Last week the Federal Reserve clearly stated that it is going to tolerate higher inflation in the future. The central bank also reaffirmed its opinion that America is now addicted to very low interest rates.
These two statements – expect higher inflation as well as low interest rates – are logically incompatible when inflation is driven by money printing.
More on that in a moment. First, let’s recap the inflation worries. We have been consistent in our inflation outlook, explaining in our Economic Newsletter how we have a big, monetized inflation gap in our economy and how that gap has the potential of causing the highest inflation we have seen in 40 years. This comprehensive forecast provides a thorough explanation of why we face such an ominous inflation threat, but we are not the only ones who have seen inflation coming. For example, on January 9, Bloomberg reported:
They’re still in the minority, but investors and economists who think America is in for a bout of inflation — perhaps a serious one — start the year with some fresh ammunition for their arguments.
They also note that the Biden administration
will likely prop up household spending with more financial aid, after Senate elections this month gave Democrats a majority. And in the background, the dollar has been weakening and commodity prices rising steadily for months. All this has pushed bond-market measures of expected inflation higher. The so-called breakeven rate on 10-year Treasuries climbed above 2% this past week to the highest in more than two years.
This break-even rate means that if you are looking for income on a coupon investment, inflation erodes its real value. The higher the inflation rate, the higher the interest rate you need in order to make money on your investment.
Here is a guy who actually puts a number on his forecast. It is still modest compared to mine, and likely not built on the same comprehensive analysis, but it is still noteworthy. From MSN Money back on December 26:
Jeremy Siegel, a finance professor at the Wharton School of the University of Pennsylvania, author of the classic “Stocks for the Long Run” and a senior investment strategy advisor to Wisdom Tree Funds, predicts that “we will see much more significant inflation for the next few years than we have seen over the last two decades.” Though Siegel does not forecast where inflation will be at the end of 2021 in particular, he says: “I would not be surprised to see 3% to 5% inflation over the next several years.”
On December 30, Jeff Cox over at CNBC noted that “many see inflation moving toward and perhaps a bit above the Federal Reserve’s 2% target rate”. He also explains:
The Fed considers some inflation good for the economy, as it signals growth and allows room for the central bank to act the next time a crisis comes along and demands help from monetary policy. However, a number of factors have conspired to keep inflation low, and they likely will help contain a rise in the coming months.
No, inflation will not be contained, but other than that there is an important point here that we will return to in just a second. First, here is a contribution from Forbes, December 29:
It also seems that much central banking stimulus has gone into producing asset price inflation rather than retail or consumer price inflation. The behaviour of stock markets in the past two years is a case in point and hints that the business cycles of old have now given way to liquidity cycles of our time.
The comment about cycles in business activities and liquidity is incorrect per se, but it does hint at the big problem here: over-monetization of the economy. It is also worth keeping in mind – as we explained in our Economic Newsletter on the monetary inflation gap – that asset-price inflation precedes consumer-price inflation. Since we have had very high asset-price inflation for some time now, and since the flow of newly printed money into the economy has continued at very high rates, it is only reasonable to expect consumer-price inflation in the near future.
Which brings us back to the Federal Reserve. In its Federal Open Market Committee statement of last week, where it explained:
The Committee seeks to achieve maximum employment and inflation at hte rate of 2 percent over the longer run. With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.
In plain English, this means that the Federal Reserve not only wants, but expects inflation to rise above two percent.
But there is more. The same day, January 27, as the central bank issued this FOMC statement, it also reaffirmed its commitment to what it called a “Statement on Longer-Run Goals and Monetary Policy Strategy”. In this statement the bank explains:
The Committee’s primary means of adjusting the stance of monetary policy is through changes in the target range for the federal funds rate. The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average. Therefore, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past.
This all sounds technical and irrelevant, but there is an explosive piece of information embedded in it. Here, the Federal Reserve says outright that in order to help keep the economy at a high level of activity – maximum employment – the bank has to keep interest rates low. Currently, the Federal Funds Rate, the central bank’s key policy indicator, stands at 0.25 percent, and we still have unemployment lingering from the 2020 artificial economic shutdown.
