Cracks in the Fiscal Dam
by Tyler Watts
I’ll admit it: we fiscal hawks are increasingly mystified that things haven’t blown up yet for Uncle Sam. The Fed has held interest rates at zero for almost 3 ½ years now, and the inflation rate hasn’t exploded—even though people are noticing price increases all around, Bernanke & company can still claim inflation is on target. Congress is well into its 4th year of trillion dollar deficits, and there’s little sign of an impending debt crisis. This unique ability to indefinitely postpone the consequences of monetary and fiscal profligacy must be what the French had in mind when they complained about America’s “exorbitant privilege” of issuing the world’s reserve currency.
Yet deep down we know this can’t last forever. Easy money and excessive government spending eventually will stoke inflation and put upward pressure on interest rates. It is true that, in a recessionary environment, increased “liquidity preference” and a flight to safety can boost the demand for both money and government bonds, thus offsetting these forces. But recessions don’t last forever. At some point, the dam has to break. Some recent news items confirm that the water level is rising fast.
First, there’s news that banks are finally starting to lend again. Stories on the subject are filled with words like “at last,” “good news,” “optimism,” and “bright spot.” A Wall Street Journal report notes an 18% increase in total bank loans from 4Q 2011 to 1Q 2012. Much of this is consumer and home loans (after all, the government is desperate to resuscitate the housing market), but the “commercial and industrial” loan category (i.e. business loans) is also up by 5%, so it’s safe to say this represents a broad based increase in credit demand.
While the Journal seems to be mainly interested in the economic growth and investment implications of this news, there are some pretty large inflationary implications as well. Bank lending is the key force in the growth of the money supply, and hence the inflation rate. The Fed can increase the monetary base all it wants—and indeed it has, growing it from around $800 billion in 2008 to over $2.6 trillion today—but as long as banks simply sit on these new reserves, and don’t lend them out, the broader money supply (M1) won’t change. M1 is “transactions” money—i.e. money people spend—so its growth rate is what we want to pay attention to when it comes to inflation. The fact that banks are picking up the pace of lending indicates that M1 should rise as well. This, coupled with somewhat stronger employment growth, means more money circulating at a faster rate, and hence an uptick in inflation. As you can see in the chart, M1 has increased by over $300 billion—more than 17%–in the past year alone.
The second news item involves the fiscal impact of low interest rates. Again, the Wall Street Journal reports that record-low interest rates, combined with record-high deficits, are saving the government around $350 billion per year on its interest bill. The story states that “the government’s net interest bill this fiscal year will be a little lower than in 1995, when the debt pile was one-third the size.” If there’s any kind of mean reversion with interest rate trends over the next few years—or worse, a rapid increase in rates due to the need to price in higher inflation rates—the extra interest bill will be akin to throwing a few hundred gallons of gas onto the already roaring fire of government deficit costs. The chart below shows the interest burden of the debt rising sometime way down the road—but these over-optimistic scenarios from the “non partisan” Congressional Budget Office fail to take into account the possibility of a big spike in interest rates, such as was seen the last time the Fed got serious about fighting inflation, circa 1980 (as shown in the next chart—look at that interest rate go!).
So, the fiscal and monetary pressures continue to build. Crisis will likely come, although, much like the Second Coming, nobody can say when. Wise citizens will do well to prepare now, before it’s too late, by both protecting their own savings against the ravages of coming inflation, and understanding the forces behind crisis. When it does finally come, this core of knowledgeable citizens will be instrumental in leading America the next generation out of this financial ruin and restoring a sound money footing for our economy and government.
