Printing money is not inflationary, say the inflation hawks at Rob Arnett’s Research Affiliates.

But no, the Newport Beach-based firm is not suddenly going all wobbly on the Fed’s quantitative easing policy.

Rather, a recently published research note by the firm’s chief investment officer, Jason Hsu, explains the mechanisms by which loose monetary policy creates the conditions for inflation, paving the way for an inflationary future.

Titled “From QE to Queasy: Fiscal Policy and the Risk of Inflation,” the research note says that the now-dominant view of economists is that inflation is a fiscal phenomenon rather than a monetary issue. In other words, quantitative easing’s primary effect is not inflationary; indeed, there has been no “material inflation” yet, despite QE-financed spending.

But the policy will lead to inflation in the following way, Hsu explains:

“When a government can issue substantial debt at a zero interest rate—which is what QE or printing money accomplishes—it will spend more recklessly than if it had to roll over the debt at double-digit interest rates.”

In other words, interest rates impose fiscal discipline. Our current low rates remove an important market signal that would work to keep public spending in check.

Hsu continues:

“Bond investors are the vigilantes who ensure that fiscally conservative politicians are not brushed aside by electorates and by populist political leaders, who are all too willing to finance today’s welfare with tomorrow’s liabilities. Once that market control mechanism is lost, the public sector will slide down the slippery slope of excess spending, crowd the private sector out, and cause the economy to become ever less productive.”

No vigilantes, no vigilance:

“If not for the debt ceiling, which acts as the last control against unsustainable deficit spending in the United States, the Fed would enable unbounded U.S. debt issuance by serving as the lone eager Treasury buyer at negative real interest rates.”

So what exactly is the problem with unchecked government spending? Hsu explains that the government is not good at producing goods and services that consumers want, but it is good at creating nominal wealth “by paying people for make-work.” This brings us to the classic definition of inflation: “too much nominal wealth chasing too few goods.”

As the public sector expands, productivity in the private sector shrinks (“crowding out” is the term used in economics). Hsu employs an extreme example to illustrate the point: it is widely agreed that war causes inflation. How so?

“War is the state crowding out the private sector to produce weapons and death, neither of which are [sic] highly desired by the consumers.” To finance the war, the government issues massive debt, creating nominal wealth; but people fighting wars are not producing goods and services in the private economy, so the economy is less productive and the result is nominal wealth chasing too few goods, i.e. inflation. Looking at the U.S. economic scene today, Hsu predicts that America’s future will look far more like Southern Europe than Japan. Massive government spending has been a factor in each, yet the Japanese economy, alone, has remained productive.

Why? “Japanese households have saved religiously for retirement, and loaned at home and abroad to governments and corporations. In other words, they completely undid the increase in public spending with aggressive private-sector belt-tightening,” Hsu writes.

The Japanese enjoy a trade surplus of 60% of GDP, compared with the average southern European country’s large trade deficit and net foreign debt of 80%.

The Research Affiliates chief investment officer pessimistically concludes:

“Culturally more like the Europeans than the Japanese, U.S. households are likely to save insufficiently to buffer the massive increase in governmental debt; rather, as the government expands and spends more, so too will the number of public sector employees and beneficiaries expand; and so too will their expenditures increase. At the same time, the private sector will produce less—this is before we even attempt to adjust for the additional decline in labor productivity due to the aging U.S. demographics.”