Simply put, the Federal Reserve says that higher interest rates will hamper economic activity and prevent “maximum employment” (which is a less ambitious policy goal than “full employment”). Therefore, we can expect that the Federal Reserve will keep interest rates well below two percent for the foreseeable future.
But how does that work with higher inflation? Does this not mean that the Fed is juggling two conflicting policy goals? On the one hand it wants higher inflation, on the other hand it wants very low interest rates. How does that work out?
It doesn’t. There will come a point when the central bank is going to have to let go of one of these two goals. The problem is that the inflation we will see is going to be monetary in nature, a kind of inflation that is virtually impossible to get rid of unless you turn of the liquidity faucet. That, in turn, will drastically raise interest rates, which will cripple the real sector of the economy.
In its statement above, the Federal Reserve makes clear that our economy has become dependent on low rates. They are correct, and the reason for this dependency goes back to our low GDP growth rates which we are not going to delve into here. What matters here is that the Fed is now caught in a situation it cannot get out of alone. The policy instruments for giving up either of its two goals – higher inflation and low interest rates – are essentially the same; the choice is a matter of policy priorities.
It may very well turn out to be the case that the Fed is unable to make that choice: so long as Congress keeps borrowing profusely (almost 25 percent of its spending already before 2020) the central bank will remain a main funding source for government spending. It cannot give up that role without forcing Congress into rapid, drastic spending reductions.
The Federal Reserve would never do this. Therefore, the choice regarding our nation’s economic future, especially its inflationary outlook, now lies squarely in the hands of Congress. It is unlikely that they will pay any attention to it before inflation actually hits.
Which, as we have been saying here at the Liberty Bullhorn, is going to happen soon.
With the outcome of the 2020 election still in limbo, so is the fiscal future of our country. On the one hand, it looks like the Democrats may be down to a slim nine-seat majority in the House, a majority that could easily fracture with continued ideological battles within that party. On the other hand, the outcome of the presidential election remains unclear, with investigations continuing of what role the Dominion election software played in the vote count.
Then, of course, there is the Senate majority, which hinges on the outcome of runoffs in Georgia.
If the Democrats secure both chamber in Congress and the presidency, we are likely going to see a tidal wave of new spending, funded in part by much higher taxes, in part by the application of Mad Monetary Theory. If the Republicans hold on to the Senate and the White House (assuming that there is substance to the Dominion-related accusations), there will be some measures taken to dampen excessive deficit spending. It is also possible that if the Republicans prevail, the moderates in the Democrat party will be emboldened, enough so to start working with Republicans on spending containment measures.
That is what America needs. It will, however, require Congress to be on quick feet in order to contain our fiscal crisis, primarily because doing so will help us reduce the threat of high, monetarily driven inflation.
I have written about this threat in the past, pointing to monetization as one of three bad ways to deal with a runaway debt crisis. I have also pointed to the threat that excessive money printing poses to our very free-market capitalist economic system, and to how exorbitant money-printing helps inflation the stock market.
This last point is crucial. Vastly inflated equity markets is the first step that an over-monetized economy takes on its route to hyperinflation. The next step is that the money flows into the real sector of the economy and ends up being spent by government and by households. When that happens, the transmission mechanisms of hyperinflation go to work.*
We are not there yet, but the stage is set for it. All we need to do is continue down the current path of completely irresponsible, monetized entitlement spending. (If we really want to fuel the inflation fire, we add tax increases to the mix, as MMT proponents want.) In fact, this transmission mechanism is nothing new: we have seen glimpses of it in the past, partly – curiously – in relation to two supply-side driven tax reforms. This tells us that it is a bad idea to continue down the same path; if we want to get our current fiscal crisis under control, we need to address the spending side of the equation.
Figure 1 reports the velocity of money in the U.S. economy. This metric, which is the ratio of GDP to money supply, shows how “often” we use the same money in order to pay for all our economic transactions in a given time period (usually a year; here the data is reported quarterly). The higher the velocity, the smaller the money supply relative GDP, and vice versa.
