Rising national debt raises prospects of eventual inflation

Inflation is as dead as the Wicked Witch of the West in a waterfall. The consumer price index has actually fallen 1.3% in the past 12 months. So why is everyone so worried about soaring prices?

In a word: debt. The government owes the world $11.4 trillion — $37,000 for every person in the U.S. In the next fiscal year, the government will add $1.8 trillion to the deficit.

The government could simply print more dollars to pay off our debts with cheap currency — a tempting but inflationary solution. Politicians wouldn't have to ask citizens to pay for the government's services, and citizens wouldn't have to think about the actual cost of what they demand — until, of course, the currency collapses, interest rates soar and the economy craters. Some on Wall Street are betting on just that scenario. Universa Investments — linked to Nassim Nicholas Taleb, author of Wall Street's biggest book, The Black Swan: The Impact of the Highly Improbable— is adding strategies that will soar if inflation takes off. Respected hedge fund adviser 36 South Investment Managers is raising $100 million for a fund that will bet on soaring price increases. And Marc Faber, editor of the Gloom Boom & Doom Report, a newsletter, predicts that U.S. inflation will someday match Zimbabwe's — that would be 236 million percent a year.

If inflation does hit, it won't be this year, barring a major jump in oil prices or a drastic change in government philosophy. You don't get inflation in an economy that's as slack as this one. And, many economists say, the Federal Reserve has many tools to contain inflation once the economy turns around. But one thing the Fed doesn't have is the ability to control federal spending. And that, ultimately, could be the thing that pushes the inflation rate higher.

Not now

If you're worried about inflation rearing its ugly head soon, relax. Inflation just isn't going to happen in this economy. "A lot of the worries about immediate inflation are examples of financial illiteracy," says David Wyss, chief economist for Standard & Poor's. "You won't get inflation until the economy gets back, and that's at least five years out."

The ultimate cause of inflation is an unwarranted increase in the money supply. The key word here is "unwarranted."

A normal inflationary spiral starts when the central bank increases the money supply even as the economy is rising. It's like piping oxygen into your barbecue. When the Federal Reserve increases the money supply, generally through lower short-term interest rates, businesses can easily borrow and expand. As companies prosper, they pay higher wages to attract new employees and retain old ones. Employees, in turn, spend more — which increases demand, and prompts companies to raise prices.

If the central bank doesn't step in and raise rates to cool off the economy, it can set off a wage-price spiral. And at the very worst, it can trigger hyperinflation, when the government prints more and more money, devaluing it to the point where a wheelbarrow is more valuable than a wheelbarrow full of cash.

To get to inflation, however, you need a humming economy, and the economy is barely breathing. For employees to demand higher wages, unemployment needs to be less than 5%; it's 9.4% now and widely expected to break above 10% this year. For demand to outstrip supply, factories have to be running at full capacity. Factories ran at 68.3% of capacity in May, the lowest since the Fed started keeping statistics in 1967.

"In this environment, we anticipate that inflation will remain low," Fed Chairman Ben Bernanke said in testimony on June 3. "The slack in resource utilization remains sizable, and notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008."

But later

The government's plan is to fight the sour economy now by spending money, and worry about the debt problem later. "If that's the price to keep from having the second Great Depression, it's a bargain," say Ken Goldstein, economist at The Conference Board.

Even ardent supporters of the government's plan, however, worry that massive U.S. debt could be inflationary. Every day, for example, the U.S. needs to borrow $15 billion to fund the deficit, says Axel Merk, portfolio manager of the Merk Hard Currency fund. "Someone has to buy all that," he says. More important, the U.S. has to repay it.

Inflation is a tempting choice to pay the nation's staggering debt, especially because the alternatives are to raise taxes or cut spending. Already, some economists are suggesting letting inflation take some of the bite out of government spending.

Kenneth Rogoff, chief economist at the International Monetary Fund, gently told Bloomberg News that a bit of inflation might be a good thing. "I'm advocating 6% inflation for at least a couple of years," said Rogoff, now a professor at Harvard University. "It would ameliorate the debt bomb and help us work through the deleveraging process."

The effects of inflation are cumulative. After five years of 6% inflation, $1 trillion would be worth $734 billion, a 27% drop. Even a 2% inflation rate would be a cumulative devaluation of 81% over 30 years.

And, at least initially, a bit of inflation would be welcome. "If you have debt, you love inflation," says Merk. Workers would get bigger raises, home prices would increase, and 30-year fixed-rate mortgage payments would remain the same.

Not-so-good long view

But any sustained burst of inflation would have some ugly long-term effects:

•Higher interest rates.The Federal Reserve typically raises short-term interest rates to cool off the economy and tamp down inflation. Even if inflation remains tame, the Fed will eventually have to return short-term rates to normal — about 3% to 5%.

Other interest rates would rise, too. Bond traders, for example, loathe inflation, which eats away at the spending power of bonds' fixed interest payments. When inflation looks likely, bond traders demand higher bond yields — and higher long-term rates can also act as a brake on the economy, raising payments on everything from corporate borrowing to home loans.

•A lower dollar. The value of the dollar on the international currency exchanges is another measure of inflation. If foreign investors think the U.S. is inflating its currency, they will demand more dollars in exchange for other currency — say, the euro or the yen.

A declining dollar makes imported goods more expensive, although it makes U.S. exports more attractive.

"There's likely to be long-term decline in the dollar; that's generally inflationary," says Mihir Worah, head of inflation-linked bond trading at Pimco, the West Coast bond powerhouse.

The nightmare scenario is that the dollar loses its pre-eminence as a world currency.

Oil, for example, is traded only in dollars, and in times of panic, investors always rush to the safety of the sawbuck. If investors — especially foreign investors — dump dollar-denominated investments, the U.S. will have to offer much higher interest rates to sell its debts. And that could have the economy grinding to a halt.

Worah doesn't think that's likely.

"I see zero chance of the dollar being replaced in global markets," he says. Goldstein doesn't think foreign investors are likely to dump the buck, either. "Where else are they going to go?" he says. The Japanese and Europeans are drowning in debt, too.

But as the deficits grow, the threat of inflation — with the problems that it brings — grows, too, if only because the measures the country needs to take to prevent inflation are so difficult. There are only three ways to cut the debt: raising revenue, cutting expenses or inflation.

Will the nation cure its debts by raising taxes and cutting spending?

"Sure," says Merk. "And then we will all fly to the moon." Otherwise, he says, "Inflation is the answer."