries associated with them are distinct.

The bank bailout and worries about inflation
Let's start with the policies designed to bailout the banking system. These polices, the main effort being the Emergency Economic Stabilization Act of 2008, provided $700 billion to purchase toxic assets from banks and allowed the Treasury to provide additional capital to banks with troubled balance sheets. In addition to these asset purchase and capital injection programs, the Fed has injected liquidity into the system by increasing bank reserves substantially -- massively is a better description -- and the result is that a very large quantity of excess reserves has accumulated within the banking system.

Reserves sitting idle within the banking system, as they are now, are not much of a problem and they provide insurance against unexpected losses in other areas of a bank's balance sheet. But the worry is that these reserves will become active once they economy starts to recover and cause an outbreak of inflation. That is, the concern is that the excess reserves make loans very cheap, and once conditions improve, the availability of cheap credit will fuel a debt driven inflationary episode.

But these worries are misplaced. With the economy still struggling to recover, we want firms to use these funds to begin making investments. We need this type of investment activity to lead us out of the recession, so we want lots of funds to be available at a low interest rate. As long as we are still below full employment, then inflation -- which is driven by an excess demand for goods and services -- is not much of a worry.

But what happens when the economy does recover and demand increases, won't all those excess reserves sloshing around in the banking system looking for something to finance cause excess demand and hence inflation? It would if these funds actually leave bank vaults and find their way into the private sector, but there's no reason that needs to happen.

Shortly after the crisis started, the Fed began paying interest on the reserves that banks hold, including excess reserves. This means that the Fed has the means to keep the reserves in the banking system and avoid the inflationary consequences. For example, suppose the interest rate that banks can earn by loaning out their excess reserves is 5 percent. If the Fed offers to pay 5.1 percent on reserves the bank holds, the bank has the choice of making a loan to a business or consumer at 5 percent, or keeping the reserves in the vault and earning 5.1 percent. In such a case, banks would not choose to lend to the private sector and the potential for a debt fueled inflation problem goes away.

Thus, so long as output is below full employment inflation is not much of a worry, and once conditions improve the Fed has the means to prevent the reserves from leaving banks and becoming inflationary.

Budget deficits and worries that high interest rates will crowd out investment
The $787 billion stabilization package that congress passed and Obama signed into law, known as the American Recovery and Reinvestment Act of 2009, is distinct from the Bush administration's bank bailout package (because both are called bailouts, one bails out the banking system and the other bails out the broader economy, they are often confused or incorrectly fused into a single policy). This combination of tax cuts and government spending is an attempt to stimulate the economy out of the recession, or, more realistically given the size of the package relative to the size of the problem, to simply prevent conditions from being much worse than they already are.

The worry here is that government borrowing will drive up interest rates, that the increase in interest rates will lower private investment (this is called "crowding out") and that, in turn, will cause economic growth to be lower that it would be otherwise.

Right now, this is not a very realistic worry. When the economy is near full employment, and when there are not bundles of cheap cash available from the excess savings in countries like China, an increase in government borrowing adds to the competition for the available funds. The increased competition for available savings drives up interest rates and crowds out private investment. But when there is an excess of available funds, as there is now (this is the excess reserves described above), and cheap loans available from foreigners (e.g. from China) -- more than the demand for funds at the current interest rate (which is essentially zero) -- the government can borrow without putting any upward pressure at all on the interest rate (when the supply of apples exceeds demand, and the price is already zero and can't be lowered any further, an increase in the demand for apples does not cause a price increase).

The long-run worries here are legitimate - if we stay on the current trajectory for the budget deficit we will have problems in the decades ahead - but those worries are mainly due to rising health care costs in the long-run. Relative to that problem, the stimulus package is tiny and can be handled relatively easily. It is only when rising health care costs are piled on top of the stabilization package that the worries become large, but this points to the need for health care reform rather than pulling back on the stimulus package (which could be disastrous if done too soon).

I don't want to be misunderstood. It's important that, once the economy recovers, we do what is necessary to pay for the stimulus package and when the economy is ready, I'll push as hard as anyone to try to make that happen. Doing stabilization policy correctly requires deficit spending in bad times, and then paying for that spending when times are better. We have been very good at running up deficits during the bad times, but not so good at paying the bills when things improve, and that needs to change.

But beginning to pay down the deficit too soon can endanger a recovering economy, and it's important to be sure that the economy is on solid footing before starting to pay the bills for the stimulus package. The day will come when it's time to do just that, but we are not there yet. (In fact, given the poor state of the job market, I'd favor even more stimulus presently, particularly programs that directly target jobs).

Lessons from the Great Depression
The experience of 1937-38 provides an important lesson for today. In the wake of the initial large downturn in the economy during the Great Depression, the economy was beginning to recover and people began to worry about inflation and government deficits. In response to these worries, the Fed began raising interest rates and the government began balancing the federal budget. This proved disastrous and caused the economy to plunge back into recession, and the economy did not revive again until after WWII began.

We are hearing the same concerns today about budget deficits, interest rates, and inflation, but it's important that we avoid repeating the mistake of giving in to these worries and pulling back on monetary and fiscal stabilization policies too soon.

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