If our long-term fiscal imbalance is not addressed, our future economy will be As economic growth improves, interest rates are likely to rise, and the federal direct, real world effect on the economic opportunities available to every American. Jul 26, Economists and policymakers are increasingly urging the U.S. government to address the federal debt now while the economy is on solid. Apr 2, Moreover, the economy would lose its currency. value of the existing debt, it causes investors to demand higher interest on future debt. So while inflation since saved the U.S. $6 trillion on debt repayments, it cost it.
After all, why should low inflation and rising debt be linked? True, from the early s inflation declined, and then stayed quite low in much of the world while debt private plus public in relation to GDP rose to new peaks. But is this not just a coincidence? On reflection, though, the link may be much tighter than we think. To understand why, we need to travel back in time.
Not too far, but some distance nonetheless. Exploring the link It probably all started some 30 years ago. The change did not come suddenly, but slowly and cumulatively, as events unfolded.
It was not a development on the surface, but something much deeper, like the adjustment of tectonic plates. Nor was it a single force, but three that eventually came together.
Each of them, taken in isolation, was, and is, highly beneficial. All of them, in isolation and as a package, were, and are, precious and worth safeguarding. Taken together, though, they arguably changed the workings of the world economy in subtle and unexpected ways, throwing up new challenges from unsuspected quarters.
And policies did not adjust. The changes engulfed financial, monetary and real-economy regimes.
Government Debt & Inflation
The first change was financial liberalisation, both domestically and across borders. Financial liberalisation began in earnest in advanced economies in the early s, and by the early s was largely complete around the world. To use Padoa-Schioppa and Saccomanni's felicitous phrase, liberalisation turned an essentially government-led into a market-led financial system. Financial liberalisation was a welcome change after the financial repression that had preceded it.
But it also gave full play to the self-reinforcing interaction between loosely anchored perceptions of value wealth and risk, on the one hand, and funding conditions "liquidity"on the other. This amplified and lengthened financial cycles, the most disruptive of which typically take the form of outsize expansions and contractions in credit and asset prices, most notably property prices, and can spread across borders through flighty capital flows, often denominated in the world's dominant currency - the dollar.
More than just metaphorically, we shifted from a cash flow-constrained to an asset-backed global economy. The second change was the adoption of credible anti-inflation monetary policy regimes. Paul Volcker led the way in the early s, and by the s the inflation dragon had been slayed around much of the world. In particular, as the s unfolded, more and more central banks adopted inflation targeting regimes, seeking to steer inflation typically over horizons of one to two years.
These frameworks paid little attention to the monetary and credit aggregates that had often guided policy in the early phases of the battle against inflation: And as the frameworks proved successful, they became increasingly ambitious, seeking to steer inflation within narrower margins. Conquering inflation was a major achievement.
Inflation had wreaked havoc with the economy and had eroded society's fabric. But the new regimes offered little resistance to the build-up of financial imbalances. History indicates that financial imbalances have often built up even in the context of low and stable inflation, sometimes also of falling prices. This was not uncommon under the gold standard, for instance - the previous globalisation wave.
But it has also been quite common since the s. Thus, as long as inflation did not pose a problem during financial expansions, there was little reason to tighten policy, especially since monetary and credit aggregates had been put to one side.
There is a kind of "credibility paradox" here: The third change was the globalisation of the real side of the economy. Globalisation came into its own in the early s and gathered pace in the early s.
- Inflation and Debt
It followed on the heels of the entry into the world's trading system of former communist countries and China as well as of the opening-up of emerging market economies EMEsnotably India. This added something like 1. Alongside the expansion of global value chains, it amounted to a string of positive supply side shocks, which raised the world's growth potential and sharpened competition.
Unleashing the global economy's growth potential helped lift large parts the world's population out of poverty.
Low inflation and rising global debt: just a coincidence?
