~~ by Sven Larson~~

Now that Republicans and Democrats have agreed to reopen the federal government, the U.S. Treasury again is free to borrow money on overtime. Stubborn spenders in the White House and Congress evaded the deficit problem, agreed to punt for a few months and let ObamaCare go into effect.

Long term, this may have been a good outcome for the Republicans as voters now get to feel the full impact of ObamaCare on their lives. However, from a macroeconomic viewpoint it was not at all what we needed. The deficit punting is going to feed expectations of a future debt default – and expectations of inflation.

Global investors are already worried about the U.S. debt. They have forced the federal government to pay more for its debt than what some European countries pay. In fact, investors believe that countries in the turbulent eurozone are less likely to default on their debt than the United States is – even though their immediate debt crisis actually is worse than ours.

This risk premium likely will increase in the next couple of months as investors factor in the leadership transition at the Federal Reserve. As I explained recently, Ben Bernanke’s successor Janet Yellen appears to be more lenient toward inflation than her two most recent predecessors. The basis for her leniency seems to be the continued existence of a large federal budget deficit. She has been quoted as preferring higher inflation to tightening the Fed’s funding of the budget deficit.

In other words, Congress and President Obama would have to do even less to balance the budget.

Higher inflation would benefit the federal government in the short run as some tax revenues would increase faster. The Wyoming state government would not benefit as much directly from inflation, primarily because we do not have a multi-bracket income tax. However, there is an indirect gain: higher inflation is normally associated with a weaker exchange rate for the U.S. dollar, which would benefit natural resources exporters and boost severance tax revenues.

For consumers, though, inflation is bad news. It eats up real wages and forces them to spend less. As a result, revenue from sales, fuel and tobacco taxes decline. Non-minerals businesses would see their markets tighten and their input costs rise. This would be thoroughly bad, as our non-minerals private sector is not doing very well.

The state government could still come out a net winner, but don’t expect the minerals sector to save the economy. Their sales margins will certainly benefit from a currency depreciation as they get more in dollars even if they cut prices in foreign currencies. However, the minerals industry is not a formidable creator of real economic value such as jobs. As I reported in August, if you exclude oil and gas and remove inflation from growth numbers for our mining industry, there has not been much growth in that sector in the past 15 years!

To be blunt, higher inflation would cement Wyoming as a mono-industrial, zero-growth state with a well-fed government and a stagnant private sector.

The question, then, is how big the risk for higher inflation actually is. As an economist I live in the world of probabilities, but I also know not to throw numbers around without proper analysis. Since the U.S. economy has been free of high inflation for three decades now, we do not have a lot of information to draw on to estimate the probability of inflation. But as mentioned earlier, we do know that international investors are worried about U.S. inflation, and that their worries have substance.

There is another indicator of inflation worries, namely the Chinese government’s increased interest in U.S. Treasury bonds. As of July 2012, China (including Hong Kong) owned approximately 7.9 percent of the federal debt. However, in the past year they have purchased one-fifth of the new external debt issued by the Treasury, boosting their total debt share to almost 8.5 percent.

This increased Chinese investment comes at the same time that China is having serious domestic debt problems. Their GDP growth is slowing down – quarterly numbers indicate slower growth in China than in the United States – while their inflation rate is notably high. This is a substantial change from past high-growth decades.

Here is the kicker. A rise in the U.S. inflation rate would exacerbate the Chinese recession problems: with a dollar depreciation, U.S. exporters will compete more strongly on the global market and Chinese manufacturing costs will rise relative to American manufacturers.

By expanding their holding in U.S. Treasury bonds, the Chinese achieve two goals. They prop up the dollar vs. their own currency and they increase their political leverage vs. Congress. The other day we got a sign of their attempts at the latter: the Chinese government’s own credit rating agency downgraded the U.S. government to A-.

While not a credible downgrade from a strict market viewpoint, it was a clear political signal to Congress to get serious about the federal debt. If Congress starts shrinking the deficit they will reduce their reliance on the Federal Reserve as one of the main funders of the deficit; by reducing the need for more deficit funding from the Fed, Congress would greatly reduce the risk for monetarily driven inflation.

There is no doubt that China has a strong interest in a low-inflation, strong-dollar U.S. economy. But so do we, even in Wyoming. Inflation is the enemy of the middle class; it erodes people’s paychecks and destroys jobs. Only government can gain from inflation, which is not a good enough reason to let ourselves get sucked in to the inflation spiral.

There is a lot we can do to prevent inflation – and prepare for it – should the worst happen. On the prevention side, Congress must get serious about the deficit. As for Wyoming, our state lawmakers and our governor must get started on a plan to encourage industrial diversification. The more we depend on one sector for our prosperity, the more remote that prosperity will be – especially if we have to deal with high inflation again.