Rising Budget Deficits Are the Surest Sign Of a Lack of Inflation

As seen in RealClearMarkets.

Iran’s rial is in decline. As of last week it had fallen to 1/600,000th of a dollar. If we’re being realistic, it’s no longer even a currency. Figure that money exchanges signal exchange of products for products, but who would hand over actual market goods, services and labor for Iranian rials? Not the Iranian people, it seems.

Which ably explains why the Iranian people are in a mad rush for dollars at the moment. Yes, you read that right. A country that in a political sense is one of the U.S.’s foremost enemies has an economy that is liquefied by dollars. Markets always and everywhere speak, and in Iran the currency of exchange is the U.S. dollar.

This is something to keep in mind given the popular narrative at the moment that budget deficits cause inflation. Big names, including the great John Cochrane (he’s written a book about it) are making a case that soaring budget deficits have inflationary consequences.

At first glance, the argument has some intriguing qualities. Governments want to borrow in size, but would perhaps rather pay back less than they’ve borrowed. Devaluation is an easy solution. Of course, that it’s an easy solution speaks to why what’s assumed about budget deficits and inflation doesn’t stand up to logical or empirical realities.

On the logic front, if it were true that deficits instigate inflation then logic dictates there wouldn’t be any deficits. Think about it, and think about it with the genius of compound interest top of mind. The gains to be had from the latter are beyond obvious to investors, so the notion that they would aggressively buy the very debt that will pay out future income streams that are being devalued belies basic common sense. Only in textbooks is money dumb. In the real world money is ruthless. 

From there, we must consider empirical realities. Over the decades Japan has run enormous deficits, albeit in concert with a mostly soaring yen against the dollar and gold. Yes, actual deflation. While Japan ran up big debt, the yen soared amid falling rates across its yield curve.

What about the United States? In 1980 total federal debt in the U.S. was roughly $900 billion, and the yield on the 10-year Treasury was over 11%. In the four full decades since, federal debt has jumped to over $31 trillion alongside a rapidly falling 10-year yield that presently sits at 4%.

What’s important is that rising government debt very logically correlates with the low inflation empirical realities just mentioned. To see why, consider yet again how smart (think the genius of compound interest) nearly all money is, and how difficult capital is to attain (think investment banker compensation) even in the flushest of flush times. These common sense truths explain why falling inflation most correlates with government debt increases, which runs counter to Cochrane’s thesis. That debt associates with falling inflation is just an expression of what’s always and everywhere true: money is never dumb, so those who have it don’t migrate toward the investments that will pay out currencies in decline.

It’s all a reminder that far from government borrowing instigating inflation, actual inflation is what makes it so much more difficult for governments to borrow. Think Iran once again. Could it issue debt that would pay out rials? Hopefully this question answers itself. Inflation, or the expectation of future inflation, is the path to the closing of the borrowing window. Again, money is smart. Since it is, there’s no market for Iranian country debt.

Unless, of course, the presumed Iranian debt were denominated in dollars. Translated, the lack of inflation associated with the dollar is what would enable any creditworthy individual, business, or country to borrow in dollars.

Importantly, none of this is to presume that the dollar’s status as the world’s currency means we can’t have inflationary episodes. We have, and we will. But it does raise a question about the present. How could there be inflation at a time when the dollar has been rising not just against foreign currencies, but also gold?

The above question is one the neo-inflationists aren’t presently answering, nor are they addressing what happened in 2020 as a logical precursor to rising prices that have nothing to do with inflation. Indeed, if global cooperation is the obvious path to cheaper and cheaper production costs, wouldn’t evisceration of same result in more expensive production? The only problem is that command and control is not inflation.

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