A decline in monetary velocity means that more money is idling in the economy. The real problem occurs when the velocity falls below 1, as it means that part of the money supply is not being used at all for the purposes of economic transactions. That money is not going to just lay idle in some bank account somewhere, but will find its way to profits. If there is no transactions demand for it, banks and investors will put it to speculative use. And, as mentioned, in a monetized welfare state, where a big chunk of government spending is paid for with printed money, inflated equity markets are the preamble to high inflation in consumer prices.
- The Reagan tax reform, which was necessary to end the punitive taxation of personal income, did not come with the necessary spending reforms. Furthermore, as David Stockman so pointedly explains in his book The Triumph of Politics, the Laffer Effect upon which the tax cuts relied, was in turn dependent on high inflation to yield the surge in tax revenue needed to close the budget gap. That inflation did not materialize; since spending continued to grow uninhibitedly, the budget deficit prevailed. In response, America had her first encounter with money printing for the purposes of covering up Congressional fiscal excesses.
- In sharp contrast to the 1980s, the ’90s offered fiscal restraint on the spending side, but not on the tax side. Presidents Bush Sr. and Clinton both signed into law new tax brackets, thus destroying the clear, transparent federal personal-income tax code that Reagan put in place. Clinton’s spending restraint worked to his and to America’s advantage, conspiring with a long growth period to close the federal budget gap entirely. Hence, the fiscal demand for newly minted dollars went away and monetary velocity increased again.
- The Bush Jr. tax cuts adjusted some of the errors that his father and Clinton had made. At the same time, the 9/11 attacks injected a big chunk of uncertainty into the economy, causing Congress and the White House to run over to the Federal Reserve and ask for help. The decline in velocity was brief, though, and to Bush Jr.’s credit the economy grew reasonably well during his White House tenure. In fact, if the Great Recession had not happened, we would likely have seen a balanced budget in 2009.
- Then came the Obama years, with the most ridiculously tepid economic recovery in recent memory. That was only partly Obama’s fault – by this time the welfare state had begun permanently suppressing U.S. economic growth – but his administration’s regulatory spree and onerous Obamacare reform certainly did not help. Thanks to the slow growth, the Treasury again started tapping into the Federal Reserve to plug its budget hole: for Congress and the President, Quantitative Easing became a way of life. And monetary velocity started plummeting.
However, all of that pales in comparison to what the coronavirus packages have done to our money supply. The velocity free-fall during the QE years, which was brought to an end by Janet Yellen, has been concentrated into a free-fall this year. For two quarters in a row our velocity has been below one. While the plummet seems to have tapered off, it does not take much to cause it to decline again. Another artificial economic shutdown would certainly do the trick, but even without that we are at great risk if Congress decides to do more “stimulus” spending.
We need a new fiscal doctrine in Washington: structural spending reform.
*) In my soon-to-be-published Socialism or Democracy: The Fateful Question for 2024, I point to this very mechanism: excessive, monetized welfare-state expansion causes hyperinflation.
As I explained last week, President Trump was entirely correct back in the spring when he predicted a V-shaped recovery for the U.S. economy. I also noted that we now have more evidence that the stimulus checks and unemployment bonuses blew out far more cash in the economy than was necessary under the artificial economic shutdown.
Now, though, it is time to issue another inflation warning. There are two mechanisms at work fueling the inflation fire. Both are caused by Congressional overspending, therefore both can be turned off with swift, responsible action by Congress.
If Congress doesn’t act, we are in for a rough ride in 2021.
In my second article on the V-shaped recovery I explained that this cash blowout
reinforces my previously expressed inflation concerns. We could be looking at a food-based surge in prices, which in turn could spread throughout the economy. It has been suggested that the artificial economic shutdown, with its disruptive effects on some supply chains, can be the origin of inflation. This is true only in theory: if we were to have permanent supply disruptions, such as in a centrally planned economy, there would be upward pressure on prices. At the same time, a centrally planned economy does not allow for market prices in the first place, so there is de facto no inflation there. Furthermore, the disruptive effects of the artificial economic shutdown in Q2 were almost entirely gone in Q3, suggesting that the rise in farmers’ earnings could be a sign of monetarily driven food-price inflation (transmitted by the aforementioned sharp rise in entitlement spending). Again, I am not suggesting that we are witnessing monetarily driven inflation. However, I see enough hints that it could be underway to suggest that the next Congress will have to make de-monetization of the economy its highest domestic-policy priority.
