Que pases unos santos días penitentes. Un abrazo
My Inflation Nightmare
Am I crazy, or is the commentariat ignoring our biggest economic threat?
16/3/2010 By Michael Kinsley
Right-wing talk radio these days is carrying fewer commercials for second mortgages. (Consolidate your debts, lower your monthly payments, and have enough left over for that dream vacation!) They’ve been replaced by commercials for gold. Gold bugs have long had a small place on the map of the American right, but to most people gold seems like a crazy investment. It doesn’t produce anything, unlike a company in which you might own shares. It can’t provide shelter, like a house. It’s too expensive to use widely in industry or commerce, except for tiny amounts that go into people’s mouths, wrap around their fingers, or hang from their ears. Gold just sits there. And yet the price of gold has gone from about $280 an ounce 10 years ago to about $1,140 today.
The only reason to buy gold is fear that the currency may collapse. Paper currency used to represent claims on a share of the gold in Fort Knox. Now it is just “fiat money,” backed only by the “full faith and credit” of the United States government. Ditto electronic money—the $5,000 you allegedly have in a savings account at the bank, whose only corporeal existence is on a hard drive somewhere. That $5,000 is $5,000 only because the government says it is. For the gold bugs, trusting the government seems as unwise as hoarding gold seems to most other people.
Another way to say “collapse of the currency” is to say “hyperinflation.” Hyperinflation is when inflation feeds on itself and takes off beyond control. You can have stable 2 to 3 percent inflation. But you can’t have stable 10 percent inflation. When everybody assumes 10 percent, all the forces that produced 10 percent push it to 20 percent, and then 40 percent, and soon people are lugging currency in a wheelbarrow, as in the famous photos from Weimar Germany.
Thirty years ago, we peered into this abyss and pulled back just in time. As inflation neared its peak of more than 13 percent, Jimmy Carter appointed Paul Volcker as chairman of the Federal Reserve Board. Using his control over the money supply, Volcker purposely plunged us into a deep recession, which is the only certain remedy. Carter got blamed for both the inflation and the recession that cured it. The columnist Robert Samuelson tells the story in his book, just out in paperback, The Great Inflation and Its Aftermath.
Even 13 percent inflation was a nightmare. A stable currency is firm ground on which you can build a life. Inflation turns life into Through the Looking-Glass: you have to run faster and faster to stay in the same place. Saving is for suckers, and money needs to be spent sooner rather than later. Planning even a year or two ahead becomes nearly impossible. Worst of all, economically, the hard knocks and lucky breaks of life, which people generally accept when they are distributed by fate, become politicized, and therefore embittering. Stop fighting, and you start losing.
Furthermore, as Samuelson notes, the damage is more than just economic. These days everyone is disenchanted with civic institutions and government. They hate the press, they loathe Congress, and so on. Studies by foundations puzzle over why. Was it the ’60s? No, it was the late ’70s and early ’80s, when government failed to deliver on its obligation to provide a stable currency.
Samuelson worries that “the entire episode” may “slip from our collective consciousness.” I’ll spare you the Santayana and just say that if we are doomed to repeat this particular bit of the recent past, the press has failed in its self-imposed obligation to be the “first draft of history.”
According to the considerable discussion of inflation on the Web, my alarm is misguided. Every economist I admire, from Paul Krugman and Larry Summers on down, is convinced that inflation will remain low for as long as we can predict. Greg Mankiw, who was George W. Bush’s economic adviser, has examined the evidence in his New York Times column and concluded that a return of debilitating inflation is pretty unlikely (although “current monetary and fiscal policy is so far outside the bounds of historical norms” that who can say for sure?). Krugman has charged that inflation fearmongering is a nefarious Republican plot. The Congressional Budget Office (usually known by its nickname, “the nonpartisan Congressional Budget Office”) projects inflation rates of less than 2 percent for the next decade. Some say the real danger is the opposite: deflation, or prices (and wages) going down across the board.
Maybe I’m like those generals who are always fighting the last war, but I am not reassured. I worry that when and if the recession is well and truly over, there is a serious danger of another round of vicious inflation. (If the recession is not over, or gets worse, we’ll have other problems.) This time, inflation will be a lot harder to stop before it turns into hyperinflation. Whether Obama navigates these shoals successfully will be a big factor in his historic reputation. And journalists will be kicking themselves (and other people will be kicking journalists) for missing a disaster story on the level of Hurricane Katrina, if not 9/11 itself.
