The Government deficit - Stopping Deflation or Initiating Inflation
As government deficits increase asymptotically, the specter of hyper-inflation rises with them. Pundits point to Argentina's recent economic catastrophe as a relevant example of what happens with uncontrolled deficits. On the other hand, those less sanguine about the effects of extraordinary deficits mention that Japan's debt-to-GDP ratio approaches 200%, a magnitude greater than that of the U.S. ratio, which approaches 80%, and Japan has had years of deflation and not inflation.
Whose forecast is more correct? One of them could be correct if the U.S. federal debt had the same characteristics as the debt of one of the previously mentioned nations. Maybe, as in all debt, some similarities exist, but both Argentina and Japan have their own distinct characteristics. Each federal debt is unique.
Media have proposed reasons for Argentina's monetary catastrophe. These include:
- As the principal culprit in Argentina's financial catastrophe, the flight of capital. Although the trade balance was highly favorable, the balance of payments was highly unfavorable. The likely sources for this anomaly were disinvestment followed by a flight of capital by foreign investors and Argentina's legions of currency speculators.
- Coupling the Argentine peso to the dollar prevented flexible monetary policies. During this period, the U.S. dollar experienced real appreciation, which resulted in an increase of export prices when compared to Argentina's trade competitors. The government acted too late in recognizing the effects of the dollar binding and could not prevent a collapse in confidence of the national currency. A massive run on banks caused inflation, eventual government's freezing of bank deposits, and a forced conversion of dollar contracts into pesos, all of which wiped out the savings of the middle class.
- Economic shocks in Brazil, Mexico and a general world recession (2001) greatly affected a fragile Argentina economy.
- Growth in government created huge budget deficits, which necessitated excessive borrowings. Spending by the provincial governments skyrocketed. In some provinces, the state employed more than half the working population and paid legislators as much as $300,000 a year.
- Argentina did not have stable institutions for a free enterprise system. After becoming president, Duhalde blamed Argentina's economic problems on the free-market system and vowed to change economic course. Industrial privatization went to an oligarchy who mishandled their legacy. Corruption wasted the IMF loans.
Similarities between Argentina's financial crisis and the United States crisis are meager. Both show huge government deficits but Argentina had no respectable currency. The U.S. is the major world currency. Flight of capital from the U.S. is conceivable, except to where? Bank runs in the U.S., which has strong institutions, are not likely
Japan has the highest public debt/GDP, approaching 200% in 2010, and it has been that way for a decade.
Nevertheless, Japan has experienced deflation rather than inflation and interest rates for government bonds have remained low during the first decade of the 21st century. Japan's relation between public debt and inflation is opposite to that of the Argentina financial dilemma. Why? Interesting answers to the question of why Japanese inflation and resulting interest rates are less susceptible to public debt is described in an IMF Working Paper, The Outlook for Financing Japan's Public Debt by Kiichi Tokuoka, Jan. 2010
Large pool of household assets. Japan had enjoyed relatively high household saving
rates (over 10 percent) until around 1999 when they began to decline sharply. Although a firm consensus is lacking on this issue, the ample saving flows have contributed to large accumulation of household financial assets, helping finance the build-up of public debt.
Strong home bias. Japanese Government Bonds (JGB) have been financed largely by domestic investors (94 percent of holdings as of end-2008), who may exhibit more stable behavior than foreign investors. The share of currency and deposits in households' financial assets is as high as 55 percent (at end FY2008)-well above 16 percent in the U.S.-and a large part of these funds is invested in JGBs mainly through the banking sector.
Existence of large and stable institutional holders. The Japan Post Bank (previously
the postal savings) and the Government Pension Investment Fund have invested about ¥250 trillion in JGBs (around 35 percent of the total JGBs). The government has relied on these institutions to help finance their lending operations. On top of these institutions, the Bank of Japan (BoJ) also held nearly ¥60 trillion of JGBs as of end-2008.
Recent large saving flows from the corporate sector. Over the past ten years, the corporate sector has been playing a supporting role in channeling funds to the JGB market.