But the new regime provided additional fuel for the emergence of outsize financial expansions, sustained by overly optimistic growth expectations - what Kindleberger would call "displacement" - as well as persistent disinflationary pressures.
Central banks' fight against inflation received unexpected support. All this helps explain the low inflation. But financial cycles, by definition, involve both expansions and contractions.
How could this then help explain the increase in global debt, public and private, that we have seen at least since the early s? The answer is a ratchet effect. The effect arises because financial busts, especially if they go hand in hand with banking crises, leave very long-lasting scars on the economy: Thus, the impact of financial cycles is not symmetric.
More importantly perhaps, policy responses may not be symmetric either. This ratchet effect has arguably reinforced other, better known forces: Let's consider the role of policy in more detail.
Fiscal policy has typically been asymmetric. The authorities have failed to recognise that financial booms hugely flatter the fiscal accounts. Potential output and growth are overestimated, financial expansions are revenue-rich, and resources may be needed to repair banking systems when a crisis occurs. The long-lasting impact of the busts on output and productivity does the rest. The experience of Spain and Ireland is quite telling. Public debt relative to GDP actually declined in the run-up to the Great Financial Crisis GFCand observers thought that the countries were running cyclically adjusted fiscal surpluses.
These purported role models of fiscal probity then faced a sovereign crisis once the financial cycle turned and their banks ran into serious trouble. Monetary policy has, unwittingly, been somewhat asymmetric too. In the context of low and stable inflation during financial expansions, there has been no reason to tighten. But the financial bust-induced damage, coupled with concerns about a deflation threat, has naturally led to protracted easing to steer the economy back towards full capacity and push inflation up.
While I also worry about inflation, I do not think that the money supply is the source of the danger. In fact, the correlation between inflation and the money stock is weak, at best. The chart below plots the two most common money-supply measures sincealong with changes in nominal gross domestic product. M1 consists of cash, bank reserves, and checking accounts.
M2 includes savings accounts and money-market accounts. Nominal GDP is output at current prices, which therefore includes inflation. As the chart shows, money-stock measures are not well correlated with nominal GDP; they do not forecast changes in inflation, either. The correlation is no better than the one between unemployment and inflation. Why is the correlation between money and inflation so weak? The view that money drives inflation is fundamentally based on the assumption that the demand for money is more or less constant.
But in fact, money demand varies greatly. During the recent financial crisis and recession, people and companies suddenly wanted to hold much more cash and much less of any other asset. Thus the sharp rise in M1 and M2 seen in the chart is not best understood as showing that the Fed forced money on an unwilling public. Rather, it shows people clamoring to the Fed to exchange their risky securities for money and the Fed accommodating that demand.
Money demand rose for a second reason: Since the financial crisis, interest rates have been essentially zero, and the Fed has also started paying interest on bank reserves. But if bonds earn the same as cash, it makes sense to keep a lot of cash or a high checking-account balance, since cash offers great liquidity and no financial cost.
Fears about hoards of reserves about to be unleashed on the economy miss this basic point, as do criticisms of businesses "unpatriotically" sitting on piles of cash. Right now, holding cash makes sense. Modern monetarists know this, of course. The older view that the demand for money is constant, and so inflation inevitably follows money growth, is no longer commonly held.
Rather, today's monetarists know that the huge demand for money will soon subside, and they worry about whether the Federal Reserve will be able to adjust. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. Laffer's worry is just that "rapid growth" in money will not cease when the "panic demand" ceases.
Plosser writes similarly Some people have questioned whether the Federal Reserve has the tools to exit from its extraordinary positions. But the question for the Fed and other central bankers is not can we do it, but will we do it at the right time and at the right pace. The Fed can instantly raise the interest rate on reserves, thereby in effect turning reserves from "cash" that pays no interest to "overnight, floating-rate government debt.
Modern monetarists therefore concede that the Fed can undo monetary expansion and avoid inflation; they just worry about whether it will do so in time. This is an important concern. But it is far removed from a belief that the astounding rise in the money supply makes an equally astounding increase in inflation simply unavoidable.
