Thursday, December 17, 2009

Do Deficits Matter?

In a previous post I described the theoretical implausibility as well as the empirical rarity of governments inflating away their debt. I concluded that a deficit-driven buyer’s strike was unlikely, by itself, to pop the bond bubble.

Does this mean that “deficits don’t matter”? Oh no, quite the contrary. Deficits do matter, but it’s important to understand the mechanism. Deficits don’t operate via a buyer’s strike unless you go into hyperinflation. Instead the channel is monetary policy.

The Treasury issues bonds. The Fed buys them. As far as I’m concerned, that’s just an internal transfer. The external effect is not bond supply; the bonds never hit the street. Instead, the external effect is government expenditure. Essentially the Treasury is spending dollars that have been newly printed by the Fed.

In the short run this policy will boost private sector consumption and employment, as indeed it is designed to do. But in the long run it will lead to inflation; seigniorage always does.

Note that this inflation will not necessarily manifest itself in the form of rising interest rates, at least not immediately. If the Fed is willing to buy 75% of each Treasury auction (matching China at its peak) then sure, bond yields will stay low.

But the increase in money supply has to be reflected somewhere. Two obvious candidates are the dollar and real assets. Sure enough, in the last year or so these two instruments have fallen and risen, respectively. Policymakers who look only at bond yields to determine inflation pressures are missing the point.

Ultimately of course rates will have to go up. If something cannot last forever, it will not.


  1. It will be very interesting to see what happens in the next 10 years. We have seen the biggest credit expansion in the history of our country. This boom seems very similar to the Japanese credit bubble that collapsed in the mid 80's. Our country is dead set on duplicating the end result.

    I will be surprised if the Federal Reserse is lucky enough to create the inflation that they desire. I am betting on a Japanese style contraction with higher interest rates. Hello stagflation!

  2. It's kinda hard to understand what this is all about but reading your post it is a good way to learn

  3. I need to study more about this Treasury bonds, this is an interesting post

  4. It is interesting what to see in the next 15 years.