Mark Thoma picks up Jagadeesh Gokhale calling for less fiscal insanity on the part of the Bush administration:
Economist's View: Cato Calls for Leadership from Fiscal Authorities: Cato's Jagadeesh Gokhale speaks on the federal budget deficit in The Financial Times and he is not happy with the leadership he sees from the administration and congress on this issue. The worry is that the fiscal deficit will eventually lead to debt monetization by the Fed:
Only leadership can defuse US fiscal time-bomb, by Jagadeesh Gokhale, commentary, FT: Alan Greenspan recently warned that monetary policy “cannot ignore the potential inflationary risks inherent in our current fiscal outlook . . .” He also said: “I assume that [fiscal] imbalances will be resolved before stark choices again confront us and, if they are not, the Fed will resist any temptation to monetise fiscal deficits.” ... Unfortunately, the “stark choices” fiscal policymakers would face if they fail to resolve the growing fiscal imbalance will eventually confront the Fed. Why? Because continued high deficits and growing debt will drain the economy of investible resources. It will also reduce foreign lenders’ confidence in US ability to resist the temptation to inflate away the real value of growing federal debt – much of which is held abroad. That may lead them to divert their savings from US shores, further draining domestic investment.
If that happens, ... domestic unemployment will increase and political pressure on the Fed to stimulate economic activity will grow. Direct monetary stimulus entails purchasing more Treasury debt for cash to keep interest rates lower than would be consistent with an “inflation neutral” level – precisely the action Mr Greenspan abjures. So the question remains: how long can his successor continue serving the price-stability goal and ignore calls for direct action? ...
Managing the public’s inflation expectations has been Mr Greenspan’s quintessential skill. ... However, and here is the really hard question, does performing such a superb job of managing inflation expectations while maintaining price stability exacerbate the problem by allowing the nation’s fiscal imbalance to grow? ... By allowing fiscal policymakers to prolong their “no tax-hikes” versus “no-spending-cuts” ... Greater confidence in the ability of monetary policy to mop up problems created by fiscal profligacy may be enabling the very irresponsible fiscal policies ... Ultimately, defusing the fiscal time-bomb will require sustained leadership directly in federal fiscal management.
We've seen this game between the fiscal and monetary authorities before. I’m sure I disagree with Cato as to how to solve the deficit problem, but that aside I too worry about the pressures to monetize the debt in coming years. That’s why I think it is appropriate and necessary for the Fed chair to discuss the implications of budget deficits and this is another place where, in my opinion, more leadership is needed.
"Debt monetization" is economist-speak for "lots and lots of inflation"