A closer look at the national-accounts data for the third quarter add more fuel to the inflation worries. My previous review was of annualized, seasonally adjusted numbers, which are good for analyzing long-term trends in the economy. However, they are not good for closer examination of short-term swings, especially when it comes to such extreme economic episodes as this year’s artificial economic shutdown.
For that purpose, the Bureau of Economic Analysis offers NIPA Tables 8.1.5 and 8.1.6, with quarterly GDP numbers that are not seasonally adjusted. These figures are as raw as they come, giving us one of the best street-level pictures of what is happening out there in the American economy (only surpassed by employment numbers from the Bureau of Labor Statistics).
Using these tables, we can see in closer detail what the V-shaped recovery actually looks like. We also get a not-so-happy picture of inflation numbers, one that we will return to in a moment. First, the recovery itself.
In current prices, third-quarter GDP was $5,318.3 billion. This is total spending in the economy in the three months July, August and September. It was a solid rebound from the $4,901.8 billion in Q2, but even more noteworthy is that it exceeded Q1 GDP by almost $73 billion. That may not seem to be much of a number to write home about – and it could change when the adjusted numbers are released in a few weeks – but it does show that the recovery is strong and our economy is resilient.
As I noticed in my first article on the recovery, we saw a strong come-back for American businesses. Capital formation – investments – rose sharply. In current prices,
- Equipment purchases increased 12 percent from Q2 to Q3 and are only eight billion dollars away from where they were in Q3 of 2019;
- Residential investments – home construction – increased by 16 percent from Q2 to Q3 and were 11.6 percent over their level from Q3 of 2019.
It is also important to note that businesses were back to increasing their inventories. In Q2 they reduced their inventories by more than $88 billion, the largest quarterly inventory decline on record. In Q3, they were back to increasing them again.
Changes in inventories are important. An expansion in inventories during a surge in economic activity is a sign of economic optimism. By contrast, inventory depletion in economic downturns (as we saw in 2009 during the Great Recession) is a way for businesses to liquidate future sales and stem losses.
The artificial economic shutdown was to some degree different. Many businesses were forced by government to cease operations. Albeit temporarily, they nevertheless had limited ability to respond to the demand they had from buyers. Depleting inventories was a way to bridge the shutdown gap.
By doing this, they could essentially keep supply flowing. To again dispel the suggestion that supply disruptions have caused inflation, Table 1 shows that inventory depletion actually correlates with a decline in prices. In short: thanks to inventories there were no significant supply disruptions in the U.S. economy in Q2. Using the two aforementioned tables from the BEA, we can get an inflation estimate for the second and third quarters and see where the inflation pressure is emerging. The “Q to Q” columns report price changes from, respectively, Q1 to Q2 and Q2 to Q3. The “Y to Y” columns report the same numbers for a full year, i.e., from Q2 and Q3 2019 to Q2 and Q3 2020. The picture is quite telling:
Table 1: Inflation estimates
Starting with the quarter-to-quarter numbers, there was an almost universal decline in prices from Q1 to Q2. The decline in prices on consumer goods – which covers everything from groceries to automobiles – of almost a full percent contrasts sharply to the 1.28-percent increase during Q3. Since Q3 was the quarter when the economy opened up, we can conclude that this increase is related to the cash blowout in the economy – and to access to cheap credit.
The low cost of credit is noteworthy. It is a spin-off effect of the massive monetary printing that the Federal Reserve has engaged in for almost a year now. In other words, this money injects inflation into the economy through at least two venues: monetized deficit spending in the form of the stimulus cash blowout; and cheap consumer credit.
We see the price push even more clearly if we disaggregate consumer goods spending into so-called durables and perishables. The former are goods that last for more than one economic period, such as lawn mowers, computers and furniture. Here, prices increased by 2.31 percent in one quarter.
Looking at the year-to-year numbers, the rise in prices of consumer durables in Q3 was enough to wipe out the decline that took place in Q2.
There is another interesting source of inflation, one that will probably be even more important going forward. Prices on consumer services essentially stood still in Q2 and increased by less than one percent in Q3. However, the year-to-year numbers tell us that prices are rising by as much as 1.76 percent here.
Access to cheap consumer credit is less of a driving factor here. More than likely, what we are seeing here is instead a price effect from the labor market: thanks to the unemployment bonus that Congress created in the spring, when the economy opened back up again it was more profitable for people with low-to-moderate income to stay at home than to go back to work. In response, employers have had to significantly raise wages.
I predicted this a bit over a month ago. The numbers we see here are a reflection of how this cost-push inflation is now working its way into consumer prices.
This means, bluntly, that we have two different inflation forces at work: one monetary and one from cost increases. Interestingly, both originate with government. The monetary inflation originates with exorbitant Congressional overspending on stimulus bills; the cost-push inflation originates with exorbitant Congressional overspending on unemployment bonuses.
As of today, inflation is not an imminent threat to the U.S. economy. However, I maintain my warning of more inflation to come: with two sources of inflation at work we will very likely see higher rates in 2021. The only way to quell the drive in prices is for Congress to end its highly irresponsible spending spree.
It has been said that Lenin, the ruthless communist dictator of the Soviet Union, once claimed that if you want to crash a capitalist economy, you destroy its banking system. Whether or not that quote is actually attributable to him is for others to determine; the point, though, is frighteningly accurate. As I explained in my article Credit, Risk and Capitalism, the recent, violently fast monetary expansion is now threatening an essential part of the fabric in a capitalist economy: the tie between price and risk on financial markets.
Our banking system exists to master the price-risk relationship. Once these two variables are separated, the essence of free-market capitalism withers away.
Today we can report more numbers that reinforce the impression that our very economic system is in jeopardy. Before we proceed to examine how the active ingredient of this destructive process – the tsunami of a monetary expansion – affects the stock market, it is worth noting that the Federal Reserve is not the real culprit here. They have printed an inordinate amount of money because Congress wanted extreme “stimulus” spending in response to the Covid-19 economic shutdown, without having to pay the political price in the form of higher taxes.
With that said, let us take another angle to the monetary explosion. Figure 1 reports the velocity of money in the U.S. economy, a variable that tells us what the balance is between money supply and money demand. The velocity is calculated as current-price GDP (representing money demand) divided by money supply (defined as M1):
Figure 1: Velocity, M1 and GDP; Quarterly data at annual rates
The velocity of money has virtually imploded in 2020, illustrating with chilling clarity how the increase in money supply has saturated the economy with liquidity for which there was neither need nor demand.*
Where, then, did the money go? We have been told that it was to cover much-needed stimulus spending, which in turn was needed to plug a big private-sector income hole caused by the Covid-19 shutdown. There is no doubt that many Americans suffered as a result of the shutdown, and as I have explained elsewhere it was the duty of Congress to compensate the private sector for the artificial, government-created disruption in economic activity. However, that compensation vastly exceeded private-sector losses, which in turn means that government has seriously over-sized its stimulus outlays. As a result, the Federal Reserve printed lots of money for which there was no intrinsic demand.
Where, then, did the money go? Figure 2 gives us a hint. It reports quarterly numbers for year-to-year changes in S&P 500 trade value (defined as trade volume times close index) and year-to-year changes in M2 money supply. Note how the two take off as rockets in the first and second quarters of this year:
Figure 2: S&P 500 Index (left vertical axis); M2 Money Supply (right)
Here is a highlight of the past six quarters, with changes to the S&P 500 index in the left column:
In other words, a good part of the newly minted money supply has come to finance equity investments. While the economy went into a severe downturn – artificial but still – the stock market apparently thought it was the right point in time to drastically raise the value of that same economy. The close index was about ten percent higher in May, June and July this year than last year, with trade volumes exceeding previous-year figures by 38-85 percent.
