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It is wrong to say debt leads to inflation only in developing countries [ClearOnMoney]
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It is wrong to say debt leads to inflation only in developing countries

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Commentary

It is wrong to say debt leads to inflation only in developing countries

30 Mar 2010 by Jim Fickett.

A number of influential sources declare that inflation is not caused by debt in advanced economies. This may be generally true but, according to historical data compiled by Reinhart and Rogoff, the United States is an exception to the rule.

In a 23 Mar 2010 speech, Janet Yellen, head of the Federal Reserve Bank of San Francisco, said:

There is one count, however, on which budget deficits should plead innocent—the charge that deficits will ignite runaway U.S. inflation. I simply don’t believe that’s the case. Concerns that deficits cause inflation have a long history. And, indeed, in developing economies, there is plenty of evidence showing that deficits are often inflationary. The logic is that a government can pay for its purchases through taxes, borrowing, or money creation. In countries with limited ability to collect taxes and where financial markets may be poorly developed, printing money may be seen as the only way to pay for the activities of government—often with dreadful consequences.

However, in advanced countries with independent central banks, government deficits do not cause inflation, either in the short run or in the long run. These links between fiscal deficits and inflation have been studied extensively and the evidence is clear (see, for example, King and Plosser 1985, Sikken and de Haan 1998, and Catão and Terrones 2005). Japan is a case in point. That country has run enormous fiscal deficits for many years and its government debt has risen to very high levels. Yet Japan has been the recent textbook case of persistent deflation, not inflation.

In a recent paper, Reinhart and Rogoff, who have collected data more comprehensive than available previously, give a primary message that echos the above:

there is no apparent pattern of simultaneous rising inflation and debt.

The first caveat to this general result is the emphasis on “simultaneous” above, which is in the original. In fact it is well known that expansion in the money supply is often followed by inflation with a delay of a few years. Reinhart and Rogoff then go on to mention another important caveat to their general result:

There are exceptions to this inflation result, as Figure 3 makes plain for the Unites States, where debt levels over 90% of GDP are linked to significantly elevated inflation. Figure 3 spans 1791-2009, but the pattern for the post-war period taken alone is very similar.

Regarding the 90% threshold: under current budget planning, according to the GPO, gross federal debt (the measure Reinhart and Rogoff use) will exceed 100% of GDP in fiscal 2011.

Despite the two very important caveats, many sources continue to mention only the more soothing general result. The Financial Times wrote, on 8 Jan 2010, shortly after the Reinhart and Rogoff study was released:

After examining the record of 44 countries over 200 years , Kenneth Rogoff, former International Monetary Fund chief economist, and Carmen Reinhart, a colleague, found little link between rising public debt and higher inflation in developed countries. That should soothe the inflation anxiety of some investors.

The chances of hyperinflation in the US are small, but they are not negligible. The best way to prevent that terrible outcome is to be honest about the possibility and discuss how to prevent it, not sweep it under the rug.

From an investment point of view, the most important things to keep an eye on are (1) any weakening in the independence of the Federal Reserve, and (2) the extent to which liabilities are openly accounted for and risks are honestly discussed.