Deficits Don't Matter- Unless They Do

I just saw former Fed Vice-Chair Larry Meyer on CNBC expounding on coming inflation. Or, rather, the lack of it.

Meyer uttered a dictum which I admit to believing. It was popular during the last eight years, during Bush's administration. The argumentative phrase is,

"Deficits don't matter."

Meyer conditioned it with the observation that there is no evidence that deficit levels are related to inflation rates.

As I noted, when it was uttered in the past decade, I concurred.

But I have begun to reflect more seriously recently on how models fail. Most economic and other behavioral models fail in times of extreme conditions and values.

My roots in quantitative work run to consumer choice modeling and statistical analysis of marketing data. Among a variety of quantitative models which were developed by the 1970s to explain or predict consumer choices between products were a class known technically as "disjunctive additive" models.

Rather than summing all terms to produce a score which was associated with some choice, these models contained thresholds which, when exceeded, caused different values to be returned.

These models weren't universally employed, in part due to the challenge of parameter estimation and, in part, due to the programming difficulties in software of the time.

But the salient point which I took away is the understanding that real human behavior is not linear over all values of relevant variables. At certain levels of environmental or model variables, behaviors change in non-linear fashion.

I'm now thinking that, throughout the past 80 years, Larry Meyer has been correct. The macro variables surrounding the US national debt and deficits- global conflict, existence of a powerful communist superpower, trading partners recovering from WWII devastation, lack of large pools of savings in other economic centers, a dynamically-growing, little-regulated US economy with sane social spending policies- were conducive to buyers of Treasuries calmly investing in said instruments.

However, it would seem that the US economy, monetary and social spending policies may now be causing the general assumptions and environments which existed in the past, which sustained Meyer's comment, to be violated. Regarding US deficits, the behavior of global investors with respect to US debt and dollars may even now be exceeding some threshold which will cause non-linear, changed behaviors with respect to their desire to hold US financial obligations, and the returns they will now demand for holding them.

Of course there is no direct, simple relationship between an annual US government budget deficit and the consumer price index, per se.

But, in extreme conditions, there probably will be. How?

Consider this transmission effect.

When total US spending grows to some very large level, necessitating either higher taxes, debt issuance, or, as I read yesterday in Von Mises' book, The Theory of Money and Credit, "the printing of notes," and there are no higher taxes, but increased debt issuance and printing of notes, then investors in Treasuries and holders of dollars will begin to observe the stealthy depreciation of their assets' values.

To Von Mises, this is inflation. It's the antecedent of Milton Friedman's historic statement,

"Inflation is always and everywhere a monetary phenomenon."

When investors in US Treasuries and/or dollars see more dollar obligations being created than value in dollars in the short term, they will demand higher rates, if they choose to hold Treasuries at all. They may even decline to bid on Treasuries at auctions and, then, when they do, demand higher rates to hold them.

Thus, government "crowding out" of private spending with government spending and/or borrowing, can create investor demands for higher rates on Treasuries, which will drive effective interest rates up for the US government.

As the effective value of dollars fall, with higher rates, prices of commodities and products bought with dollars, now having less value, will necessarily, in dollar terms, appear to rise.

That's inflation.

I think the current period is actually different than those prior periods underpinning the research on which Meyer relies for the validity of his observation.

Eighty years of nearly-constant explicit US government deficits, not counting the hidden unfunded social obligations of Social Security, Medicare, Medicaid and various state and local government employee pensions, seem to have delivered the US to a point at which deficits may now finally matter for inflation prospects.