The federal debt was equivalent to 41% of GDP at the end of 2008. The Congressional Budget Office estimates it will rise to 82% of GDP in 10 years.

According to John Taylor in today’s Financial Times, the federal debt could hit 100% of GDP in just another five years. This from Taylor:

I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget.

A 60% tax hike won’t happen. The government will attempt to inflate the problem away instead. As we have discussed in previous issues, this will radically reduce the value of your savings.

To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. This 100% increase in price levels would mean about 10% inflation for ten years.

According to Taylor, “it would not be that smooth.” He reckons it would “probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.”

What was giving us nightmares was Japan. If fiscal stimulus is so stimulating, then Japan would have experienced on the of the biggest economic booms of all time after its government ramped up the debt-to-GDP ratio there from 50% to almost 170% to ward of the recession that struck the former Asian powerhouse in the 1990s.

Instead, as Van Hoisington and Lucy Hunt put it recently in John’s Mauldin’s Quarterly Review and Outlook, Japans economy “is in shambles.”

After two decades of repeated disappointments, Japan is in the midst of its worst recession since the end of World War II. In the fourth quarter, their GDP declined almost twice as fast as that of the U.S. or the EU. The huge increase in Japanese government debt was created when it provided funds to salvage failing banks, insurance and other companies, plus transitory tax relief and make-work projects.

In 2008, after two decades of massive debt increases, the Nikkei 225 average was 77% lower than in 1989, and the yield on long Japanese Government Bonds was less than 1.5%. As the Government Debt to GDP ratio surged, interest rates and stock prices fell, reflecting the negative consequences of the transfer of financial resources from the private to the public sector. Thus, the fiscal largesse did not restore Japan to prosperity. The deprivation of private sector funds suggested that these policy actions served to impede, rather than facilitate, economic activity.

It seems fiscal stimulus, by sucking investment into government spending, can actually be deflationary rather than inflationary.

Another problem is monetary velocity. Although the Fed can increase monetary base, it cannot force the banks to lend out this money and thus create the credit necessary for inflation to occur. Right now, banks would rather sit on their reserves rather than lend it out and risk default due to deflation. And as long as banks hold onto their toxic assets, they will need all the cash they can get to cover the costs of writedowns and credit losses.

In this way, the banks in their current state are more like vampires than zombies: they are sucking the lifeblood (money) out of the economy and perpetuating the deflationary spiral the feds are stuffing them full of money to avoid.

It continues to amaze us here at Notes that the Obama administration has so far gotten away with protecting banks’ unsecured creditors at the expense of the economy as whole. Of course, this can’t last forever. And once the banks do start lending again… we could be in for a serious inflationary surprise.