Will Sarah Palin and the Tea Party Cause Hyperinflation?

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Hey inflation, I’m going to pump you up, maybe (Scott Audette/REUTERS)

Sarah Palin is concerned that Federal Reserve Chairman Ben Bernanke may cause inflation to shoot up and stay there. But could the greatest potential culprit of wealth-destroying, Germany-1930s-type hyper-inflation be, not the central bank, but Palin and the Tea Party? That in part is the conclusion of some recent research by Indiana University professor Eric Leeper and Wall Street economist Troy Davig of Barclays Capital. In a recent paper, called Temporarily Unstable Government Debt and Inflation, which can be downloaded from this website, Leeper has a chart that he unofficially calls the Tea Party shock graph, on page 25. Before the Tea Party, inflation is rising slowly. But in the first year the Tea Party or a group with similar views wins the Presidency or takes over Congress, whamm-o. Inflation doubles, and keeps going up. He wrote the paper in October, so he puts the potential date of Tea Party takeover as 2019, but after this election Leeper concedes Tea Party induced hyper-inflation could come much sooner than that. So is Palin riding the Hyper-Inflation Express? Maybe. Here’s why:

Ever since the financial crisis, some, Tea Partiers in particular, have been predicting that the country may have an upcoming massive bout of inflation. And why not. Many of the things we have been through seem like the type of stuff that should make our currency dive and prices go up. First of all, there was the failure of our banking system. That’s got to take some wind out of the value of your currency. Then you have the government’s response to it. Bailouts and massive stimulus. Again, government spending is generally thought to produce inflation. Add in near zero interest rates, and prices should be shooting through the roof. Gold, believed to be an inflation hedge, is soaring. Indeed, some people seem so certain that inflation is on the rise that they are buying inflation-protected Treasuries with a negative yield. That means if inflation doesn’t rise, the people buying those bonds will have to pay interest to be a lender to the government. Normally it’s the other way around. Screwy.

Nonetheless, inflation, so far. Not so much. Palin herself seems to have missed the fact that prices in the past year or so have barely budged. So for the past few months, Leeper and Davig and another of Leeper’s colleagues Todd Walker have been looking into why. Turns outs that it is very unlikely the Fed would cause hyper-inflation. That’s why near zero interest rates and the Fed’s early efforts to drive down long-term interest rates have done little to boost inflation. The real threat of inflation comes from tax policy, namely lower taxes. Lower taxes and the government will have a harder time paying back its debt. Investors run from our bonds and currency. Inflation ensues.

But here’s the trick. Leeper doesn’t just model actual tax policy. He is looking at tax expectations. You don’t actually have to lower taxes for inflation to rise. Nor do you have to raise taxes to get inflation to fall, for that matter. Leeper says as we get closer to the point that is looks like the government is unwilling to raise taxes people will get increasingly nervous about our debt. And that’s the problem with the Tea Party.

Now before you go claiming that Leeper’s research is a Liberal hit piece consider this: Leeper agrees that when governments have high levels of debt higher taxes do slow growth and cause massive inflation. But we’re not there yet. Currently, our US Federal Debt is equal to about 62% of annual GDP. That’s a lot, but not enough to make higher taxes a threat. According to Leeper’s calculations, at our current level of US Federal Debt higher taxes, even modestly higher taxes, tends to reduce inflation by three quarters of a percentage point. And the inflation fighting affect of higher taxes tends to grow as the level of debt rises closer to one. Inflation drops by about 1.3 percentage points when the US Federal deficit equals GDP. After that the equation shifts. When debt hits 120% of our annual debt, that’s when the trouble hits. At that point, higher taxes tends to make inflation rise, not fall. But even if Bush’s tax cuts are kept in place we are ten years or more from hitting that point.

But the real problem may be the Tea Party itself, according to Leeper. “The Fed is well aware that its policies could have profound inflation consequences,” says Leeper. “Where as the Tea Party is not thinking that at all.” In fact, just the opposite.