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Trump's Ideas About the Deficit Sound Inflationary

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Donald Trump is difficult to take seriously on policy matters, because he’s kind of a random idea generator -- he just throws out a lot of different policy plans, many of them contradictory. This is a great defense against criticism from policy wonks -- as soon as we criticize one of his proposals, he just offers up the exact opposite. For example, he’s advocated reducing the federal debt, spending more and cutting taxes (or possibly not).

So while we can’t evaluate Trump on the strength of his proposals -- since he will just do a 180 next week -- it’s still interesting when Trump tosses out economic ideas that are rarely suggested in American politics. This gives us an excuse to talk about interesting things that we otherwise probably would ignore.

One example is Trump’s recent statements about the national debt. At first, he suggested a sovereign default. That idea was met with almost universal condemnation, since a government default is very damaging to a nation’s economy. Even those who believe -- wrongly, in my view -- that the debt is a problem don’t think that a default is a good idea. Fortunately, interest rates didn’t rise after Trump’s comments, indicating that the bond market doesn’t believe that Trump has much of a chance of ever following through.

And true to form, the next week Trump reversed himself. Instead, he suggested that the Federal Reserve could just print money to pay off the debt, instead of defaulting. “You never have to default because you print the money,” he declared.

That’s interesting, because Trump is right. Lots of countries are in a position to just print money to pay off debt. Many people claim this can only be done by countries that borrow in their own currency (as the U.S. does), but any country can do it as long as it has a printing press and a foreign-exchange market. If your debt is in euros, and you can print dollars, you can print dollars and trade them for euros in the foreign-exchange market, and use those to pay off what you owe. Only if foreigners stop accepting your currency for any price at all will you be forced to default. If your debt is in dollars, then it’s even easier -- just fire up the presses and pay it off.

The question is whether this is a good idea. Many economists believe that if you print a lot of money, inflation will go way up. That makes sense, since usually if you increase the supply of something its value falls -- inflation is just a decrease in the value of a currency in terms of real goods and services. So there’s a fear that if the U.S. starts paying off the debt using printed money, the result could be an inflationary spiral -- everyone raises prices because they expect everyone else to raise prices. That in turn could explode into hyperinflation, a rare but terrible phenomenon in which a currency essentially becomes worthless, wrecking the economy in the process. Venezuela is experiencing this now, and it isn’t pretty. Hyperinflation would be even worse than default.

But many people now believe that the danger of hyperinflation isn’t as big as economists believed in the past. The Fed doesn’t actually control the money supply -- it’s controlled by banks. If Fed money creation is balanced out by private banks withdrawing money from the economy, then money-printing almost certainly won’t cause hyperinflation. This is exactly what has been happening in the past few years. As the Fed has created unprecedented amounts of money through asset purchases under its quantitative easing program and swelling the monetary base, the money supply has increased at a modest and steady pace:

And even if the money supply does increase, inflation still might not result -- people might spend their money less frequently, leading to muted pressure on prices. This has also been happening recently. More dollars in the economy has led to a collapse in the frequency with which dollars are spent (known as the “velocity” of money):

Some people believe that this process can go on forever -- that the Fed can keep printing money to pay off the national debt, and banks will just stick that money in their vaults, keeping a lid on inflation. The school of thought that believes this goes by the name of modern monetary theory, or MMT. It’s typically associated with leftist politics -- in fact, Stephanie Kelton, a leading proponent of MMT, is an adviser to the presidential campaign of Bernie Sanders. So as Matt Yglesias notes over at Vox, this is another case of Trump-Sanders policy convergence.

I’m a bit more skeptical. Hyperinflation, like a stock-market crash or a bank run, is a phenomenon that depends crucially on people’s expectations of what other people will do. If everyone thinks that no one else will spend their dollars, inflation stays low. But if some people start to believe that other folks are about to go out and spend their stockpiles of cash, they will respond by doing the same, so they can buy things before prices start to rise. That will turn inflation into a self-fulfilling prophecy. And just as with bank runs and stock market crashes, we know that expectations can shift very quickly and catastrophically. Hyperinflation is like a bank run on a national currency.

So although the danger of hyperinflation looks very remote for now, a President Trump might change that. If he successfully pressured the Fed to start supporting infinite government borrowing, expectations might suddenly snap, and hyperinflation could result. It’s a risk I’d rather the U.S. didn’t take.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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