1. http://www.federalreserve.gov/faqs/economy_14400.htm
I responded to the claim that inflation is created with the goal of financing a government deficit, and I stand by the claim that that's crackpot conspiracy theory.
To substantiate that claim, you would have to prove somehow that the real interest rate is lower than it would be without this inflation.
While Fed Chairman Ben Bernanke claims the Fed is simply "managing the monetary base" [1], the Fed does in fact purchase US Treasury Bonds without requiring the Treasury to pay back the debt. This monetization of debt allows the Treasury to increase government spending. The outcome is an increase in the monetary base which leads to rising price levels, or inflation.
So while saying that inflation is created with the goal of financing government deficit is somewhat backwards, it's only a conflation of cause and effect--not a "crackpot conspiracy theory".
1. http://research.stlouisfed.org/publications/es/article/9644
If the nominal interest rate exceeds nominal growth in GDP, then wealth effects (aka people have more money thanks to interest and therefore spend more) will eventually encourage faster growth of nominal GDP - either by stimulating more production (real GDP growth) or by driving up prices (inflation), or, more likely, by a mix of both.
If nominal interest rates are below nominal growth in GDP, then it becomes more profitable to borrow money to invest in production. People will do this, and this will adjust interest rates up (you can understand this from two directions: on the one hand, profit is being spread around via interest, on the other hand, demand for loan drives up interest rates).
These adjustments do not take over night - they probably operate on the timescale of years (unfortunately, economics tends to pay very little attention to how fast such market mechanisms operate, so we basically have no scientific basis for such statements, just common sense and gut feelings). Still, you cannot escape those adjustments of the interest rate in the long term.
What does this have to do with governments, inflation, and financing the deficit? If the government consciously acted to increase inflation to finance its deficit [1] this would indeed temporarily benefit borrowers. However, this is a temporary measure and certainly not the case today. Furthermore, governments have also consciously acted to decrease inflation, which obviously has the opposite effect. So in the end, it's at best a wash.
One last point:
the Fed does in fact purchase US Treasury Bonds without requiring the Treasury to pay back the debt
The same happens in the real economy as well. Firms operate using debt that is effectively never paid back. The debt is regularly rolled over, sure, but it is de facto permanent and contributes to a permanent increase of the money supply, which is what matters (if any of those quantities matter).
The Fed does buy mostly Treasuries to create the monetary base (which is necessary for purely technical reasons), but what else would you have them buy? I personally wouldn't want "my" central bank to gamble on risky assets.
[1] Also, I find it fascinating that the goldbugs never point to actual examples where this happened. I suspect they don't because it's a myth, at least in the countries those people come from outside of wartime.
People are not free to adjust their behavior accordingly. The average person is forced to transact in the official currency. Any alternative that threatens to become liquid enough for the average person to use will be shut down. (Thus the interest in this Bitcoin backers meet government regulators article)
Sovereign countries with key energy resources must sell them for US dollars exclusively and they must recycle excess dollars into US government bonds, or receive freedom and democracy. This is the Petrodollar system, and it is the reason why the Feds can run endless deficits, and the Fed can put trillions of dollars of unmarketable assets onto its balance sheet without creating Weimar-style problems.
And any central bank can do crazy amounts of QE without inflation once the economy hits the Zero Lower Bound. The ECB did something rather similar.
All of this has nothing to do with my central point, which was about real rates of interest.
It's not crackpot, though it's slightly inaccurate. The Federal Reserve is established by Congress and its chairman appointed by the President. It's otherwise somewhat independent, is part public and part private, but might be considered a de facto fourth branch of the government.
And among its remits are to manage the long-term inflation rate through open-market transactions (buying and selling treasury bills).
You pretty much allude to that -- how could you have a target inflation rate ... without some means of aiming for and hitting that target.
Now, the question of how effective monetary (and fiscal) policy are in actually affecting long-term economic growth is a whole 'nother barrel of tadpoles. I subscribe to the thermoeconomic / biophysical economic heterodoxies (very strongly influenced by ecology) which say that the cheapness (which is to say, ease of access) and abundance (flow rate) of energy are principle.
The US has grown its way out of past debts. Because real wealth and economic activity was also growing, the inflation, while significant, was still reasonably limited.
Attempting to continue growing the money supply while the real economy is stagnant or contracting won't have that effect.
Unless the Fed directly injects money into the Federal treasury, where it's paid out. In which case, unless the money is then lost through nonproductive economic activity, it will inflate the currency. In any event, the ability to continue immense levels of Federal borrowing will end.
