Fighting the recession will not be without its costs.
Washington has already racked up nearly a $2 trillion deficit to ensure that America’s credit crisis does not lead to a replay of Japan’s lost decade of economic growth. But it’s not the specter of Japanese deflation we should fear. Far from it. History shows unequivocally that it is reflation, not deflation, that is the dancing partner to these size public deficits.
Saddled with a deficit that will mortgage the future of a generation of taxpayers, Washington will turn to what it has always done to alleviate such fiscal burdens. It will monetize the deficit, using the subsequent burst of inflation to rob bondholders of their real return. While the bonds will mature at par, what that buys may be a whole lot less than what the bondholder expected, thanks to the inflation trail that always follows in the wake of financing such mega-deficits.
Bondholders who financed America’s World War Two deficits saw their bonds lose nearly 15 percent of their real value in the ensuing inflation that peaked at around 17 percent in 1947. Bondholders who financed the Korean War also lost from inflation, which quickly went from negative territory to almost 10 percent. And twenty years later investors were once again swindled by reflation out of their return from financing the deficits that arose during the Vietnam War. Inflation robbed those bondholders of nearly a third of their real return. The later two deficits were less than half today’s in relation to the size of the US economy.
Monetizing deficits, which is simply printing more money to pay for them, is particularly attractive for a country like the United States, whose greenback is still the reserve currency of the world. The fact that other countries want to hold your money allows you to sell them bonds that are denominated in your currency. That obviously gives the borrower a huge advantage, because the creditor is at the mercy of the borrower’s exchange rate. The easiest way to stiff a foreign creditor is through devaluing your currency. And the higher the inflation rate that a country runs, the more its currency will devalue.