I have recently written several ties that one of the many reasons Obama is rushing his agenda is the realization that his massive deficits will eventually lead to inflationary ills, such as skyrocketing prices, vanishing capital markets, soaring interest rates and so on.  The one thing that puzzled me was that no signs of inflation had appeared yet. But today, while responding to a comment, I realized what I had overlooked, inflationary consequences are happening, they are just hidden.

First, let me explain why inflation should be a problem.

The bailout, being funded through deficit spending, could be funded one of two ways. First, treasury bonds could be sold to the public to fund it, but that has usually been a small minority of our funding, with the exception of the Reagan era when it was the predominant financing method, at least part of the time. Far more common is to issue special bonds, bought by the Federal Reserve system through the creation of new credit accounts. The mechanism is a bit complicated, but, in the end, for every dollar of deficit financing, two to three dollars of new credit can be created, meaning that our trillion dollar bailout could support about two to three trillion dollars of new money. As the money in the system is now about fourteen trillion, that means a fifteen to twenty percent increase in the money supply,

Of course quantity is only part of inflation¹. If we were dealing with inflation due to the quantity of money, the explanation would be easy. Most of our spending has not taken place, so prices have not risen. But expectations are a huge part of inflation. The anticipation of more inflation is why hyperinflationary prices run far ahead of the increases in quantity, or why small, isolated increases often cause little or no change in prices. As the market must already expect the trillion dollar expansion, as well as future expansions from the expanded programs in coming years, I would expect much of that inflationary pressure to appear before the money itself comes into existence.

But it hasn't.

Or rather, we haven't noticed. You see, what I forgot was that we are also in the middle of an economic slump brought about by past inflation², and, as a consequence, prices are already depressed due to lowered demand. Similarly, the capital markets are sluggish due to a lack of demand for new venture capital or expansion of existing firms. And so, it is quite possible that we are seeing some early inflationary increases, but they are simply masked by the greater downward pressures brought about by the lack of economic demand.

On a positive note, this does indicate two bit of good news.

First, that one function of the bailout failed. One reason the bailout was so large, and financed through creation of currency, was the Keynesian belief that deficit financing stimulates activity. And this has been supported in the past when new inflation checked deflationary crises in the dot-com bust, and the 2001 crisis. However, it only does so by creating a greater future crisis (such as the one today). And, at some point, you reach a position where additional inflation simply cannot dig you out of the hole created by past inflation. That is, thankfully, where we are now, and hopefully Obama's economists will recognize it and not try any additional inflationary solutions³.

Second, we have dodged the hyperinflation bullet. In past posts I have worried that attempts to inflate our way out could kick off hyperinflation, and even in the early stages that can be hugely destructive. And while that would have been good politically, as a repeat of "stagflation" or worse would have ensured a single term for Obama, I have to say I am glad we avoided the harm that hyperinflation, even the mild early stages (such as Carter's "stagflation") would have caused.

Then again, this also bodes ill for a quick recovery. Once the economy begins to recover,and demand recovers, we will probably be hit with the full force of all that accumulated inflationary increase in both prices and interest rates. And should Obama still be in office, or anyone else expected to engage in large scale deficit spending, add to that any expectations about future inflation as well.

So, while we might have dodged the bullet in terms of the biggest problem, hyperinflation, we still have some more hard times to anticipate. And, while I say above that hopefully the failure of the bailout has discouraged more efforts, I can't be certain of that. After all, some administration members have been talking about the first bailout being too small, so there is always the threat of even more deficit spending, piling up more and more inflationary damage, just waiting for the economy to recover a little⁴.

So, I suppose, I should just end on an indefinite note, and say "We will see."

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1. I don't think any still ascribe to the strict quantity theory of inflation, so I doubt I need to spend any effort on debunking it. Then again, some neo-Keynesians do seem to subscribe to a modified version, finding inflationary pressures in their imaginary "multiplier", thinking prices rise due to an increased "velocity" of "circulation", blaming inflationary price increases not on the creation of currency but on the number of transactions through which that currency passes. Debunking that is beyond the scope of a footnote, but let me ask this, to highlight how much less sense this theory makes than even the most simplistic quantity model: If I charge $1 for an apple, does it matter if I sell 10 or 1000? Or will I change my prices if they make 10 trades among themselves? Or 10 million? How does the number of transactions change that price? But if my customers have twice as much money, it is likely I can double my prices.

2.  I know many blame the housing bubble or Wall Street or something else, but underlying any specific details is the simple fact that inflation causes distorted economic signals which lead to such problems, or exacerbate them. Our crisis, whatever the superficial cause, is the result of inflation.  (Eg. The housing bubble was the result of inflationary price escalation, thus inflation lies behind the bursting of that bubble.) (See Postscript for a list of articles discussing this.)

3. As I mention elsewhere, this is not guaranteed, as some apparently think that the current bailout failed only due to being insufficiently large. So we might still see more attempts to solve our problems through inflation.

4. If the administration should try yet another bailout then we could yet see hyperinflation. We did dodge it for the moment, but any additional inflation, or any change in expectations could renew the threat.

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POSTSCRIPT

The following, lengthy, list contains all my writing on inflation after "A Reason to be Afraid", earlier posts can be found in the very lengthy postscript to that article:

A Reason to be Afraid
Michael Barone Gets His Economics Wrong
The Problem With Economic Debate
A Question of Perception
Defying Nature
Thomas Sowell Imitates Me
A Sober Look at the Economy
Borrowing Versus Taxing
My How Things Change
Alan Greenspan's Hubris
AIG Absurdities
Planning For Imperfection
Weimar Republic Here We Come!
Elevating Mob Rule
How Does This Work?
AIG Nonsense
Inflation and Uncertainty
Very Good Article
Geithner's Problem
Derivatives and Other Investments
Do I Need to Comment?
Something to Keep You Awake
How AIG and GM Ruined Any Chance at a Less Intrusive Bailout
The Problem With The Auto "Bailout"
When You're Right, You're Right
A Thought on the Clinton Surpluses
At Last!
WSJ Misses the Mark AGAIN
Place Blame Fairly, Regardless of Party
"Good People"
Subsidizing Irresponsibility and Poor Planning
He Said It At Last!
Too Big To Fail
Why Gold?
Proof Keynes (and Krugman) Are Insane
Shopaholic Government
All the News That's Fit To Invent
Treasury May Be Doing the Right Thing
Signs the Fed Is Not Getting It Right
Living Large During the Good Times
Specious Argument
The Rubber Yardstick
Trashing the Economy
Does It Matter?
Surprising
Mixed Blessing
Numbers Aren't Always What They Seem
Mathematical Deception
More Signs of Inflation?
Even More Confirmation

For those who doubt my claim that our current crisis is inflationary in origin, I would recommend starting with "Place Blame Fairly, Regardless of Party",  "A Thought on the Clinton Surpluses", "Not Entirely to Blame", "Explaining Past Crashes", "Alan Greenspan's Hubris", "The Inflation Engine", "Inflation and Uncertainty", "A Final Comment on the Futility of a Bailout", "History Repeating Itself", "Revisiting Old Thoughts on Our Economic Situation" and "Our Financial Problems". It is a long list, and there is certainly quite a bit of repetition among the articles, but I think taken together they make a strong case for the part inflation, on the part of presidents and congresses of both parties, led to our current situation.