In short, I can’t help feeling that the gold bugs are right. No, I’m not stashing gold bars under my bed. But that’s only because I lack the courage of my convictions.
My fear is not the result of economic analysis. It’s more from the realm of psychology. I mean mine. The last time I wrote about this subject, The Atlantic’s own Clive Crook called me a “fiscal sado-conservative.” I would put it differently (you won’t be surprised to hear). Maybe, at least on economic matters, I’m a puritan. The recession we’ve been going through did not occur for no reason. Even though serious misbehavior by the finance industry triggered it, sooner or later it was bound to happen. For a generation—since shortly after Volcker saved the country, and except for a brief period of surpluses under Bill Clinton—we partied on borrowed money. We watched a real-estate bubble get larger and larger, knowing but not acknowledging that it had to burst. Then it did burst, and George W. Bush slunk off to Texas, leaving Barack Obama to clean up the mess. Obama has done the right things, mostly, pushing through a huge stimulus package and bailing out a few big corporations and banks. Krugman says we need yet another dose of stimulus, and maybe he’s right.
But this cure has been one ice-cream sundae after another. It can’t be that easy, can it? The puritan in me says that there has to be some pain. That’s not to say that there hasn’t been plenty of economic pain. But that pain has come from the recession itself, not the cure.
My specific concern is nothing original: it’s just the national debt. Yawn and turn the page here if you’d like. We talk now of trillions, not yesterday’s hundreds of billions. It’s not Obama’s fault. He did what he had to do. However, Obama is president, and Democrats do control Congress. So it’s their responsibility, even if it’s not their fault. And no one in a position to act has proposed a realistic way out of this debt, not even in theory. The Republicans haven’t. The Obama administration hasn’t. Come to think of it, even Paul Krugman hasn’t. Presidential adviser David Axelrod, writing in The Washington Post, says that Obama has instructed his agency heads to go through the budget “page by page, line by line, to eliminate what we don’t need to help pay for what we do.” So they’ve had more than a year and haven’t yet discovered the line in the budget reading “Stuff We Don’t Need, $3.2 trillion.”
There is a way out. It’s called inflation. In 1979, for example, the government ran a deficit of more than $40 billion—about $118 billion in today’s money. The national debt stood at about $830 billion at year’s end. But because of 13.3 percent inflation, that $830 billion was worth what only $732 billion would have been worth at the beginning of the year. In effect, the government ran up $40 billion in new debts but inflated away almost $100 billion and ended up with a national debt smaller in real terms than what it started with. Ten percent inflation for five years (if that were possible) would erode the value of our projected debt nicely—but along with it, the value of non-indexed pensions, people’s savings, and so on. The Federal Reserve is independent, but Congress and the White House have ways to pressure the Fed. Actually, just spending all this money we don’t have is one good way.
Compared with raising taxes or cutting spending, just letting inflation do the dirty work sounds easy. It will be a terrible temptation, and Obama’s historic reputation (not to mention the welfare of the nation) will depend on whether he succumbs. Or so I fear. So who are you going to believe? Me? Or virtually every leading economist across the political spectrum? Even I know the sensible answer to that.
And yet …
RESPUESTA DE KRUGMAN:
Stagflation Versus Hyperinflation
March 18, 2010, 9:16 am — Updated: 9:16 am -->PAUL KRUGMAN
I’m a bit late to this, but Mike Kinsley has an odd piece in the Atlantic in which he confesses himself terrified about future inflation, even though there’s no hint of that problem in the real world. He’s not alone: there are a lot of voices predicting imminent hyperinflation in 2009, make that 2010 (and yes, I am keeping a record).
What I want to take on, however, is this piece of analysis in Kinsley’s piece:
Hyperinflation is when inflation feeds on itself and takes off beyond control. You can have stable 2 to 3 percent inflation. But you can’t have stable 10 percent inflation. When everybody assumes 10 percent, all the forces that produced 10 percent push it to 20 percent, and then 40 percent, and soon people are lugging currency in a wheelbarrow, as in the famous photos from Weimar Germany.
Uh, no — at least not according to textbook economics, which makes a real distinction between the kind of inflation that bedeviled the 1970s and 1923 (or Zimbabwe)-type hyperinflation.
Hyperinflation is actually a quite well understood phenomenon, and its causes aren’t especially controversial among economists. It’s basically about revenue: when governments can’t either raise taxes or borrow to pay for their spending, they sometimes turn to the printing press, trying to extract large amounts of seignorage — revenue from money creation. This leads to inflation, which leads people to hold down their cash holdings, which means that the printing presses have to run faster to buy the same amount of resources, and so on.
