On March 2, 2011 Federal Reserve Chairman Ben Bernanke replied to Congressman John Campbell (R-CA) about the timing of a financial crisis from massive government deficits "close to $5 trillion in the next 36 months." Bernanke explained that it was "hard to know about the timing but eventually the lenders would decide the United States is not a good credit risk and interest rates would spike." He said that economists have a name for what could happen, "debt dynamics" where things "kind of spiral out of control." Bernanke said that recently there were examples from other countries when confidence was lost. "On Tuesday everything was OK but on Wednesday there was a fear that suddenly the process is breaking down."
The Federal Reserve plays a central role in financing the huge government deficits. There are two ways to finance government budget deficits. Either borrow the money or, at the discretion of the officials at the Fed, issue new money. Legislators in Congress can vote spending bills and the President can sign them into law but neither can literally appropriate money to finance them. After the spending appropriations receive President Obama's signature they go next door to the Treasury. If the government revenues, mostly taxes, do not cover the authorized spending the Treasury must borrow the money to finance the deficit by selling Treasury securities (bonds, bills, and notes) to the public. Seventy percent of government deficits for 2008, 2009 and 2010 were financed by borrowing from the public, including from foreign purchasers.
Borrowing money to finance government spending involves giving the public money and then taking it back in exchange for the Treasury securities. That may have little simulative effect though the spending benefits the recipients. I ran statistical tests in 1969 under the supervision of Milton Friedman (chairman of my dissertation committee), Henri Theil (a world famous statistician) and Lester Telser (a renowned mathematical economist). The effects of U.S government deficit spending from 1930 to 1939 and during the post-World War II period to 1969 were tested. The borrowed part of the deficits had no discernable simulative effects in those periods. The other part of the deficits, financed by money creation, had strong short run simulative effects on income. Any simple relationship between small changes in money growth and inflation disappeared during the 1980's but prolonged faster money growth to stimulate the economy can produce more rapid inflation.
The Fed reduces federal government borrowing by buying the securities the Treasury issues with money the Fed creates. Thirty percent of government deficits for 2008, 2009 and 2010 were financed by the expansion of the monetary base of the country's money supply (currency, coin and bank reserves).
Last year Paul Krugman suggested: "A commitment to, say, 4 percent inflation [rather than the probable 2 percent Fed target], on the other hand, could work: it's enough to produce full employment ..." The inflation rate came close by May 2011, hitting 3.6 percent since a year ago. The Fed assisted with its short term attempt to spur the economy with Quantitative Easing 2 (QE2), buying $600 billion. The unemployment rate dropped slightly with a slightly smaller labor force. The rising prices severely impacted low income people including, perhaps, 20 million unemployed people. Millions of low income people with no phone or permanent residence are not included in the 10-year Census or the Bureau of Labor Statistics' Household survey. The Fed may continue to expand the monetary base rapidly under different programs adding uncertainty with on again/off again faster money growth policies.
Stopping inflation produces a severe economic problem. Former Federal Reserve Chairman Paul Volcker's policies to stop an inflation that reached over 13 percent in 1980 produced a double dip recession with unemployment over 10 percent. It is likely that today many people will react more promptly to the expected consequences of a monetary stimulus with the digital communication system available that was not in use in 1980. The monetary stimulus may begin to weaken a few minutes after longer term predictions are widely dispersed.
Part of the Fed's rapid money base expansion since October 2008 is parked in banks which receive interest from the Fed, an incentive to hold the money rather than make loans to consumers and businesses. The Fed has a costly policy to keep these bank reserves, $1.6 trillion, quarantined. It would be a huge stimulative short term shock to income and inflation if the banks flooded the economy with their huge excess reserves and the Fed did not reduce the bulging monetary base it has created. Hopefully the Bernanke Fed will not continue to disregard the damaging consequences of more rapid inflation and its devastating remedies, what Bernanke called Wednesday.
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