Add to the IMF findings, the Japanese trade surplus, which strengthens the yen and maintains lower import prices, a less reliance on foreign credit, a low consumer demand, and huge foreign reserves of almost $1 trillion in May 2010, all of which diminish the push towards inflation. The U.S. Treasury Department indicates that in March 2010, Japan's government's foreign debt was $687.7 billion compared to U.S. $3.75 trillion of which Japan held $785 billion. The ratio of Japanese government foreign debt to GDP calculates to be about 14% compared to U.S. 25 % while the foreign debt per capita compared at $5,500 to $12,500.
And that's not all. Japan's debt has an additional unique quality. Its Ministry of Finance reported that at the end of 2009, Japan's net foreign assets hit a record high of 266.2 trillion yen ($3 trillion) making it the world's top creditor nation for the 19th straight year.
However, some of the principal reasons for the deflationary trend at the end of the last century are similar to those now affecting the United States - fallen asset prices with bubbles in both equities and real estate. The fallen asset prices led to insolvent companies and insolvent banks.
The United States financial difficulties are different and unique.
The U.S. financial problems can be separated from Argentina's descent into inflation, bankruptcy and chaos by one fundamental aspect: The dollar is still the international currency. The U.S. also has, unlike Argentina, relatively stable institutions serving a free enterprise economy, no danger of flight of capital, and protection against bank runs; at least for the year 2010.
Unlike Japan, the U.S. has a huge trade deficit, excessive foreign debt, relatively large consumer demand, and households with large private debt who prefer stocks to public debt. Many deflationary aspects that propel the Japanese economy can be found in the U.S. economy. Nevertheless, there are sufficient differences that make it uncertain that the U.S. economy will follow Japan's decade of mild deflation.
Inflation depends on exorbitant money supply, rapid circulation of money, large demand for goods and lower supply of goods. The Federal Reserve has bought bank securities and increased the money supply, but most of the funds remain in the banks and don't circulate. And that is reversible. The government is testing a plan to issue government type CDs to reduce the future money supply. Considering that the unemployment and payrolls still remain static despite government deficits, and that there are no shortages of goods, the elements that create inflation are not apparent, nor seem ready to become apparent for several years.
Inflation in the U.S.
The inflation rate in the United States shows that inflation increases dramatically during total mobilization for war. In World War I and World War II, inflation reached high rates. During the Cold War, a slow simmering inflation, coupled with wage pushes and oil shortages at the end of the 1970 decade, ignited into hyperinflation at the end of the 1970's decade, and then subsided to lower levels. After 1982, inflation steadily decreased and moderated up to 2010. Low inflation ruled, despite steady increases of government deficits during the Reagan and Bush I years, dramatic increases during Bush II administration and tremendous rise of oil prices. With wage declines rather than wage increases, overproduction rather than shortages, moderate rather than total mobilization for war and government lending only replacing private lending, hyper-inflation lacks ingredients.
This has been verified by University of Maryland economic historian Carmen Reinhart (together with Kenneth S. Rogoff) in a classic study, May 26, 2010, The Aftermath of Financial Crises: A Global Perspective, and by a May 20, 2010 testimony before the Committee on Financial Services: Statistics don't show a relation between credit and inflation. Ms. Reinhart claimed that the U.S. can and has defaulted on debt. In 1933, the Roosevelt administration restructured debt contracts by changing the price of gold so that the fiat currency lost 33 percent.
If inflation arrives, it most likely will be due to increases of import prices. This will come about either due to rising wage rates in South East Asia producers or depreciation of the U.S. dollar. With which major currencies can the world's currency standard greatly depreciate; not with the Euro for some time; possibly with the Japanese Yen and the Chinese Yuan. The latter depreciations have a compensating effect. As the dollar depreciates, its exports become cheaper and its creditors start taking losses. Maintaining a stable dollar benefits the emerging economies. With no standard to replace the dollar, it's doubtful the dollar can fall too far and inflation can rise too much.
The Obama administration deficit spending is geared to stopping deflation and hoping it does not stimulate inflation.
June 1, 2010
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