Inflation with fiscal deficits is the last remaining tool to get our economies back on track. That is; if the goal is to increase GDP and reduce unemployment, these economies can no longer rely on monetary stimulus alone. A short revisit to basic economic theory may refresh our understanding before I lay out a brief (and admittedly simplistic) argument.
Remember first that we have two sides to any market; supply and demand. The supply side is not the problem this time around: GDP is not low because we lack capacity to produce. The high unemployment rates give ample evidence that there is plenty of spare capacity around. What is needed here is demand. Thus, if you care about getting the economy back to its long run sustainable level, you must for now accept some Keynesian thinking and leave your supply side arguments for the different discussion of how to maximize long term growth (yes this is just as important, but not the focus of this post).
The disagreement is not whether demand needs stimulus (it does), but how it can be achieved. So, this leaves us with two schools of thought to battle this out: The traditional Keynesian would suggest the use of fiscal deficits (i.e. government spending) to kick start demand directly, and thereby increase the income of consumers who then will increase their demand; and so the multiplier goes. This will increase both debt and GDP, but because the Keynesian multiplier is assumed to be greater than one, we will see GDP growing faster than the stock of debt. Conveniently, this leaves us with a lower debt to GDP ratio, and we are all happy.
The counter argument is that of the now so-called “Austerians” who have little faith in the government’s ability to stimulate demand. They will argue that there is no Keynesian multiplier. The reasoning tends to take one of the following shapes:
(1) Consumers are not stupid and understand that government debt is just another name for future taxes. And if we expect higher future taxes, we must start saving now in order to maintain a smooth (and optimal) inter-temporal consumption pattern. This implies Ricardian Equivalence: an increase in Government spending will be met by an equal off-setting increase in private saving – leading to higher government debt and zero net change in GDP. (2) Debt itself is damaging to the economy. It increases risks and interest rates which hurts private investment. It makes us pessimistic about the future which has a negative impact on consumer confidence. And last but not least, it is unfair to future generations. (It also implies more tax-payer money to be distributed by politicians whose incentives may not be perfectly aligned with the needs of our economy).
Personally, I do believe fiscal stimulus could give a strong boost if combined with further rounds of QE, both in the US and in Europe. However, I am also worried about the potential risks of rapidly increasing debt to GDP levels. Thus, I have no intentions to close this debate. All I have to say is: More inflation will make the pain easier. And I strongly suspect inflation is the outcome our policy makers are aiming for. We will continue to see economists with a taste for easy money to be placed in the driver’s seat of our central banks (think of Carney at the Bank of England, Kuroda at the Bank of Japan and possibly Yellen at the Fed). And I think that’s a good thing. Easy money will make the expansive fiscal policy more powerful and less costly. This even neutralizes the Ricardian equivalence argument: If consumers see the fiscal deficits today and expects higher inflation tomorrow, they will see that the real value of future taxes is lower than the real value of spending today. Thus the increase in government spending will be met by a less than one-for-one increase in private savings, and there is a net positive impact on demand today.
There will of course be pockets of pundits who predict widespread hyperinflation as a consequence. And yes, that is a real risk, but the question is with what probability? And then the next question is: what is the highest probability of hyperinflation we are willing to accept in order to get our economy back on track today?