Covid-19 fight will bring inflation, higher taxes

Gordon L. Weil

Fighting the health and economic impacts of Covid-19 costs a lot of money.

The government has pumped out trillions of dollars to support urgent health care and to help people and companies survive the loss of jobs and business activity. Spending and lending at this level has never happened before.

These massive outlays result from the lessons learned in both the Great Depression of the 1930s and the Great Recession, a dozen years ago. Previously, Congress had reacted slowly and with too little financial support for the economy. The Federal Reserve played only a small role, at least at first.

Recovery from the Depression took more than a decade and was ended by massive spending for World War II. Recession recovery dragged on almost as long. In both cases, spending was limited by Republican opposition to increasing the federal debt.

With strong bipartisan support, Congress has passed four rescue bills with a $3 trillion price tag. Aid is supposed to cover some personal and business income losses until the economy opens again. No money was raised to cover its cost.

Before this virus spending, the federal government was on track to run a $1 trillion deficit this year. With the virus outlays, deficit spending could push the federal debt to nearly $22 trillion. That's a new record.

That debt will have to be repaid. Government tax revenues will decline during the crisis, and taxes cannot be raised now, so the added debt will not be offset by revenues. It will keep growing, but must be paid off by future government revenues.

Some critics say we should not be overly worried. Interest rates are close to zero, so the debt will grow only slowly as unpaid interest is added to the debt over time.

They have also come up with an optimistic way of looking at the size of the federal debt. If you measure debt against the size of the economy, it does not look so bad, especially if the economy grows faster than the debt. Future prosperity could pay today's bills.

That was the theory behind the big GOP tax cut in 2017. Of course, it would raise the deficit, the annual budget shortfall and debt, the total amount government owed. But the reduction would encourage growth, which in turn would produce the tax revenues to more than offset the shortfall caused by the cut.

It didn't work. Even before the Covid-19 crisis, new tax revenues did not come close to covering their cost.

The GOP had traditionally accused the Democrats of “tax-and-spend” policies and creating deficits. Once in power, Republicans warmed to increased outlays and adopted “borrow-and-spend” policies. Using debt, they even had room to lower taxes. And most Republicans abandoned their dislike of deficits.

Debt may have reached the point where repaying it out of federal revenues would require impossibly large tax increases. The more likely solution is to make the dollar worth less and repay the debt with cheaper dollars.

The purchasing power of the dollar would be reduced. Prices would increase. Though people might be paid more dollars, their higher incomes would produce higher taxes, used to pay down the debt. Its amount would not have changed, but each dollar used to repay it would be worth less, making it cheaper.

One word explains this process – inflation. Everything would cost more except the debt. Even with more dollars, people would face higher living costs. They would lose purchasing power.

Add to all this the Federal Reserve. Having seen the slowness of action by Congress and unsure about its response, the central bank has moved on Covid-19 with greater force than ever in its history.

Congress spends; the Fed lends. It has created money and loaned trillions, much more than Congress has spent. It buys federal government debt and bank loans to businesses. To pay back those loans, businesses will have to raise prices, fueling inflation.

The Fed supposed will be paid back, but in those future, cheaper dollars. Any defaults by borrowers will be covered by the federal budget.

Then, there are the states. The federal government can deficit finance, but states cannot. In effect, states want to shift their deficits to the federal government.

Eventually, there will have to be tax increases. Add to that inflation and reduced purchasing power. Deficits and debt cannot continue at current levels indefinitely. The combined cost of the existing deficit budget and Covid-19 outlays must be paid and tax increases cannot cover it.

The price of today's massive debt will most a major tax increase, but most if it will take the form of a reduced standard of living.