Guest post: Paul Kasriel on fiscal deficits and inflation

Today I had the pleasure of exchanging a few emails with Paul Kasriel, Chief Economist of Northern Trust. Paul is in my opinion one of the greatest economic forecasters around (you can read him here). I don't think he would disagree if I said he is a great student of Friedman and Hayek, and that he knows what is money and what is inflation. Here is what I asked him and his response:

RK - Some economists argue that money and government bonds are near-perfect substitutes in an investor portfolio. Thus, they conclude, large fiscal deficits will result in higher rates of inflation, whether or not the central bank lets the money supply grow very fast or not. What is your opinion of this theory?

PK - I do not understand the argument. If the government sells the public bonds and the banking system (including the central bank) does not create the credit for the purchase of these bonds, then the public is transferring purchasing power to the government. The public cuts back on its current spending and the government increases its current spending. In contrast, if the banking system creates the credit for the public to purchase government bonds, then the public does not have to cutback on its current spending and the government can increase its current spending. This would be inflationary. In the former case, the Austrian economists refer to this as "transfer" credit inasmuch as purchasing power is transferred from one entity to another. The Austrians refer to the latter case as "created" credit in that the banking system and central bank create credit, much like a counterfeiter, enabling one entity to increase its purchasing power while not necessitating any other entity to cut back on its purchasing power. Perhaps I am missing something in the argument of these economists who believe that government debt issuance is inflationary in and of itself.

Those economists I mention (they seem actually to be a majority of economics scholars), believe that a dollar is a dollar, is a dollar. But if you issue a bond, someone has to cut its spending in order to buy it. Also, why not extend the theory and include AAA rated private bonds to government bonds? And while you're at it, just throw in all investment grade bonds.

To conclude, Japan seems to provide a pretty convincing evidence for Paul's point of view. But as he says, maybe we're missing something?