And like the Keynesians, the monetarists do not consider our deficits and debt when they think about inflation. Their formal theories, like the Keynesian ones, assume in footnotes that the government is solvent, so there is never pressure for the Fed to monetize intractable deficits. But what if our huge debt and looming deficits mean that the fiscal backing for monetary policy is about to become unglued?
About half of all federal spending is borrowed. Then, as the Baby Boomers retire, health-care entitlements and Social Security obligations balloon, and debt and deficits explode. And the CBO is optimistic.
First, the debt-to-GDP ratio is a misleading statistic. But there is no safe debt-to-GDP ratio. There is only a "safe" ratio between a country's debt and its ability to pay off that debt. If a country has strong growth, stable expenditures, a coherent tax system, and solid expectations of future budget surpluses, it can borrow heavily.
Ineveryone understood that war expenditures had been temporary, that huge deficits would end, and that the United States had the power to pay off and grow out of its debt. None of these conditions holds today. Second, official federal debt is only part of the story. Our government has made all sorts of "off balance sheet" promises. The government clearly considers the big banks too important to fail, and will assume their debts should they get into trouble again, just as Europe is already bailing its banks out of losses on Greek bets.
State and local governments are in trouble, as are many government and private defined-benefit pensions. The federal government is unlikely to let them fail. Each of these commitments could suddenly dump massive new debts onto the federal Treasury, and could be the trigger for the kind of "run on the dollar" explained here. Third, future deficits resulting primarily from growing entitlements are at the heart of America's problem, not current debt resulting from past spending. But even if the United States eliminated all of its outstanding debt today, we would still face terrible projections of future deficits.
In a sense, this fact puts us in a worse situation than Ireland or Greece. Those countries have accumulated massive debts, but they would be in good shape Ireland or at least a stable basket case Greece if they could wipe out their current debts.
Promised Medicare, pension, and Social Security payments known as "unfunded liabilities" can be thought of as "debts" in the same way that promised coupon payments on government bonds are debts. To get a sense of the scope of this problem, we can try to translate the forecasts of deficits in our entitlement programs to a present value.
The idea that these fiscal problems could lead to a debt crisis is hardly a radical insight. As even the circumspect Congressional Budget Office warned earlier this year: It is possible that interest rates would rise gradually as investors' confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis. But as other countries' experiences show, it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply.
The exact point at which such a crisis might occur for the United States is unknown, in part because the ratio of federal debt to GDP is climbing into unfamiliar territory and in part because the risk of a crisis is influenced by a number of other factors, including the government's long-term budget outlook, its near-term borrowing needs, and the health of the economy.
When fiscal crises do occur, they often happen during an economic downturn, which amplifies the difficulties of adjusting fiscal policy in response. Bernanke has been echoing this warning with a degree of bluntness very unusual for a Fed chairman.
In testimony before the House Budget Committee earlier this year, he said: The question is whether these [fiscal] adjustments will take place through a careful and deliberative process.
But precisely the situation they warn about carries a significant risk of inflation amid a weakening economy — an inflation that the Fed could do little to control. Why does paper money have any value at all? In our economy, the basic answer is that it has value because the government accepts dollars, and only dollars, in payment of taxes. The butcher takes a dollar from his customer because he needs dollars to pay his taxes.
Or perhaps he needs to pay the farmer, but the farmer takes a dollar from the butcher because he needs dollars to pay his taxes. As Adam Smith wrote in The Wealth of Nations, "A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money.
If that happens, people collectively try to get rid of the extra cash.
Low inflation and rising global debt: just a coincidence?
We try to buy things. But there is only so much to buy, and extra cash is like a hot potato — someone must always hold it. Therefore, in the end, we just push up prices and wages. The government can also soak up dollars by selling bonds. It does this when it wants temporarily to spend more giving out dollars than it raises in taxes soaking up dollars. But government bonds are themselves only a promise to pay back more dollars in the future. At some point, the government must soak up extra dollars beyond what people are willing to hold to make transactions with tax revenues greater than spending — that is, by running a surplus.
