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Fiscal conservatives claim that President Biden’s $1.9 trillion stimulus proposal surely will lead to excessive inflation. However, in Congress the recently proposed Public Banking Act opens the door to a new policy tool that could quickly and painlessly stop excessive inflation in its tracks were it to develop.
Economists such as Stephanie Kelton in her book “The Deficit Myth” argue that although we must avoid excessive inflation, deficit spending is not inherently a problem. The key point in her argument is that interest rates have remained low. Low interest rates make larger deficits manageable because they keep interest payments on the debt low. Moreover, low interest rates are a sign that investors have not lost faith in the soundness of U.S. Treasury securities. Although the interest rate on 10-year government bonds has risen to around 1.5 percent, it has not yet approached levels that would be of any real concern.
But already we have seen the prices of gasoline, lumber and some foods rising significantly. What if President Biden’s $1.9 trillion COVID stimulus package were to push us into an upward inflationary spiral? Biden supporters argue that this is unlikely, but what if it did? Would the Federal Reserve have the policy tools to stop excessive inflation quickly without throwing the economy into recession?
In the past the Federal Reserve has stopped inflation by significantly raising interest rates in the New York financial markets. Most notably in the early 1980s after inflation soared to 13.5 percent, Chairman Paul Volker led the Federal Reserve to raise rates and throw the economy into a deep recession. Could the Biden stimulus bring this upon us once again?
The key to solving this problem is in understanding “The Inflation Dilemma.” The fundamental cause of excessive inflation is when too much money is chasing too few goods which drives up prices. In the face of excessive inflation, high interest rates are needed to encourage consumers to divert more of their money to savings to earn the higher interest rate and, therefore, cut back on unnecessary expenditures. This reduces the demand for goods and services.
However, at the same time, low interest rates are needed to encourage producers to supply more goods and services to help drive prices back down. Businesses would like to respond to excessive demand by supplying more. But high interest rates discourage them from borrowing the money they need to add another line of production.
When faced with rising prices, we need to cut back on demand and raise supply. Raising interest rates enables the former, but discourages the latter. This inflation dilemma can be overcome only by providing high interest rates for consumers, motivating them to increase their savings and reduce demand, and at the same time providing low interest rate to companies to increase supply.
The Public Banking Act opens up the opportunity to solve this inflation dilemma. From 1910 to 1966 the post offices throughout the United States offered banking services. You could go to any post office to cash a check or set up a savings account. A resumption of these services as currently proposed in the Public Banking Act would be particularly beneficial to low-income, disadvantaged people, who, after a job loss, car accident or uninsured medical emergency, need to borrow money but have to go to loan sharks, pawn shops or “cash now” opportunists and end up paying high interest rates. Under the Public Banking Act they could apply for a small loan at a relatively low interest rate at any post office.
But the Public Banking Act could also serve to defeat the threat of excessive inflation and solve the inflation dilemma. Limiting postal savings accounts to individuals based on their Social Security numbers and placing a limit on how much of the savings in their accounts could earn interest, the accounts could offer a high interest rate when excessive inflation threatened. Limiting interest payments to accounts with $10,000 or less would keep wealthy individuals from transferring large amounts of money to these savings accounts from the private banking system. At the same time, the Federal Reserve could keep interest rates low in the New York financial markets enabling both the payments on the federal deficit to remain low and encouraging businesses to employ more workers, not less, as they expanded supply in the face of rising prices. Thus, the inflation dilemma would be solved by offering consumers high interest rates to reduce demand and businesses low interest rates to increase supply. The combination of less demand and more supply could slow or stop price increases without entering a recession.
Please provide your insights and comments on The Inflation Dilemma and How to Solve It.
Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone.
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