This lecture will describe inflation as a fiscal phenomenon. You have heard that inflation is, anywhere and everywhere, a monetary phenomenon. This lecture will take a more nuanced view.

The conventional wisdom would say that we can run large deficits without causing inflation, as long as we do not monetize those deficits. I am not so sure that this is the case.To say that inflation is a fiscal phenomenon is to claim that inflation has to do with government debt. For example, suppose that no one will lend to the government, so that government debt can only take the form of money. If spending exceeds borrowing, then the government must print money. In this extreme case, there is no difference between saying that inflation is a fiscal phenomenon and inflation is a monetary phenomenon.

The case of “no difference” is actually an important one. It is quite possible for a government to find no willing lenders. Such a government usually wants to spend much more than it takes in through taxes. Therefore, it prints a lot of money. This lowers the purchasing power of money, leading it to need to print more money. Thus, you get hyperinflation. I believe it is a fair statement that every hyperinflation is caused by unsustainable government indebtedness combined with an inability to raise taxes or cut spending to balance the budget. I believe it is a fair statement that hyperinflations end when governments do balance their budgets. Thus, hyperinflation is a fiscal phenomenon.

What about a government deficit that is not so far out of control? In the standard monetary mechanism, a large government deficit could lead to a higher interest rate. Since money does not bear interest, this will cause people to try to go about their business holding less money. This will raise the velocity of money, and hence produce inflation. But that seems like a fairly minimal effect.

In a model where inflation is determined by a Phillips Curve (also known as the aggregate supply curve), a deficit raises aggregate demand, reduces unemployment, and thus creates upward pressure on wages and prices. That view of inflation was popular in the 1960’s, took a beating in the 1970’s, was pretty well purged in the 1980’s, but seems to be making a comeback–when you see someone snort that it makes more sense now to worry about deflation than inflation, you are seeing someone with a Phillips-Curve view of the world, and I do not dismiss such a view.

The U.S. government is planning to run an experiment which requires issuing bonds in massive quantities over the next five years and beyond. The monetarist view is that those bonds can be issued without raising the price level, provided that the Fed does not expand the money supply by purchasing too many of those bonds. I doubt that this view is correct–I give it only about a 10 percent chance. The Phillips Curve view is that those bonds can be issued without raising the price level, provided that the unemployment rate does not fall below its “natural” rate, and we are currently in little danger of that. I give this about a 40 percent chance of being correct.

That leaves me with a 60 percent chance that we will see a dramatic rise in the price level over the next decade, with annual rates of inflation at the peak going above double digits. Issuing bonds amounts to printing interest-bearing government debt, and printing interest-bearing government debt will not turn out to be all that different from printing money.

The financial crisis of 2008 can be described as a big surge in liquidity preference, where that preference was expressed for Treasury securities rather than for money. If you can have liquidity preference that expresses itself in terms of T-bills, then it seems to me that you can have changes in the price level with reference to the dollar quantity of T-bills. I think we can have inflation well in excess of the growth of the usual measures of the money supply, and the experiment we are running will test my hypothesis.

Next, let me make the case for a high inflation forecast from within the Phillips Curve paradigm. The story for the Phillips Curve that I have always preferred is the one that James Tobin gave in his AEA Presidential Address about thirty years ago, called “Inflation and Unemployment.” The idea is that you have two sectors where relative wages are out of whack, and wages are sticky downward in nominal terms. You have a booming sector where wages are fine, but you have a troubled sector where wages are too high. You get unemployment in the sector where wages are too high. If you expand demand in both sectors, the wages in the booming sector go up (hence inflation) and you get more employment at unchanged wages in the troubled sector.

That is a good story for situations where troubled sectors are only mildly troubled (a bit of excess inventory in durable goods). If a troubled sector is deeply troubled, and in fact a lot of capacity needs to exit that sector, then there is not much that can be done about it. In terms of the textbook model, a deeply troubled sector acts like an adverse aggregate supply shock. If you will, the natural rate of unemployment rises. From this perspective, raising aggregate demand may not increase employment by very much in the troubled sector, but it could raise prices in the booming sector.

Right now, it is hard to name a booming sector of the economy (other than government, which does not need to raise wages). However, my guess is that as economic activity picks up, we will see bottlenecks and bidding wars for specialized labor pick up long before full employment. Thus, we will get the inflation of the Tobin Phillips Curve much earlier in the process than folks would like.

In short, we can have inflation that consists of too many T-bills chasing too few goods.