The kind of inflation we had in the 1970s, the famous era of stagflation — high inflation combined with high unemployment — was quite different. Deficits weren’t the issue — actually, US deficits were much smaller in the inflationary 70s than in the disinflationary 80s. Instead, what you had was a combination of excessively expansionary monetary policies, based on an unrealistic view of how low the unemployment rate could be pushed without causing accelerating inflation (the NAIRU), plus oil shocks that pushed up inflation across the board thanks to widespread cost-of-living clauses in contracts. There was never any risk of hyperinflation; the only question was whether and when we’d be willing to pay the price in high unemployment of bringing inflation back down.
Kinsley seems to be confusing the logic of the natural rate argument, which says that expected inflation gets built into price-setting, so you need an accelerating inflation rate to keep unemployment below the NAIRU, with the very different logic of hyperinflation, which is about people fleeing money.
Meanwhile, for those predicting hyperinflation, my question would be: what is it about the United States now that looks different to you from Japan in say, 2000? Big budget deficits and high debt? Check. Huge expansion in the monetary base? Check. And yet Japan’s GDP deflator has fallen 9 percent since 2000
RESPUESTA DEL PRIMERO:
Kinsley: Inflation vs. Hyperinflation
By Michael Kinsley on March 23, 2010 9:06am
What kind of fool gets into a public argument about economics with Paul Krugman? In the April Atlantic, there is a column by me expressing alarm about the possible return of debilitating inflation, or even hyperinflation, as the only way that a government unable either to cut spending or raise taxes will be able to reduce the burden of the national debt. I acknowledged that all the big-name economists, including Krugman, think differently. Writing in his New York Times blog, Krugman demonstrates that at least I got that part right.
Krugman says that I mistakenly conflate inflation and hyperinflation, although “textbook economics…makes a real distinction” between the two. I will confess that I was not aware of this distinction. I thought hyperinflation was inflation out-of-control. Mea culpa. However:
(1) Krugman should stop bullying people with accusations of economic ignorance. I would never pretend to know a tenth of economics Paul knows. But if he means, in calling this distinction a matter of “textbook economics [subtext: you idiot],” that economic textbooks make this distinction, he is wrong. Or at least no such distinction between inflation and hyperinflation is made, despite an extensive discussion of inflation, in the leading economics textbook, by Harvard Professor Gregory Mankiw.
(2) Krugman’s definition of hyperinflation—“when governments can’t either raise taxes or borrow to pay for their spending, they sometimes turn to the printing press”—is more or less precisely what I wrote that I was afraid of. I suppose there’s a difference between the government printing money to pay off its debts (Krugman’s definition) and the government printing money to reduce the real value of its debts (my fear). But not much of one.
(3) Krugman, Brad DeLong, Matt Yglesias and others make the point that there is no current economic evidence of inflation on on the horizon. I conceded as much in the original piece. But using Krugman’s definition, hyperinflation is the result of explicit policy choices by public officials. There is a “real distinction” between this and inflation ordinaire, which results naturally from the interplay of economic forces.
Therefore, the fact that there is no sign of inflation today says very little about whether there may be hyperinflation tomorrow.There are reasons to worry that our political leaders may opt for inflation even if there is no economic evidence of it happening naturally. (Of course the interplay of economic forces can force the hand of public officials. But if we go down this road, we are muddying that key distinction between hyperinflation and inflation.)
I have been waiting for Paul Krugman to tell me how we are going to handle the debt, once we get this recession out of the way. No, really. There’s no economist whose judgment I trust more. (About economics, that is.) I’ve been all for the stimulus and the jobs bill and even, I guess, the sundry bailouts. But don’t we at some point have to start paying the money back? And how are we going to do that? Krugman’s failure (unless I’ve missed it) to give us an answer to that question is one of the things that makes me worry.
A final word to Matt Yglesias, who thinks my problem is “thinking too moralistically about the economy,” because I express doubt that we can escape without pain from the dilemma we find ourselves in. Obviously (or perhaps not) this is a prediction and not a hope. I am not in favor of pain. I just don’t see any way to avoid it. Yglesias apparently believes that we can escape our fiscal dilemma without pain. I would like to know how. And if there is such a way, why have we denied ourselves for so long? Why do we ever bother to show fiscal restraint? Why have taxes at all? Why deny ourselves anything money can buy? If $15 trillion in debt can be a freebie, why not $30 trillion or $60 trillion?
