Janet Yellen is a fantastic choice for Fed Chairwoman, but she faces a huge challenge. She needs to be the global economic cheerleader, fix the banking system (in my view along the lines of Limited Purpose Banking), and stop the Fed’s practice of printing money to pay Uncle Sam’s bills.

There is a clear and present danger of very high inflation, if not hyperinflation, arising from the Fed’s policies.

In his parting act, Federal Reserve Chairman Ben Bernanke has decided to continue printing some $85 billion per month (6% of GDP per year), spend those dollars on government bonds and, in the process, keep interest rates low, stimulate investment and reduce unemployment.

Trouble is, interest rates are rising, investment remains very low, and unemployment remains very high. Bernanke’s policy hasn’t worked and should be ended.

Since 2007 the Fed has increased the economy’s basic supply of money by a factor of four. That’s enough to sustain, virtually overnight, a four-fold increase in prices. Having prices rise that much, that quickly, would spell hyperinflation.

And while Bernanke says this is all to keep down interest rates, there is a more worrying subtext here. When the Treasury prints bonds and sells them to the public for cash, and the Fed prints cash and uses it to buy the newly printed bonds back from the public, the Treasury ends up with the extra cash, the public ends up with the same cash it had initially, and the Fed ends up with the new bonds.

Yes, the Treasury pays interest and principal to the Fed on the bonds, but the Fed hands that interest and principal back to the Treasury as profits earned by a government corporation. So, the outcome of this shell game is no different from having the Treasury simply print money and spend it as it likes.

The fact that the Fed and Treasury dance this financial pas de deux shows how much they want to keep the public in the dark about what they are doing. And what they are doing, these days, is printing, out of thin air, 29 cents of every $1 being spent by the federal government.

I have heard one financial guru after another discuss quantitative easing (QE) and its impact on interest rates and the stock market, but I’ve heard no one make clear that close to 30% of federal spending is now being financed via the printing press.

That’s an unsustainable practice. It will come to an end as soon as prices start to rise and fingers start pointing at the Fed for fuelling the inflation. At that point, Congress will have to come up with an extra 6% of GDP on a permanent basis either via huge tax hikes or huge spending cuts. The third option is simply to borrow the 6%, but not monetize the borrowing, i.e. not have the Fed buy up the bonds the Treasury sells to the public. This would raise the deficit, defined as the increase in Treasury bonds held by the public, from 4% to 10% of annual GDP if we take 2013 as the example.

So why aren’t prices rising? This year’s inflation rate is running at just 1.5%. There are three answers.

First, three quarters of the newly created money hasn’t made its way into the blood stream of the economy – into M1 – the money supply held by the public. Instead, the Fed is paying the banks interest not to lend out the money, but to hold it within the Fed in what are called excess reserves.

Since 2007, the monetary base – the amount of money the Fed has printed – has risen by $2.7 trillion and excess reserves have risen by $2.1 trillion. Normally, excess reserves would be close to zero.  Hence, the banks are sitting on $2.1 trillion they can lend to the private sector at a moment’s notice. We’re looking at a ginormous reservoir filling up with trillions of dollars whose dam could break at any time.

Why is the Fed paying the banks to hold reserves, rather than make loans? Good question. Presumably because it is more interested in improving the banks’ balance sheets than in juicing the economy. Whatever the reason, as lending rates rise, as they are now doing, the banks will start lending their excess reserves to the private sector.

If this happens in full, we’ll see M1, which was $1.4 trillion in 2007, rise from its current value of $2.6 trillion to $5.7 trillion. Since prices, other things equal, are supposed to be proportional to M1, having M1 rise by 219% means that prices will rise by 219%.

But, and this is point two, other things aren’t equal. As interest rates and prices take off, money will become a hot potato, i.e. its velocity will rise. Having money move more rapidly through the economy – having faster money – is like having more money. Today, money has the slows; its velocity – the ratio of GDP to M1 – is 6.6. Everybody’s happy to hold it because they aren’t losing much or any interest. But back in 2007, M1 had a velocity of 10.4.

If banks fully lend out their reserves and the velocity of money returns to 10.4, we’ll have enough M1, measured in effective units (adjusted for speed of circulation), to support a nominal GDP that’s 3.5 times larger than is now the case. Basically, we’ll have the wherewithal for almost a quadrupling of prices. But were prices to start increasing rapidly, M1 would switch from being a warm to a hot potato: velocity would rise above 10.4, leading to yet faster money and higher inflation.

I hope you’re getting the point. With Congress and the Administration hooked on the printing press, there is no easy exit strategy. Continuing on the current QE path spells even greater risk of hyperinflation. But calling it quits requires much higher taxes, much lower spending, or much more net borrowing (with requisite future repayment) from the public. That said, weaning Uncle Sam off the printing press now is critical before his real need for a fix – paying for the Baby Boomers’ retirement benefits – kicks in.

The one caveat to this doom and gloom scenario is point three – increased domestic and global demand for dollars. The Great Recession put the fear of God into savers worldwide. And the fact that the US price level has risen since 2007 by only 15%, half of the increase, whereas M1 has risen by 88% reflects a massive expansion of domestic and foreign demand for dollars. This is evidenced by the velocity of money falling from 10.4 to 6.6. People are now much more eager to hold onto dollars than they were six years ago.

If this increased demand for dollars persists, let alone grows, inflation may remain low for quite a while. But our ability to get American citizens as well as foreigners to hand over real goods and services in exchange for green pieces of paper is hardly guaranteed once everyone starts to understand the incredible rate at which we are printing and spending this paper.

This is my final point. Regardless of how much money the Fed prints, the consequences of inflation depend on the lending behaviour of the banks and the views of the public about holding money. If everyone gets it into their heads that prices are taking off, individual beliefs can become a collective reality. As the Fed prints more money, the worries about high inflation, if not hyperinflation, could become a self-fulfilling prophecy.

Author: Laurence Kotlikoff is Professor of Economics at Boston University and co-author of The Clash of Generations and author of Jimmy Stewart Is Dead. He is a member of the World Economic Forum Global Agenda Council on Fiscal Sustainability.

Image: Stacks of U.S. hundred dollar bills. REUTERS/Bernardo Montoya