The University of Chicago's John Cochrane has an important, somewhat technical, new paper (pdf) out headlined, "Understanding Fiscal and Monetary Policy in the Great Recession: Some Unpleasant Fiscal Arithmetic." Some non-technical highlights:
a fiscal inflation may well look like a stock market collapse. The tipping point... can come quickly and unpredictably... It can come as a surprise to a Federal Reserve and to economists unused to thinking about fiscal limits to monetary policy....Where is the fiscal limit? I don't know. But there is a fiscal limit, and wherever it is, we are a few trillion dollars closer to it than we were last year, and we will be another few trillion dollars closer next year. ..it is closer than we think....
The volume of popular press coverage of deficits and inflation — clearly about expected future inflation — and even the ads for gold on cable TV suggest at least a more widespread concern about inflation than has been present for some time.
Professor Cochrane quotes Federal Reserve Chairman Ben Bernanke's April 27, 2010 testimony to the National Commission on Fiscal Responsibility and Reform: "a loss of investor confidence in the ability of a government to achieve fiscal sustainability can itself be a source of significant economic and financial instability."
More, from Professor Cochrane's conclusion:
Will we get inflation? The scenario leading to inflation starts with poor growth, possibly reinforced by to larger government distortions, higher tax rates, and policy uncertainty. Lower growth is the single most important negative influence on the Federal budget. Then, the government may have to make good on its many credit guarantees. A wave of sovereign (Greece), semi-sovreign (California) and private (pension funds, mortgages) bailouts may pave the way. A failure to resolve entitlement programs that everyone sees lead to unsustainable deficits will not help.
When investors see that path coming, they will quite suddenly try to sell government debt and dollar-denominated debt. We will see a rise in interest rates, reflecting expected inflation and a higher risk premium for U.S. government debt. The higher risk premium will exacerbate the inflationary decline in demand for U.S. debt. A substantial inflation will follow — and likely a "stagflation" not inflation associated with a boom. The interest rate rise and inflation can come long before the worst of the deficits and any monetization materialize. As with all forward-looking economics, no obvious piece of news will trigger these events. Officials may rail at "markets" and "speculators."....
This is a scenario, not a forecast. Whether it happens depends on the actions of our public officials, which are very hard to forecast.
What a scary scenario. One of my favorite parts of this paper is the footnotes. There are a raft of papers by famous economists -- Ben Bernanke, Doug Elmendorf, Martin Feldstein, Arthur Laffer, John Taylor -- and then, in the middle of them, a citation to one Julie Satow, for an article she wrote for the New York Sun.