EEUU saldrá de la crisis subiendo impuestos a tope, no con inflación:
A Fiscal Train Wreck
(Greg Mankiw) A couple days ago, Bloomberg reported:
The bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama.
Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.
The $2.59 trillion of Treasury Department sales since the start of 2009 have created a glut as the budget deficit swelled to a post-World War II-record 10 percent of the economy and raised concerns whether the U.S. deserves its AAA credit rating. The increased borrowing may also undermine the first-quarter rally in Treasuries as the economy improves....
While Treasuries backed by the full faith and credit of the government typically yield less than corporate debt, the relationship has flipped as Moody’s Investors Service predicts the U.S. will spend more on debt service as a percentage of revenue this year than any other top-rated country except the U.K. America will use about 7 percent of taxes for debt payments in 2010 and almost 11 percent in 2013, moving “substantially” closer to losing its AAA rating, Moody’s said last week.
Actually, a default on U.S. government debt is much less likely than another scenario, suggested by Paul Krugman:
How will the train wreck play itself out?...my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt.And as that temptation becomes obvious, interest rates will soar. It won't happen right away....But unless we slide into Japanese-style deflation, there are much higher interest rates in our future. I think that the main thing keeping long-term interest rates low right now is cognitive dissonance. Even though the business community is starting to get scared — the ultra-establishment Committee for Economic Development now warns that "a fiscal crisis threatens our future standard of living" — investors still can't believe that the leaders of the United States are acting like the rulers of a banana republic. But I've done the math, and reached my own conclusions.
Actually, Paul wrote that in 2003, and we know now that his prediction of higher inflation did not come to pass. But budget deficits are much larger now, so maybe his logic will apply this time around. If it does, the inflation would adversely affect the real return on both government and private bonds.
My own guess is that the United States will raise taxes substantially, and taxes will reach levels as a percentage of GDP never seen in U.S. history (although common in Europe). The politics of that will be fascinating to watch. If the political process is stymied as our leaders debate the relative merits of tax hikes versus spending cuts, bond investors may get nervous, and we could get witness either the Krugman inflation scenario or the much less likely default scenario.
Y Morgan Stanley también entra en este debate:
Debating Debtflation
March, 2010 By Spyros Andreopoulos, Joachim Fels & Manoj Pradhan London
The Greek crisis has brought sovereign debt to the forefront, capturing markets' attention. We think another dimension of the sovereign issue, the inflation risks inherent in high levels of public debt for economies that can print their own currency, is being overlooked by the markets. High levels of public debt in many advanced economies raise the spectre of inflation, in our view: if high debt is deemed undesirable, but the political will for higher taxes and lower spending is lacking, then ‘soft default' through inflation becomes a possibility.
Recently, we have tried to put some numbers on the inflation risks inherent in the current and prospective US fiscal position (see The Return of Debtflation? February 10, 2010). We looked at a hypothetical scenario whereby policymakers attempt to stabilise debt to GDP at the current 60% level over the next ten years. The thought experiment assumes the debt is dealt with in exactly the same way now as in the post-war period (1946-2003). That is, if the same weight is given to inflation and real GDP growth as factors behind the erosion of the debt, we are able to back out the required inflation rates (for any given level of the deficit). We calculate that, over the next ten years, on average,
• a 5% deficit would require 9% inflation
• a 3% deficit would require 6% inflation
• achievement of a 2% inflation target requires a 1% of GDP budget surplus.
Scary stuff.
Clients and colleagues have questioned both our assumptions and our conclusions (see US Economics: We Can't Inflate Our Way Out, February 19, 2010). This is our response.
I. Our Assumptions, or: Why Debtflation Is Possible
For simplicity, we have assumed that interest payments, as a share of GDP, remain constant. True, this is a strong assumption. But even if interest to GDP increases with inflation, we don't think it will be by enough to prevent substantial debt erosion - at least for some time. Here's why.
What matters most for successful debtflation, our colleagues rightly point out, is whether the (effective, i.e., maturity-weighted) nominal interest rate on the debt can be pushed below the rate of growth of nominal GDP. Put another way, the question is whether, and for how long, inflation can lower the effective real interest rate on the debt. We believe that's possible for a sustained period: debt does not roll instantaneously; and bond yields are slow to incorporate changes in inflation. These two factors can be thought of as the crucial frictions that allow for debt erosion.
