Deficits, Inflation, and Conflict
What is actually wrong with government deficits
The point I wish to make is this:
Deficit spending creates future conflicts between citizens. Inflation is one form that these conflicts can take.
I apologize for the simplicity of the economy I am about to describe. Recently, John Cochrane described inflation in a more realistic economy, with multiple goods, capital, interest rates, and other characteristics. As he pointed out, these complicating factors make inflation difficult to define and to measure.
What I will describe is closer to what I have often criticized as a “GDP factory,” in which only one good gets produced. But with just one good, inflation is well defined. If one unit of the good is priced at $100 this year and $110 next year, then inflation is 10 percent.
In this economy, production consists of harvesting acorns. Polly harvests 10 acorns now, eats 8 of them, and puts 2 of them in the bank. The bank gives her $100 for each acorn. In the winter, Polly will buy those 2 acorns back for $100 each and eat them then.
Now we introduce a government, along with another person (or squirrel), named Wally. You can think of Wally as being on welfare, or working for the government. Regardless, he produces nothing. Polly pays a tax of $100, which the government gives to Wally, which he can use in the winter. Polly gets the $100 by selling an additional acorn to the bank, along with the 2 acorns that she puts in the bank for saving. When winter comes, Wally buys one acorn from the bank and eats it. Polly buys back two acorns and eats them. No inflation, no uncertainty. Maybe Polly likes paying the tax, maybe she doesn’t, but everything is above board. There is no winter conflict.
Suppose instead that the government simply hands $100 to Wally, without taxing Polly. Now when winter comes, there are only 2 acorns, and Wally and Polly both want them. Wally has $100 and Polly has $200, so the price of an acorn will go to $150. Inflation makes both Wally and Polly unhappy. This was deficit-spending financed by money printing, and we know that causes inflation. Inflation in the winter is a symptom of the conflict between Wally and Polly over who gets to eat the two acorns.
As another exercise, suppose that instead of printing money, the government borrows $100 from Polly. The way that works is that when Polly puts 2 acorns in the bank and gets $200 in return, she lends $100 to the government. The government gives $100 to Wally and a $100 IOU to Polly. Polly retains $100 in bank notes and the other $100 is an IOU from the government.
Winter comes, and Polly presents to the bank her $100 in bank notes and $100 IOU from the government, expecting 2 acorns in return. But Wally also has $100 in bank notes and wants an acorn. There are only 2 acorns in the bank, so the price of an acorn will go to $150.
Inflation takes place even though the government did not print money. It takes place because government debt creates artificial wealth.
Artificial wealth leads to social strife, because no one thinks that they should be the one to have to pay it back. Wally does not think he should pay back $100. Polly does not think she should pay back $100. So after Polly harvests the 10 acorns and the government borrows $100 from her to give to Wally, he thinks he is $100 richer. And Polly thinks that she has 8 acorns to eat now and $200 to purchase acorns in the winter. The harvest is only 10 acorns, but Wally and Polly together think they have 11 acorns in wealth.
Inflation is a form of social strife that results from the government fooling people into thinking that they are wealthier than they really are, by running deficits. It is natural for people to feel upset when the inflation hits.
During the pandemic, the government handed out checks to raise demand. But people were afraid to go to work and/or were ordered to stay home, which reduced supply. The inflation that resulted was inevitable.
These days, the government is using “industrial policy” to raise demand for chip factories and various forms of green energy. It is adding new government debt at the rate of a trillion dollars every few months. Meanwhile, NIMBYism and various labor market regulations are restraining supply. The way I see it, inflation is likely to result, regardless of what the Fed tries to do.
Meanwhile, looking at the likely path for the Federal budget, Mark Warshawsky writes,
the deficit will increase to 8.8 percent of GDP in 2029, 11.1 percent in 2034, and 14.4 percent in 2039. Debt outstanding will increase to 115 percent of GDP in 2029, 138 percent in 2034, and 168 percent in 2039, a level near that which International Monetary Fund economists estimate will result in a financial crisis for the United States and which the CBO doesn’t expect us to reach until 2053.
Have a nice day.
substacks referenced above:
@
The wrong way to approach this is what the GOP is doing, which is talking about cutting SS which will inevitably lose them an election and even if they win they won't cut it and we know it.
Let's just own up to the fact that we are going to have a fiscal crisis over the boomers retirement and try our best to prepare for it.
You write that “the government fool[s] people into thinking that they are wealthier than they really are, by running deficits.” But (apparently) people are already making a mistake, regardless of government action. As an American, a substantial part of my wealth consists in the American government’s capacity to provide me with services. By running deficits the government reduces this capacity. But I (and other Americans) do not notice the associated decline in my own wealth, because *I never did include my share of governmental capacity in my estimate of my wealth*. Thus I was fooled about the significance of the deficits *because of a mistake I had been making all along*.