This is a lesson that most people in the developed world do not understand, however, their counterparts in the developing world understand all too well. There is a relationship between government deficits, debts and inflation, but it is not a straightforward one. Because of this, it is a good idea to review what we know.
Inflation is always bad, deflation is always good.
To begin with, let’s get one thing straight. Inflation is simply too much money chasing goods. Deflation is goods chasing too little money. Now, the concept of “too much” and “too little” are there so that you understand what central banks are doing. They are not there as a suggestion or recommendation that the amount of money needs “adjusting” or “managed” in any shape or form.
Therefore, when we have inflation, we constantly need more money to buy the same amount of goods or services. When we have deflation, we constantly need less money to buy the same goods and services. Inflation robs us while deflation gifts us. Inflation is caused by central banks while deflation is caused (mostly) by an efficient and free market.
The reason is simple, only central banks control the amount of money in circulation, and they almost always create more to accommodate their political master’s wishes. This is so bad, that many countries now have “inflation rate targets” in the area of 2% per year. This is like saying that for a healthy patient we need a constant fever of about 2% over its normal body temperature. Yes, it is that ridiculous! Yet, there you have it; official policy.
An efficient and free market creates more goods and services at cheaper prices through competition and therefore people need to spend less money to get the same amount of goods and services. A free market cannot create money; it can only attempt to dull the impact of their creation.
It is clear now who the good and bad guys are.
We have seen this process in action in our lesson Senseless Inflation and Interest Rates but we have not explained its relationship with deficits. We are correcting that shortcoming here.
Bonds
When our political masters and their drones at central banks have not managed to mess up the free market too much, they attempt to control interest rates and inflation by buying and selling what are essentially bonds.
Bonds are simply the terms at which a person borrows money. If I sign a document saying that if you lend me 100 euros I will return 110 euros in one year, this document is a bond and it’s interest rate is 10% over one year. Both of these parameters matter, the interest rate and the expiry term.
Of course, the market does is slightly differently and there are complex relationships between a bond’s interest rate and its price in the market. We will not concern ourselves at this time with those since for this lesson, it is not necessary.
When times are good
When governments have a happy spending time, they always overspend. In other words, they spend more than what they collect in taxes. We have explained the reasons for this effect in several other lessons and so we won’t repeat them here again.
Therefore, they are left with only one massive way to get money: borrow. They do so by selling bonds. There are three possible markets to sell bonds to:
- Citizens
- Countries
- Banks
If they sell to citizens, this is not inflationary (yet) because they are receiving money from the people. People takes the money out of the bank, gives it to the government which spends it on other people who return the money into banks. This does not create new money.
If they sell to countries, this is not inflationary (yet). This is so because the bond buying country simply buys bond currency in the market and uses it to buy bonds. For example, if Brazil sells bonds to Venezuela, Venezuela takes its currency (a Bolivar) and purchases Brazilian currency (a Real) in the Forex market from banks. Then, they use these Reales to buy Brazilian bonds. The Brazilian government spends this money which returns to banks. This does not create new money.
If they sell to private banks, this is an entire different story. Let’s say that a central bank wishes to create 100 Giga morlocks (Morlock being the name of the currency) out of thin air. This central bank uses its own accounts to purchase 10 Giga morlocks of existing bonds from banks. The banks receive this money, which they use as a “reserve” to create 100 Giga morlocks out of thin air. They are allowed to do so thanks to the wonders of the “fractional reserve system”. Then, these banks use this new money to purchase 100 Giga morlocks from the central bank. The central banks passes these morlocks to the politicians who promptly spend them. These new morlocks then are stored in banks by the sellers of goods and services to the government. Voila! 100 Giga morlocks were created out of thin air. This does create new money and it is therefore inflationary.
Hence, for as long as the debt is small and central banks sell bonds to citizens or other countries, this is not inflationary. However, when these central banks sell to their own banks, this is inflationary.
So the question as to whether or not deficits are inflationary in good times, must be qualified by asking to whom are central banks selling bonds to.
Note: please see the Glossary if you are unfamiliar with certain words.
Continue to Deficits Debts And Inflation - Part 2