1. Debt maturities
The fact that the whole stock of debt does not roll every period means that the effective nominal interest rate on the debt is slow to respond to an increase in market yields. For the US, average maturity on Treasury debt is poised to exceed the postwar average of about 5 years by the end of fiscal 2012 (September), on our forecasts. The implication is that even if market yields were to adjust instantaneously to the higher inflation regime, effective nominal interest rates on the debt would respond only partially. So there is a debt erosion effect even if inflation were to be perfectly anticipated.
2. Yields are slow to adjust to a new inflation regime
Inflation - especially a change in the inflation regime - is rarely, if ever, perfectly anticipated. Inflation expectations lag behind actual inflation. In turn, bond yields lag behind inflation expectations. Evidence is abundant:
• Historically, yields lag behind inflation. Throughout the 1970s, bond yields never meaningfully caught up with the inflation takeoff: real interest rates were mostly very low - indeed negative for sustained periods - a bad time for bonds. Exactly the opposite happened during the Great Moderation of the 1980s and 90s. The sustained decline in inflation meant real interest rates were high, giving rise to a long bull market for bonds.
• Statistical work suggests the same conclusion. The empirical academic literature suggests both that bond yields take a long time to incorporate inflation expectations, and that inflation expectations themselves are sticky. Put another way, the fact that nominal yields take time to catch up with inflation gives rise to the observed negative correlation between inflation and real yields.
In short, inflation lowers the real effective interest rate the government pays on the debt through reducing a) the nominal effective interest rate, and b) real market yields. Moreover, the evidence suggests that these mechanisms work over a sustained period of time - allowing substantial debt erosion.
And there are additional reasons that make inflation relevant today. The evidence strongly suggests that, for the US as well as internationally, high debt has historically come hand in hand with lower growth as well as higher inflation (see Carmen Reinhart and Kenneth Rogoff, Growth in Times of Debt, NBER Working Paper 15639). For the US, they show that debt to GDP ratios in excess of 90% have meant materially higher inflation and lower growth. Indeed, we expect trend growth to be lower across developed economies over the next five years. But sluggish real growth leaves fewer options of dealing with the debt.
II. The Road to Debtflation, or: Global Inflation Risks Intensifying
Yet inflation is low almost everywhere. And with yawning output gaps, surely inflation is nothing to worry about. Policymakers, some say, couldn't inflate even if they wanted to.
Not quite. It is true that inflation will remain subdued for some time to come. But inflation risks are visible on the horizon. Our US team expects the inflation picture to turn at around the middle of the year, as import prices pick up and the output gap narrows (see US Economics, Mind the Gap: Even Record Slack in the Economy Won't Crush Inflation, January 29, 2010).
But there are further reasons to worry about inflation (see Global QE, Global Inflation, July 1, 2009).
• In many advanced economies, there may be less slack than meets the eye. Output gap measures are highly unreliable most of the time - but even more so when an economy is undergoing structural change. The US and the UK for example need to turn from consumers into producers. This means a lot of the spare capacity is in sectors where it is not needed, for example in construction. But worker skills may not be immediately transferable: the resulting unemployment may not exert as much downward pressure on wages. And skill shortages in the expanding sectors may still allow wages to be bid up there.
• Dollar peggers in EM have been importing the Fed's ultraexpansionary monetary policy. Some of these economies risk overheating, generating upward pressure for commodity prices globally and DM import prices.
• There is an enormous amount of monetary stimulus in the system. Since the beginning of QE in September 2008, narrow money M1 is higher by 11.5% in the US, and 17% in the euro area. This monetary expansion is unlikely to be reversed before policy rates are back, or above, neutral - a long way off on our forecasts. For the US, additional risks emanate from the 1.1 trillion dollars of excess reserves in the banking system: if banks decide to increase lending as growth recovers, some of those reserves could find their way into the economy (see ER, RR, IOR, and RRR, February 17, 2010).
III. Our Conclusions, or: Inflation Targeting in Times of Debt
Some clients and colleagues also disagree with our view of central banks (CB). Surely, a DM CB would never monetise public debt? In a nutshell, we think that in the game of chicken between the fiscal authority and the CB, it may well be the CB that swerves: it could be preferable for a rational CB to create some controlled inflation now to ease public and private sectors with their debt burden, than risk the debt creating greater problems down the line. We think that CBs are likely to continue to pay lip service to existing inflation targets, while more often than not overshooting them. Cynical? But this would only be a repeat of what happened over the last ten years or so (see From Inflation Targeting to Price Level Targeting? July 15, 2009).