If not, we get inflation. If people come to believe that bonds held today will be paid off in the future by printing money rather than by running surpluses, then a large debt and looming future deficits would risk future inflation. And this is what most observers assume.
In fact, however, fears of future deficits can also cause inflation today. The key reason is that our government is now funded mostly by rolling over relatively short-term debt, not by selling long-term bonds that will come due in some future time of projected budget surpluses. Half of all currently outstanding debt will mature in less than two and a half years, and a third will mature in under a year. As the government pays off maturing debt, the holders of that debt receive a lot of money.
Normally, that money would be used to buy new debt. But if investors start to fear inflation, which will erode the returns from government bonds, they won't buy the new debt. Instead, they will try to buy stocks, real estate, commodities, or other assets that are less sensitive to inflation.
But there are only so many real assets around, and someone has to hold the stock of money and government debt. So the prices of real assets will rise. Then, with "paper" wealth high and prospective returns on these investments declining, people will start spending more on goods and services.
But there are only so many of those around, too, so the overall price level must rise. Thus, when short-term debt must be rolled over, fears of future inflation give us inflation today — and potentially quite a lot of inflation.
It is worth looking at this process through the lens of present values. The real value of government debt must equal the present value of investors' expectations about the future surpluses that the government will eventually run to pay off the debt. Bond holders will therefore try to sell off their debt before its value falls. If only long-term debt were outstanding, these investors could try to sell long-term debt and buy short-term debt. The price of long-term debt could fall by half thus long-term interest rates would rise so that the value of the debt would once again be the present value of expected surpluses.
But if only short-term debt is outstanding, investors must try to buy goods and services when they sell government debt.
The only way to cut the real value of government debt in half in this situation is for the price level to double. In a sense, this confirms the Keynesians' view that expectations matter, but not their view of what the sources of those expectations are. A fiscal inflation would happen today because people expect inflation in the future. A "loss of anchoring," to use a Keynesian term, would thus likely to lead to stagflation rather than to a boomlet of growth.
The Treasury probably borrows using short-term bonds because short-term interest rates are lower than long-term rates. The government thus thinks it's saving us money. But long-term rates are higher for a reason: Long-term debt includes insurance against crises. It forces bondholders to bear risks otherwise borne by the government and, ultimately, by taxpayers and users of dollars.
Like all insurance, a premium that seems onerous if there is no disaster can seem in retrospect to have been remarkably small if there is one. And, unfortunately, the very fact that so much of our debt is short term makes such a disaster more likely. An increase in interest rates could also bring on inflation today, compounding the inflationary effect of a potential debt crisis through a very similar mechanism.
Just how low are today's rates? The one-year rate is now 0. We have not seen rates this low in the post-war era. If an investor lends money at 0.
Such low rates are therefore unlikely to last. Sooner or later, people will find better things to do with their money, and demand higher returns to hold Treasury debt. Low interest rates are partially a result of the Fed's deliberate efforts. But both the Fed's desire to keep rates this low and its ability to do so are surely temporary. Low interest rates are also partly a reflection of investors' "flight to quality," as they have sought shelter in American debt amid the financial crisis and the emerging European debt crisis.
Investors believe that the United States will never default or miss an interest payment, and that surprise inflation could not eat away much of the real value of short-term debt in a year. People are willing to hold it despite low interest rates for much the same reason they are willing to hold money despite no interest rate. But this special status, too, could change. It became clear during this past summer's debt-limit negotiations that the federal government is less committed to paying interest on its debt than many observers had thought.
For example, in a July breakfast with Bloomberg reporters, President Obama's chief political advisor, David Plouffe, said on the record that "the notion that we would just pay Wall Street bondholders and the Chinese government and not meet our Social Security and veterans' obligations is insanity, and is not going to happen.