I'm not inclined to swallow the Republican line, but I'm coming to see long-term Federal deficits as a looming and increasing problem. Keep an eye on those Federal Reserve interest rates.
If real GDP growth stops or even becomes negative, then the real interest rate will have to end up being zero or less as well, regardless of what the government supposedly does to create inflation or not. Ultimately, even if government acts like every gold bug wants it to act, the private sector will create inflation through its action if the real interest rate remains too high. [1]
So I don't know what we should make of all this? Perhaps you want the government to stop borrowing when the Limits of Growth have been reached? But (a) we are not at this point yet, so it is irrelevant for current decisions, and (b) how would you recognize when we've reached this point?
Perhaps you recognize it when there is zero unemployment and real GDP is still shrinking?
In any case, this is very unclear territory.
[1] Since I don't want to repeat myself too much, this is the comment where I've tried to explain my understanding of the mechanisms behind this: https://news.ycombinator.com/item?id=6291096
Given that return on invested capital has been decreasing 1965-2009, and I've seen similar charts for GDP, we're on track for that. How our banking/finance system resolves that situation will be ... interesting
http://www.deloitte.com/view/en_US/us/Insights/Browse-by-Con...
http://www.forbes.com/sites/stevedenning/2012/01/25/shift-in...
I still don't see an argument that the real interest rate is decreased by long-term stable inflation.
I need to think this over a bit more. I'm not sure there is a stable long-term relationship here -- the financial system is part of the internal control and feedback system of the economy, growth is ultimately dependent on exogenous factors (notably resources). So it's fair to say that the real interest rate is determined by the nominal rate and the inflation rate. And the nominal interest rate is strongly influenced by the real rate of return on investment. See Shift Index above.
Though I'm trying to reconcile that with the low interest rates of the late 1960s / early 1970s and high interest of 1979-1982 or so.
Given that return on invested capital has been decreasing 1965-2009, and I've seen similar charts for GDP, we're on track for that. How our banking/finance system resolves that situation will be ... interesting
http://www.deloitte.com/view/en_US/us/Insights/Browse-by-Con...
http://www.forbes.com/sites/stevedenning/2012/01/25/shift-in...
I still don't see an argument that the real interest rate is decreased by long-term stable inflation.
I need to think this over a bit more. I'm not sure there is a stable long-term relationship here -- the financial system is part of the internal control and feedback system of the economy, growth is ultimately dependent on exogenous factors (notably resources). So it's fair to say that the real interest rate is determined by the nominal rate and the inflation rate. And the nominal interest rate is strongly influenced by the real rate of return on investment. See Shift Index above.
Though I'm trying to reconcile that with the low interest rates of the late 1960s / early 1970s and high interest of 1979-1982 or so.
Perhaps you want the government to stop borrowing when the Limits of Growth have been reached?
Not so much "want" as "it will have to, as the costs of borrowing will start increasing uncontrollably".
But (a) we are not at this point yet
You and I disagree on that point.
(b) how would you recognize when we've reached this point?
Real, depreciation-adjusted (e.g., declining stocks of energy reserves), EROEI-adjusted, quality-of-life adjusted aggregate and per-capita growth falling. GDP itself is a poor metric, it's mostly just easy to obtain (sum up everyone's incomes). There are other alternatives which have been proposed: FISH, GPI, UNHDI, among them.
A long, sustained, global recession or depression from which neither fiscal nor monetary stimulus seems sufficient to restore growth might lend another clue.
zero unemployment and real GDP is still shrinking?
I'd expect unemployment to be rather nonzero. Better: workforce participation rates to be low despite considerable pressures for individuals to seek out work.
This is crackpot conspiracy theory stated as fact. There is a very obvious reasons why this theory doesn't make any sense: People know about inflation, and are free to adjust their behavior accordingly. The simple fact is that if inflation were lower, nominal interest rates would be lower to match as well, and vice versa. In the end, the real interest rate will end up in the same place.
So the real story is much more nuanced. One important aspect is that monetary policy works better with higher inflation, because it takes longer to hit the Zero Lower Bound. This is why many economists have recently advocated raising the inflation target, with the hindsight experience of the ongoing aftermath of the Great Recession.
Another important aspect is essentially the Red Queen Hypothesis of economics. Due to the way pricing works in the real world outside of financial markets and auctions, prices move up more easily than they move down. For markets to work well, relative prices must adjust quickly to reflect changing underlying conditions. This relative adjustment is easier to get when the overall price level tends to move upwards.