Note also that when public - and private - debt is high, a CB that is being consistent on its inflation targeting (IT) could do serious damage to the economy. Recall that IT works if the CB responds to deviations of inflation from the target by increasing the nominal interest rate by more than one for one with inflation. In other words, IT does by design what is worst for highly indebted public and private sectors: increase the real interest rate on the debt.
In short, public and private leverage imply substantial constraints on monetary policy. At best, the risks are ‘soft' IT and creeping inflation. At worst, (continued) monetisation of public debt and a new regime of high inflation.
Finally, consider this scenario. Suppose inflation jumps higher because any of the risks the Fed itself recognises materialise - even against the Fed's best intentions. Would the Fed then push the economy into recession to squeeze inflation out of the system, or acquiesce and accept higher inflation, at least temporarily? We leave the answer to investors' own judgement.
Bottom Line
The Greek crisis likely marked the beginning of a wider sovereign risk crisis. We think this crisis may well engulf central banks too, as high levels of public and private debt will test monetary authorities' resolve - and ability - to deliver price stability going forward. Meanwhile, we think investors should hedge against inflation risks.
Los problemas de EEUU se resumen en la insostenibilidad de su DEUDA PUBLICA, algo que nos es muy conocido aquí en España. Morgan Stanley hace una simulación de qué déficit público tendría que tener EEUU para conseguir estabilizar la deuda pública americana y que no siga subiendo. Pues el tercer factor es el que nos temíamos: hay que tener inflación para que esto ocurra, para que se devalúe el dinero y se reduzca la deuda pública. ¿Podríamos asumir una tasa de inflación del 4-6% durante un cierto periodo, se plantea la FED?
Advierten de la racionabilidad de reducir la DEUDA PUBICA simplemente devaluándola, generando inflación. Entonces, concluyen, hay que PRESERVAR EL CAPITAL por doble motivo, por riesgo de default y por riesgo de que se nos devalúe por la inflación.
Economics: The Return of Debtflation?
February, 2010 By Spyros Andreopoulos London
US public debt as a share of GDP is now higher than at any other time in history except after World War 2 - and rising: our US colleagues expect public debt to GDP to increase to 87% by 2020 (see US Budget Forecast Update: The Song Remains the Same, January 29). How policymakers will deal with this fact will likely be one of the main drivers across markets going forward. So what are the implications of high public sector debt for fiscal sustainability and inflation? To answer this question, we look at how the US economy escaped high debt following World War 2. We then quantify the inflation risks inherent in today's US fiscal position by asking what would happen if policymakers were to deal with the current debt overhang in the same way.
Stabilisation of public debt to GDP at current levels would require average inflation rates between 4-6% over the coming decade - even under much lower budget deficits than currently in place. On our numbers, even with budget deficits that are much lower than the current (and projected) levels, average inflation over the next ten years would have to be substantially above 2% to keep debt in check. Even a balanced budget would require 3% average inflation over the next decade. With an average deficit as low as 3% of GDP, debt stabilisation would require average inflation above 6%. Note that in the current fiscal year (FY) we expect a deficit of 9% of GDP, projected to decline to 5.2% of GDP by 2020. Suppose the government were to reduce the deficit to 5.2% from 2011 onwards - rather than by 2020. Stabilising the debt at current levels would then require an inflation rate of 9% on average over the next 10 years. What level of deficit would be consistent with achieving a 2% inflation target, on average, over the next 10 years? A 1% of GDP budget surplus.
It is clear that inflation risks of this magnitude are not in the price: currently, markets are anticipating inflation to be below 2.5% over the next 10 years, on average. Should we be worried about ‘debtflation' - the Fed engineering inflation to keep the debt in check? A forward-looking central bank may prefer to create a little controlled inflation now to the pressure of inflating a lot later on. And the idea of controlled inflation has influential advocates in policy circles. Former IMF Chief Economist Kenneth Rogoff has suggested the Fed announce a 4-6% inflation target for a limited period. Coincidence?
1. The Fiscal Consequences of the Crisis
The financial crisis and the Great Recession have increased US public indebtedness substantially. The debt to GDP ratio has shot up from 37% pre-crisis (fiscal year 2007) to around 60% in FY 2010, on our forecasts. With the exception of the World War 2 peak, this is higher than at any other time in the entire history of the US - including World War 1 or the Great Depression. From a fiscal perspective, it's as if the economy has just gone through World War 3.
