Must We Choose between Depression and Inflation?
By Nayyer Ali MD
The COVID-19 pandemic has taken 100,000 American lives and continues to prowl the land. Along with the physical toll, the economic devastation has been immense with unemployment now likely around 25%. State governments are running out of money and looking at additional massive cutbacks and layoffs. We are basically in an economic depression.
So why doesn’t it feel like a depression? Why aren’t millions losing their homes, and the unemployed lining up at soup kitchens? Why is it not looking like 1932 did? One big reason: the government has responded by flooding the country with money. Congress has disbursed two trillion dollars in bailout funds and stimulus checks and unemployment benefits that have kept companies from going bankrupt, and allowed the unemployed to continue to pay their bills and buy essentials. There is severe hardship for some, but the scale has been mitigated so far. However, this has only bought us about 3-4 months of support. What happens over the next year?
While everyone is hoping for a vaccine as soon as possible, the economy is going to remain depressed for quite a while. Even after a vaccine begins to be deployed, tens of millions of people and tens of thousands of small businesses cannot resume normal work immediately and in some cases, never.
So what should we do over the next year until we can get the economy back on its feet? There is only one answer, continue to spend as much money as necessary to keep the nation afloat and keep people current on their mortgages and car payments and still able to buy food and essentials. This may mean another 1-2 trillion dollars just in support payments. Another 500 billion dollars need to be sent to the states to plug the massive holes in their revenues so they can avoid widespread layoffs of teachers and other state employees. This may be enough to avoid catastrophic hardship over the next 6-12 months until a vaccine can allow us to return to normal activity.
But even after that, the economy will need a giant stimulus to get people back to work and to generate the massive demand needed to get businesses to hire back tens of millions of people in a short time. Normally, a good year of job growth will add 2-3 million workers. We have had almost 40 million people file for unemployment, and we need to get them back to work in 12-18 months after a vaccine. The federal government will have to spend another 2-3 trillion on that needed stimulus.
Where and how can the Federal government find the 4-5 trillion dollars, on top of the 2 trillion it has already spent, needed to restore the US economy and get us out of a depression that otherwise could last 10 years till we get back to full employment? There are basically only three ways a government can raise money: it can collect taxes, it can borrow the money from its citizens by selling bonds, or it can print the money. In the US and most advanced countries, the government is not legally able to print money, it can only tax or issue bonds. There is however the nation’s central bank, in the US case the Federal Reserve. It is a creation of the Federal government, but it is independent and not controlled by Congress or the President (they do pick who gets to serve on its board). The Federal Reserve, like all central banks, does in fact have the awesome power to print money.
Clearly, the rational thing to do is for Congress and the President to borrow the money needed. That’s what has happened with the first two trillion dollars, and that is what will happen with the next 5 trillion. But won’t that put a crippling burden of debt on the nation? Not necessarily, if the Federal Reserve prints 7 trillion dollars. Money printing does not literally happen, but what does happen is that the Federal Reserve buys the US government bonds from the open market with electronic credits of dollars that it simply creates at will. It has already bought over 2 trillion dollars in government and even corporate debt in the last 2 months to keep the economy from crashing. It can easily buy the next 5 trillion of debt that Congress takes on. The government then makes interest and principal payments to the Federal Reserve that it is obligated to do for those bonds, but the bank then returns all the interest payments to Congress as bank profits, for which it is also legally obligated. In essence, it becomes free money for the government to spend.
There has to be a catch to this right? Wouldn’t a government that printed money debase its currency and get hyperinflation, like in Weimar Germany in 1924 or in Zimbabwe in the 1990’s? It is a question of degree. In a depressed economy with idle labor, capital, and factories, this sort of government spending does not lead to inflation of any sort, much less hyperinflation, where prices double every month or even more often. In an economy at full employment however, this sort of thing would let inflation out of hand.
Has this ever worked before without causing hyperinflation? Yes, it has. It worked in the US in the last decade as we recovered from the Great Recession. Obama ran massive deficits his first four years in office, but most of that debt was bought by the Federal Reserve and still is held by them. Inflation never took off, despite many conservatives insisting it would and blasting Ben Bernanke, the head of the Federal Reserve, for his wise policies.
An even more dramatic example has been Japan in the last 20 years. Japan has faced a very slow growth economy with actual deflation in many years because of sluggish demand, much of which is driven by its aging demographics and shrinking population. The Japanese government has responded with overwhelming deficit financed stimulus spending year after year. They have done so much that Japan’s national debt is now over 200% of its GDP. But over half of that national debt has been purchased by the Bank of Japan, so the government owes that money to itself. This amount of money printing has resulted in zero inflation, and interest rates on Japanese government debt are incredibly low, in fact negative for 10 year bonds. 10 year bonds are actually at negative yields in France and Germany, and less than 1% in Canada, the UK, and the US.
The US can avoid both a prolonged depression and hyperinflation. It will need to spend 5-7 trillion dollars to restart the economy rapidly, and the Federal Reserve should provide that money by purchased those bonds as Congress requires. This will result in 2024 with the Federal Reserve holding perhaps 50% of GDP worth of US government debt. Those bonds can be paid back over 10-30 years. Once the economy does come roaring back, the government will need to stop its stimulus spending, and the Federal Reserve will stop its bond buying. It could even choose to tighten economic policy if inflation starts to rise by selling some of its government bonds back to the market and taking cash out of circulation. It can at some point even start to raise interest rates, but it took six years of recovery from the Great Recession before the Federal Reserve felt the need to start to minimally raise rates from zero. It may be that long or more before it does so again. Rates that low will mean that interest rates on even long-term US government bonds will likely stay under 2% and maybe under 1%. In Japan and Germany in the last few years, interest rates on government debts even went negative, despite significant deficits. Could we see negative interest rates on US government debt before this depression ends?