Missing interest payments would instantly mean a loss of liquidity of U. A loss of the special safety and liquidity discount that American debt now enjoys could add two to three percentage points. A rising risk premium would imply higher rates still. And of course, if markets started to expect inflation or actual default, rates could rise even more.
Low interest rates can climb quickly and unexpectedly, as Greece and Spain have learned. A rise in interest rates can lead to current inflation in the same way a change in investor views about long-term deficits can.
Every percentage point that interest rates rise means, roughly, that the U. And this number is cumulative, as larger deficits mean more and more outstanding debt. Again, present values can help clarify the point. The rate of return that investors demand in exchange for lending money to the government is just as important to the present value of future surpluses as is the amount of future surpluses that investors expect.
And since so much debt is short term, a fall in the real value of the debt must push the price level up. These two factors — expectations of future surpluses and deficits, and increases in interest rates — are likely to reinforce each other.
If bond investors decide that the government is likely to inflate or default on part of the debt, investors are likely to simultaneously demand a higher risk premium to hold the debt. The two forces will combine to apply even greater pressure toward inflation. Unlike a bank run, however, it would play out in slow motion.
Before the financial crisis, Bear Stearns and Lehman Brothers rolled over debt every day in order to invest in mortgage-backed securities and other long-term illiquid assets.
Each day, they had to borrow new money to pay back the old money. When the market lost faith in the long-term value of their investments, the market refused to roll over the loans, and the two companies failed instantly.
The United States rolls over its debt on a scale of a few years, not every day. So the "run on the dollar" would play out over a year or two rather than overnight. Furthermore, I have described for clarity a sudden one-time loss of confidence.
The actual process of running from the dollar, however, is likely to take more time, much as the European debt crisis has trundled along for more than a year. In addition, because prices tend to change relatively slowly, measured inflation can take a year or two to build up after a debt crisis. Like all runs, this one would be unpredictable. After all, if people could predict that a run would happen tomorrow, then they would run today.
Investors do not run when they see very bad news, but when they get the sense that everyone else is about to run. That's why there is often so little news sparking a crisis, why policymakers are likely to blame "speculators" or "contagion," why academic commentators blame "irrational" markets and "animal spirits," and why the Fed is likely to bemoan a mysterious "loss of anchoring" of "inflation expectations. This scenario is a warning, not a forecast. Extraordinarily low interest rates on long-term U.
Government Debt & Inflation | The Money Enigma
If markets interpreted the CBO's projections as a forecast, not a warning, a run would have already happened. And our debt and deficit problems are relatively easy to solve as a matter of economics if less so of politics.
But we are primed for this sort of run. All sides in the current political debate describe our long-term fiscal trajectory as "unsustainable. Treasuries and even shorting them, as major players like Goldman Sachs famously shorted mortgage-backed securities before that crash.
As with all runs, once a run on the dollar began, it would be too late to stop it. Confidence lost is hard to regain. It is not enough to convince this year's borrowers that the long-term budget problem is solved; they have to be convinced that next year's borrowers will believe the same thing.
It would be far better to find ways to avert such a crisis than to be left searching for ways to recover from it. We have come to think that central banks control inflation. In fact, the Fed's ability to control inflation is limited — and the bank would be especially impotent in the event of fiscal or "run on the dollar" inflation. The Fed's main policy tool is an "open-market operation": It can buy government bonds in return for cash, or it can sell government bonds to soak up some money.
Thus, the Fed can change the composition of government debt, but not the overall quantity. Money, after all, is just a different kind of government debt, one that happens to come in small denominations and doesn't pay interest.
Bank reserves, which now pay interest, are just very liquid, one-day maturity, floating-rate debt. So the Fed can affect financial affairs and ultimately the price level only when people care about the kind of government debt they hold — reserves or cash versus Treasury bills.
But in the "run from the dollar" scenario, people want to get rid of all forms of government debt, including money.