And it's likely to get worse, implying fiscal and inflation risks. Our US colleagues expect public debt, as a share of GDP, to climb further to 87% by 2020 (see US Budget Forecast Update: The Song Remains the Same). Given this trajectory, fiscal sustainability remains a concern with investors and the public. Further, given the historical link between high public debt and inflation both in the US and internationally, such a precarious fiscal position may also pose a danger for price stability.
Quantifying these inflation risks with the help of history - and a simple accounting framework. Yet how large, exactly, are the inflation risks inherent in the current US debt position? Could inflation substitute for budgetary tightening in the pursuit of fiscal sustainability? Conversely, what is the size of the budget deficit or surplus consistent with low inflation? In short, what are the options policymakers have to keep debt in check? To answer these questions, we look to history for guidance. We ask through what mechanisms - the budget balance, economic growth, or inflation - did the US economy escape the record World War 2 debt levels? In other words, what mix of fiscal and monetary policies ensured fiscal sustainability after World War 2? Assuming the same mix is applied to the current situation, we can then put a number on long-term inflation risks.
2. Looking Back: A History Lesson
War debt burden was reduced not through budget surpluses... World War 2 left the US with a large debt overhang. In 1946, US public debt was 108.6% of GDP. Nearly 60 years later, in 2003, public debt to GDP was just 36%. Within two generations, debt had been reduced by over 70pp of GDP. This corresponds to an average decrease of debt/GDP (‘the debt ratio') by 1.2% every year. How was this achieved? Remarkably, between 1946 and 2003 the federal budget was, on average, in deficit, to the tune of 1.6% of GDP as the surplus in the primary balance (0.3% of GDP on average) was not enough to cover interest payments on the debt (1.9% of GDP on average).
...but through (nominal) economic growth... So how was the debt ratio reduced despite the US government having, on average, run budget deficits? The answer is, of course, through growth in nominal GDP. The denominator in debt/GDP grew faster than the numerator, bringing down the ratio over time. By how much, exactly? Nominal GDP growth reduced the debt/GDP ratio by 2.8%, on average, between 1948 and 2003.
... with the inflation effect larger than the real GDP growth effect! But this begs a more important question: how much of the erosion of the debt was due to growth in the real economy and how much of it was due to inflation? We split the Nominal Growth Effect (NGE) on the debt ratio into a Real Growth Effect (RGE) and an Inflation Effect (IE; we explain the accounting framework in the Appendix in the full stand-alone note).
Our numbers show that while real GDP growth reduced debt/GDP by 1.3% on average, the effect of inflation on the debt ratio was larger: 1.6%, on average, between 1946 and 2003. (In relative terms, 56% of the total Nominal Growth Effect on the debt ratio is due to inflation, with the remainder being due to real GDP growth.)
Note that the largest contribution of inflation to debt reduction came in the decade immediately after World War 2 (1946-1955). Despite a primary surplus of 1.2% of GDP, overall the budget was in deficit by 0.3% of GDP on average. Yet, the debt was reduced by 4.9% of GDP a year, through a nominal growth effect of 5.2% annually, as nominal GDP growth averaged 6.5% over the period. This very large nominal growth effect is mainly due to a substantial inflation effect - inflation averaged 4.2% over the period - which reduced debt to GDP by 3.7% every year, and to a much lesser extent to real GDP growth, which on average contributed 1.5% of GDP to debt reduction. The 1970s - the time of the Great Inflation - also exhibited a sizeable inflation effect. How come inflation was so successful in eroding the debt? We see three main factors. First, outlays were not closely linked to inflation. Second, bondholders were surprised by inflation both after the war and in the 1970s. Third, in the first post-War decade, the average maturity of the debt was - at more than 100 months - exceptionally high.
3. What If? Looking Ahead
Suppose policymakers deal with the debt now in the same way they did after WW2. Assuming the same relative roles for inflation and real economic growth as in the post-War period, how much inflation is needed, for a given budget deficit, to keep the debt ratio from increasing? Conversely, assuming a given inflation target - say 2% - what is the size of the budget deficit or surplus required to keep debt from increasing?
Our assumption for the policy objective is stabilising the debt ratio at our current estimate for FY 2010 - 60% of GDP - rather than it increasing to 87% by 2020, our long-term projection (see US Budget Forecast Update: The Song Remains the Same). On the fiscal policy side, policymakers control the primary deficit - the deficit excluding interest payments on the debt - rather than the total deficit (at least in the long run). Hence, the choice between inflation and the budget deficit is really a choice between inflation and the primary deficit, given the size of interest payments (as a share of GDP).
