- The Washington Times - Friday, February 19, 2010

As the White House tried one more time Thursday to galvanize support from a recalcitrant Congress for a deficit commission to tackle the nation’s dangerously bloated debt, fears are growing that the United States will once again resort to printing money and ginning up inflation to resolve its debt problem.

While accelerating the printing presses could do irreversible damage to the dollar’s international reputation and the U.S. economy, history suggests that this is the way Washington will go to avoid the political pain of having to raise taxes and cut spending on popular programs such as Social Security, defense and Medicare.

Some notable economists argue that such a move would avert a debt crisis like the one confronting Greece and other European countries that have been unable to reduce spending because of strong public resistance.

Political leaders and the Federal Reserve, which is charged with printing and circulating U.S. dollars, strenuously deny that they have any intent to “inflate” out of the debt.

Nevertheless, a sign emerged this week that the prospect is increasingly becoming an issue in internal Fed deliberations.

The Fed’s most strident inflation fighter, Thomas Hoenig, president of the Fed’s Kansas City reserve bank, warned on Tuesday that “short-term political pressures” are prompting Congress to take a risky gamble by continuing to borrow at unsustainable rates rather than address the deficit problem and he expects political leaders to be “knocking at the Fed’s door” to demand that it print money to pay for the debt.

This path “inevitably leads to financial crisis,” Mr. Hoenig said, while the inflation it would spawn would threaten American living standards and destroy the independence and credibility of the Fed, whose most important job is to prevent inflation.

Chairman Ben S. Bernanke and other Fed officials have been more vague and less urgent in warning against the dangers of political pressures, leaving Mr. Hoenig as a lone dissenter in the last meeting of the Fed’s monetary policy committee in urging more vigorous action to move against inflation.

But despite some resistance and wariness at the Fed, a growing number of Wall Street gurus expect the U.S. to adopt at least an unofficial policy of growing or “inflating” out of the debt in light of Congress’ unwillingness to tackle budget deficits running at more than $1 trillion for the foreseeable future.

They point to the example set after World War II, the only other time the U.S. accumulated a massive public debt totaling more than 100 percent of yearly economic output, the figure it is projected to reach in the next decade.

The country never really paid off the war debt. Rather, it was able to reduce the debt burden within a couple of decades to a minimal 30 percent of economic output through a combination of robust growth after the war and moderate inflation rates of between 4 percent and 6 percent. By printing more dollars and slowly diminishing their value over several years, the U.S. was able to pay back its debts more easily.

Spyros Andreopoulos, international budget analyst at Morgan Stanley, said investors and citizens who look at Greece’s debt plight and fear the U.S. government may one day face a similar crisis in which it is in danger of default are missing the point.

“A hard default is inconceivable” for the United States, with its huge debts and leading economic role in the world, he said. But “soft default through inflation is a clear risk.”

Mr. Andreopoulos calculates that it would take post-World War II levels of inflation or higher today to keep public debt at the still-high but manageable level of about 60 percent of economic output, where it is today.

“Inflation was the largest factor behind debt reduction” after World War II, he said. “Growth was the second-largest factor,” with Congress making only a small contribution through modest budget restraint. The behind-the-scenes role of the Federal Reserve in accommodating faster growth and inflation through faster money creation was critical, he added.

Whether the Fed would cooperate today with an unstated agenda of inflating out of the debt is a question not only because of resistance from inflation hawks like Mr. Hoenig.

Mr. Bernanke has frequently insisted that it is Congress’ responsibility to resolve the deficit problem, not the Fed’s. He warned about the threat of political pressures on the Fed last summer in a rare public question-and-answer session and said that resisting such pressures will be “critical for the stability of our economy.”

“The independence of the Fed is extraordinarily important. If the Congress or the administration were to begin to interfere with our monetary policy decisions, then the markets would say, wait a minute, there’s going to be more inflation because of political reasons, more inflation because the government wants the Fed to spend money in order to pay for the deficit.”

But some analysts say the Fed undermined its own case last year by instituting programs that had the effect of helping to underwrite the Treasury’s debts.

