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behind the numbers

Many investors are petrified that the United States' enormous budget deficit will mean trouble down the road in the form of much higher inflation. History, though, suggests that the fears are overblown.

Andrew Smithers, an economist and chairman of London-based Smithers & Co. Ltd., has looked at the relationship over the past century between U.S. deficits and consumer prices – and found that a swelling national debt hasn't typically led to inflation.

History "provides no support" for the argument that inflation is an inevitable consequence of either high deficits or runaway debt, Mr. Smithers writes in a recent report.

This may come as a surprise to gold bugs. One favourite argument of the gold-loving crowd is that the United States is doomed to experience a period of rapidly rising prices because of its dire financial situation. Some fear that Washington will deliberately engineer higher inflation to help erode its mounting debt burden.

But rather than peering ahead into an uncertain future, Mr. Smithers looked backward at the picture that the past has already painted. He charted changes in the consumer price index – a standard gauge of inflation – and the fiscal deficit during the years between 1900 and 2010. He also compared inflation to the national debt. The result? A "lack of pattern," he writes.

Looking at the spikes in budget deficits during this period, Mr. Smithers found little evidence to tie them to rising inflation. The U.S. deficit rose sharply when the country entered the First World War in 1917, for instance, but a rise in inflation preceded the deficit rather than following it.

A couple of decades later, the Great Depression forced the deficit up again – but prices fell. During the Second World War, the deficit spiked, but price controls limited inflation during the conflict's later period and the inflation rate jumped only as the deficit began to fall. There is equally little evidence to show inflation rates rise hand-in-hand with national debt levels, Mr. Smithers shows.

While this is reassuring, it doesn't mean we can entirely dismiss the risk of inflation. Central bank blunders could spark a period of rapidly rising prices – as could a deliberate policy decision. Some economists have argued that setting higher targets for inflation would help boost the economy by, among other things, reducing the real burden of carrying debt.

But Mr. Smithers argues that higher inflation would actually be of little help. His analysis indicates that there's no stable relationship between changes in inflation and changes in debt, either private or public. Higher inflation also doesn't do much to spur spending – if anything, households save more when inflation goes up. "We conclude that advocates of higher inflation are wrong and that it would be damaging," he writes.

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