The Deficit-Inflation Frontier. Given the choice of (primary) deficit and the historical sizes of inflation and real GDP growth effects, we can calculate the inflation rate required to achieve the debt target: the Deficit-Inflation Frontier (DIF). On the horizontal axis we have the primary deficit, on the vertical axis the inflation rate. The DIF with the solid line assumes the long-term average (1946-2003) IE and RGE. The line above that assumes the 1946-1955 IE and RGE - it is above the long-term average DIF because in the first post-war decade the erosion of the debt was heavily skewed towards inflation. The least inflationary debt erosion took place in 1996-2003. Based on the IE and RGE of that period, we obtain the lower DIF.
Primary surpluses of at least 2.4% of GDP required to achieve a 2% inflation target. According to our numbers, with inflation at 2% on average, a primary surplus of 2.4% of GDP is required in the benchmark case of debt stabilisation at current levels. Given 1.4% interest to GDP, this implies that a 1% budget surplus is required. After World War 2, primary surpluses of the required level have been achieved during one period only: 1996-2003.
A balanced primary budget would imply inflation of 4.7%. If government expenditure other than interest equals revenue, the primary balance would be zero. (The budget deficit would then be equal to interest expenditure.) In such a case, the inflation rate required to keep debt stable is 4.7%. What inflation rate would be consistent with the primary surpluses we have seen historically? The average primary surplus as a share of GDP over 1946-2003 was 0.3%. Stabilising the debt ratio at 60% with this primary surplus would require inflation of 4.3% on average. A primary deficit of 1.2% - the 1915-2003 average - would imply an inflation rate of 6.1%.
Caveats. Our framework does not take into account the following factors: First, a given level of inflation may not have the same effect on the debt because the average maturity is shorter - though rising quickly towards, and above, the historical average on our forecasts. Second, by now almost half of federal outlays are de facto indexed to inflation. What does this mean for the inflation risks we outline? Essentially, that possibly even more inflation is needed to erode a given level of debt - at least mechanically (see also our discussion in the Box of our stand-alone note). And finally, we don't take into account the potential effect of higher inflation on real GDP growth in the medium term - or of the potential repercussions of an inflation spiral. Nevertheless, these caveats do not substantially affect our main message. The level and trajectory of the debt imply tough choices between fiscal rectitude and price stability.
4. Debtflation Nation?
This leaves one question open. Why would the Fed - in principle an independent institution - want to generate inflation? Independence means the Fed cannot be forced to inflate - at least not directly. Recent threats to its independence aside, for inflation to take hold it must be because the Fed allows it to happen. Surely, this is inconceivable?
Maybe not. Consider a Fed that faces the prospect of an 87% debt ratio in ten years' time, with population ageing and all its negative budgetary consequences imminent. In that case, a rational central bank may prefer to create a little inflation now rather than having to create a lot of inflation later on (see "Debtflation", The Global Monetary Analyst, October 21, 2009). The forthcoming increase in the average debt maturity will help.
Last but by no means least, note that the range of inflation rates we have calculated here - around 5% for the case of a roughly zero primary balance - are already being debated in policy circles. Former IMF chief economist Kenneth Rogoff has advocated a 4-6% inflation target for the Fed, and ex Bank of England MPC member David Blanchflower has made similar proposals. And Professors Aizenman and Marion calculate - in a different framework - that a "moderate" inflation rate of 6% could reduce the debt/GDP ratio by 10 percentage points within four years (see "Using Inflation to Erode the US Public Debt", NBER Working Paper 15562).
We think investors should take note - and buy TIPS, rather than CDS, if they are worried about ‘default': while hard default is inconceivable, soft default through inflation is a clear risk.
PD1: En España pasa lo mismo. “Twin deficits”: doble déficit: PUBLICO y EXTERIOR. Doble problema. Le vale la misma solución: mucha inflación, es la forma que todo valga menos. Pero hay que preservarse de la inflación: es un impuesto. Es penosa. Es mala, muy mala
PD2: Da miedo. Pensar en que la solución a nuestros males es espiral de inflación, se devalúa la deuda pública, y aquí paz y mañana gloria. Da mucho miedo. ¿No se pasarán de listos? Espero que no esté todo pensado y repensado. Ay de los políticos!!!
PD2: Como ven al mundo los americanos:
