Monday, December 01, 2008

Inflation for the Long Run? Don’t Count on It!

There is a lot of talk these days about deflation, which is a general decline in prices. We worry about persistent declines in prices because they encourage consumers and businesses to delay purchasing goods, services and capital since the price tomorrow will be lower that the price today. This, of course leads to increased unemployment, decreased corporate profits, and downward pressures on the nation’s gross domestic product. While we have experienced deflation in most commodities of late (the producer price index, ppi), be certain that it won’t be persistent, nor will it result in deflation in terms of consumer prices (the CPI).

The current crisis has forced (or encouraged) our government to add trillions of dollars to our current national debt, which just passed the $10 trillion mark much faster than expected. This year the U.S. budget deficit is expected to top $800 billion. Coupled with possible tax cuts in the short-term future, increases in government spending on public works, and promises of an additional stimulus package, a potential disaster, in terms of inflation, looms in the future. A former chief auditor of the federal government said it best—the first thing you need to realize about the government is that they have no money.

You can’t lower taxes while piling on debt, increasing government spending, and adding another stimulus package without expecting someone to pay for it in the future. Two government actions in the future will surely dampen the prosperity of X and Y-ers as they age in the work force.

There are only three paths available:
1) To pay for its future obligations, the government can print more and more money which depreciates our currency (the $ will be worth less in real terms) making foreign goods more expensive in the U.S. Accordingly to the quantity theory of money, MV = PQ where M is the money supply; V is velocity of the money supply or how fast the money turns over; P is the price level; and Q is the level of goods and services or output. Thus, if velocity is fairly stable over time-which it is- and output increases at a pace of 3 percent to 5 percent, prices will make up the difference. Thus if the money supply grows by 10 percent, prices will increase by 5 percent to 7 percent. Not only is this not deflationary, it is inflation at a pace well beyond the level that is acceptable. http://en.wikipedia.org/wiki/Quantity_theory_of_money

2) Taxes will be raised in future years to pay off the debt and interest on the debt.

3) Interest rates will rise as the government issues more debt to pay interest costs and to retire the old debt.

Thus, any signal of deflation in prices now is a façade; expect higher prices in the future (maybe double digit inflation for some time) and a dollar that will be more useful in starting fires than buying a loaf of bread (nothing like a little hyperbole to bring the point home). When will this occur? Not until 2010 when U.S. Treasury Paulson is lounging on a beach in Hawaii sipping on a Margarita.

Aaron Konen and Ernie Goss

7 comments:

Marty said...

I do not agree that taxes have to be raised to pay off the debt. We have seen in history that lowering the tax rate and a robust economy can actually raise tax revenues. I think that is one of the fallacies in government policy. Need more revenue, raise taxes. What about lowering taxes and receiving more revenue from a robust economy?

Aaron Konen said...

True, the Laffer curve (http://www.investopedia.com/terms/l/laffercurve.asp) states that lowering taxes can raise revenues. However, this only works if your tax rate is on the high end of the spectrum (like France, for example). Our tax rate is relatively low compared to other developed nations, so this argument doesn't necessarily hold.

Anonymous said...

The federal government might not necessarily need to raise its tax rates. Rather they could make a few smart moves to bring the tax rates to Regean levels. Most concervatives would be able to stomach this since Regean is in their opinion a great President.

Martin Maness said...
This comment has been removed by the author.
Marty said...

Our corporate tax rate is one of the highest.

CU's MBA Finance Class Fall 08 said...

Our corporate tax is one of the highest, but this is only a portion of tax revenue the gov't collects. You need to look at corporate, personal, sales, and property taxes in aggregate. When you add these up and look at them as a % of yearly income, the total tax rate in the US is much less than many developed countries, like western Europe, for example.

Anonymous said...

Yup, our tax rate is low by U.S. historic standards so it would be tough to use Laffer curve concepts here.