The rally has subsided somewhat in recent months, but both close index and trade volumes still exceed 2019 numbers. In short: the stock market is in love with 2020, and a good part of the reason is that the Fed’s money printing presses are working overtime.
Which brings us to the dire problem embedded in these numbers. Since there is no macroeconomic value to motivate this stock-market rally, its sustainability is entirely dependent on the Fed’s decisions going forward. We know already that the central bank has no plans on turning off the money faucet, but for a host of reasons this monetary fueling of equity prices is entirely unsustainable. It will collapse by the weight of its own over-inflated might.
Unless, of course, the money printing first causes hyperinflation in the economy. Which, again, is now a possibility – not probability but possibility – we have to consider.
There is only one way to kill this monetary inflation vortex: drastic reductions in government spending. Will that happen? We’ll see.
*) The terms “need” and “demand” are used deliberately. The difference is too intricate to cover in a blog article, but will be explained upon demand.
The excessive borrowing by the federal government in response to the Covid-19 economic shutdown is beginning to show up in economic statistics. As I have explained already, there was no need for the stimulus checks, and the combination of those checks, the unemployment bonus and excessive monetary expansion to fund the Gargantuan deficit may create a perfect storm of inflation.
The monetary component in this inflation threat is particularly serious. Other forms of inflation can usually be dampened with fiscal policy and other real-sector measures that allow the economy to return to price stability. Monetary inflation, however, creates a pricing pattern in the economy that is immune to such measures. Non-monetary inflation forms, often referred to as demand-pull and cost-push, depend on pricing of goods and services in various parts of the economy. By contrast, monetary inflation injects purchasing power into the economy that has no ground in any real-sector activity whatsoever.
Before we look at some frightening numbers on our monetary expansion, a note is needed on why high inflation is so dangerous. We have not had an experience with it in America, which very likely has insulated our policy makers against the dangers that come with it.
Technically, higher inflation means that prices are marked up by bigger percentages than usual. The higher the inflation rate gets, the larger the price increases in any given year. Furthermore, when inflation rises past a “breaking point” – somewhere in the bracket of 10-50 percent inflation – price setters start making price changes more frequently than otherwise. This results in an acceleration of the inflation rate by virtue of the “compound interest” effect.
The pricing frequency shortens because price setters do not want to be wrong in their price expectations. For every pricing period there is an expectation of how much prices will rise in general; if the price setter learns that he has under-estimated inflation, he will mark up his prices more, and more frequently, in the future. The higher inflation climbs, the steeper the price for being wrong about it: high inflation feeds expectations of higher inflation, which in turn feeds a behavior that makes those expectations come true.
Plain and simple, high inflation becomes a self-fulfilling prophecy. Monetary inflation is the most dangerous type of inflation, driving the rate of price increases up faster than any other form. Therefore, it is also the inflation type that most rapidly gains a momentum of its own. This is why our history is full of hyper-inflation episodes driven by reckless monetary expansion.
We are far away from hyper-inflation, and chances are we will never get there. However, every path to runaway prices hikes begins with a first step – and we have now taken that step. Figure 1 has a frightful story to tell:
Figure 1: M1 Annual Monetary Expansion
Source of raw data: Federal Reserve
The liquidity that has now been pumped out in the U.S. economy has to go somewhere. Transmission mechanisms between the monetary and the real sectors have already gone to work, and will continue to work their way spreading this liquidity. Since this money is printed out of thin air, it does not constitute payment for any real-sector transactions, but it just dropped into the real sector in the form of a massive line of credit.
Bluntly, spending materializes out of thin air. The real sector of the economy is suddenly supposed to respond to spending that no intra-real-sector transmission mechanisms have accounted for. The result will be a spike in prices.
I am not going to speculate in how high our inflation rate will be as a result of this monetary expansion. What we can say with certainty, however, is that our path to high inflation will be determined in the near future. If this enormous increase in money supply is at least partly reversed in the second half of this year, we may have dodged the inflation bullet. If not, we are in trouble.
The Republicans in the House of Representatives have put together a task force to study U.S. and Chinese military capabilities. In reporting on their findings, Representative Liz Cheney (R-WY) explains that Congress needs to increase defense spending by 3-5 percent per year – in real terms – to keep our military on top of the game.
This is a tall order, but a necessary one: national defense is the first priority of government, one that we should fund in full before any other functions are considered. That, of course, is not the case today, which reduces defense spending to an item in the budget like any other: less than 15 percent of federal spending goes to defense today, compared to half of the budget 60 years ago.
In other words, by promising to do almost everything under the sun, Congress has already made it harder for itself to fund defense. However, there is another problem that Representative Cheney and the others in the Republican leadership need to consider if they want to reach their necessary but difficult funding goal: inflation.
As I explained recently, there are forces at work in our economy that point to higher inflation going forward. It is entirely possible that we will see four percent inflation next year; higher numbers are unlikely this side of 2022, but over the long term, higher inflation is more likely than lower inflation.
An inflation rate of four percent would of course make real increases in defense spending very hard. For every percentage point of inflation, Congress needs to add approximately $7.5 billion to the defense budget just to protect the military’s purchasing power. At two percent inflation – which is basically where we are today – that means $15 billion more for defense, without even adding any new real money into their budget.
Currently, Congress is giving $45-55 billion more per year to the Department of Defense, which means about four percent in real terms. However, the increase in appropriations is scheduled to taper off as we go forward, falling below two percent beyond 2022. In real terms, this means that defense spending is actually going to go backward.
And that is at the current inflation rate.
The problem is, as mentioned, that there are forces at work in the economy that are driving the inflation rate higher. To make matters worse: Congress is responsible for both of them:
- Cost-push inflation. As I explained recently, the cost of labor is going up at rates we have not seen in at least ten years. This increase is not caused by high growth or rapid gains in productivity, but by the wage toll that the federal government has placed on the labor market. That toll, of course, is the bonus that Congress is paying out to the unemployed: the $600 weekly compensation on top of regular unemployment has dropped to $300, but it is still there. To motivate workers to come out of idleness, employers therefore need to pay their workers more than what is motivated by the value they add to the business. The only way employers can make up the balance is by raising prices.
- Deficit monetization. Congress is borrowing money at rates we have not seen in peacetime, and the Federal Reserve is printing money faster than it has ever done on record – and everything suggests that they will keep the monetary printing presses working overtime for the foreseeable future. Even if the money-supply growth rate tapers off, it will nevertheless keep growing for as long as Congress maintains its enormous budget deficit. Money printing eventually leads to monetary inflation – the most dangerous form of inflation.
To add yet another warning signal of pending inflation, the Federal Reserve has “modified” its inflation goal. It is no longer looking to maintain a two-percent cap on inflation: the goal is now to keep inflation at an average of two percent, without any specification of the period of time over which that average will be calculated.
In plain English, the Federal Reserve has decided to prioritize the funding of the budget deficit over low inflation. This will have serious consequences for the economy over time; for now, it is a major problem for Congress itself – where the monetized inflation originates. Looking again specifically at the defense budget, to protect the real value of DoD procurement and employment checks, at four percent inflation our elected officials will have to add $30 billion per year to the defense budget.
If we get bad monetary inflation, in other words prices go up around ten percent per year, that $30 billion becomes $75 billion. And those numbers are calculated solely based on current spending; compound inflation is not considered. Then comes the fight to actually increase the defense budget by 3-5 percent in real terms.
Common sense – and a dollop of political cynicism – suggests that with the defense appropriations being less than 15 percent of the federal budget, and the welfare state consuming more than two thirds, it is fairly simple to see where the Congressional priorities will be – especially if inflation starts eroding entitlement checks. Therefore, the message to Republicans in Congress is clear, cold and unmistakable:
Entitlement reform – now. Roll back your promises of economic redistribution.
Otherwise, your only choices will be from the list of three bad options I discussed earlier. Not one of them will benefit our national defense.