The Fed printed money to purchase $200 billion of Treasury bonds last year in an effort to keep interest rates low and nurture an economic recovery. The rationale was that interest rates paid by consumers and businesses are linked to Treasury rates. But Fed officials ended the program in the fall, partly out of concern that it gave the appearance that the central bank was printing money to help underwrite the national debt.

Mr. Andreopoulos said the acquiescence of the Fed to a plan by politicians to inflate out of the debt might seem impossible. But he said the Fed might come to accept it in light of the dire consequences of not dealing otherwise with the nation’s grave debt problems, which will worsen dramatically in coming years as baby boomers retire.

“Recent threats to its independence aside,” he said, “a rational central bank may prefer to create a little inflation now rather than a lot of inflation later on.”

Some respected economists have openly advocated an inflation strategy for reducing the debt. Kenneth Rogoff, a former chief economist at the International Monetary Fund, has suggested a 4 percent to 6 percent inflation target for the Fed to help deal with the debt.

A Bank of England board member and a number of academic and liberal economists have urged the same approach, arguing it is better than driving the country into a debt crisis by turning down the Fed’s money spigot and raising interest rates.

For now, the Fed remains on course to slowly end programs that have helped the Treasury finance its huge $1.5 trillion deficit in the past year, though it is maintaining short-term interest rates at very low levels that minimize the burden on the Treasury.

One program the Fed said it will end next month continues to help the Treasury through the purchase of $1.25 trillion of Fannie Mae and Freddie Mac mortgage bonds - ostensibly with the goal of aiding a recovery in the housing market. In that program, the Fed has displaced private and foreign investors who in the past purchased the mortgage bonds, pushing those investors into the Treasury market.

Unlike the U.S., Greece and other European nations troubled by overwhelming debts do not have the option of printing money to pay their bills. Those nations signed on to a common currency that is controlled by the European Central Bank in Brussels.

Though the idea of inflating out of the debt may seem plausible to some, budget hawks warn that it would be counterproductive and just as destructive to the U.S. economy and government finances in the end as going through a debt crisis like the one in Greece. They point out that once investors realize that the U.S. is pursuing higher inflation, they will demand higher interest rates on Treasury securities to compensate.

“As our debt mounts, the risk grows that our creditors, especially foreign creditors who own half our debt, will lose confidence in our ability to get our house in order and will demand dramatically higher interest rates,” said Alice Rivlin, former director of the Congressional Budget Office. Significantly higher rates would “derail the economic recovery and balloon the cost of servicing the federal debt.”

As interest rates rise along with inflation, the Treasury’s debt payments - already one of the largest items in the federal budget - could grow out of control, eventually putting the government in the position of having to choose between making payments on the debt and sending out benefit checks to veterans and retirees, budget hawks say.

Rudolph G. Penner, another former director of the Congressional Budget Office, said there would be a “total bond market meltdown” if the U.S. got to the point where its ability to make debt payments came into question. Then the U.S. would be forced to drastically slash the budget as Ireland and Greece are doing to regain the confidence of investors, he said.

But some investors are aware that the U.S. might adopt a subtle inflation strategy to deal with the debt. China, until recently the largest holder of U.S. debt, has complained for a year about the prospect that the U.S. will stoke inflation and devalue the dollar to make it easier to repay its debts.

Rather than demand higher interest payments on its Treasury investments, however, China has been concentrating its purchases on Treasury bills that mature in the next three months to three years, when inflation is not expected to be a major problem because of the weak economy, analysts say.

The Chinese and other buyers appear to be shunning long-term Treasuries such as 10-year notes and 30-year bonds, whose value is eroded by higher inflation over time. Investors recently have been demanding somewhat higher yields on Treasury’s long-term securities to compensate for the possibility of higher inflation in the future.

But with Treasury still paying coupon rates lower than 4 percent on such long-term bonds, analysts say they would hold their value only if inflation stays around or less than 2 percent, where it is today. The bonds would quickly become worthless if inflation rose to the 4 percent to 6 percent range envisioned by Mr. Rogoff and Morgan Stanley.


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