In the Fall 2011 issue of the National Interest, John H. Cochrane explores the \”Inflation and Debt\” connection. He points out that most economists don\’t see it as very likely that government debt will be the proximate cause of inflation. They point to the sluggish economic recovery, which tends to hold down price and wage levels. They believe that if inflation gets started, the Federal Reserve can act to nip it in the bud.
Cochrane takes the other side of this argument. He writes: \”As a result of the federal government\’s enormous debt and deficits, substantial inflation could break out in America in the next few years. … The key reason serious inflation often accompanies serious economic difficulties is straightforward: Inflation is a form of sovereign default. Paying off bonds with currency that is worth half as much as it used to be is like defaulting on half of the debt. And sovereign default happens not in boom times but when economies and governments are in trouble.\”
Can the Federal Reserve stop inflation? Cochrane argues that much of the conventional economic thinking about anti-inflation policy assumes a background of a reasonably sound fiscal policy. \”[R]easonably sound fiscal policy .. is the central precondition for stable inflation. Major explosions of inflation around the world have ultimately resulted from fiscal problems, and it is hard to think of a fiscally sound country that has ever experienced a major inflation. So long as the government\’s fiscal house is in order, people will naturally assume that the central bank should be able to stop a small uptick in inflation. Conversely, when the government\’s finances are in disarray, expectations can become \”unanchored\” very quickly. … But what if our huge debt and looming deficits mean that the fiscal backing for monetary policy is about to become unglued?\”
Cochrane cites familiar evidence that federal indebtedness is on an unsustainable path. He suggests that a process of \”fiscal inflation\” will unfold in this way:
\”[O]ur 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. Roughly speaking, the federal government each year must take on $6.5 trillion in new borrowing to pay off $5 trillion of maturing debt and $1.5 trillion or so in current deficits.\”
\”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.\”
Cochrane argues that investors are already worrying about even the current low rates rates inflation, given the prevailing ultra-low interest rates, and that the result could be a slow-motion financial run:
\”Just how low are today\’s rates? The one-year rate is now 0.2%; the ten-year rate is about 2%, and the 30-year rate is only 4%. We have not seen rates this low in the post-war era. Furthermore, inflation is still running at around 2-3%, depending on exactly what measure of inflation we choose. If an investor lends money at 0.2% and inflation is 2%, he loses 1.8% of the value of his money every year. Such low rates are therefore unlikely to last. … But both the Fed\’s desire to keep rates this low and its ability to do so are surely temporary. …
\”A \”normal\” real interest rate on government debt is at least 1-2%, meaning a 4-5% one-year rate even if inflation stays at 2-3%. 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. …
\”These dynamics essentially add up to a \”run\” on the dollar — just like a bank run — away from American government debt. Unlike a bank run, however, it would play out in slow motion. … 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…. Like all runs, this one would be unpredictable…. For that reason, I do not claim to predict that inflation will happen, or when. This scenario is a warning, not a forecast. Extraordinarily low interest rates on long-term U.S. government bonds suggest that the overall market still has faith that the United States will figure out how to solve its problems…. But we are primed for this sort of run. All sides in the current political debate describe our long-term fiscal trajectory as \”unsustainable.\”… As with all runs, once a run on the dollar began, it would be too late to stop it…. Neither the cause of nor the solution to a run on the dollar, and its consequent inflation, would therefore be a matter of monetary policy that the Fed could do much about. Our problem is a fiscal problem — the challenge of out-of-control deficits and ballooning debt. Today\’s debate about inflation largely misses that problem, and therefore fails to contend with the greatest inflation danger we face.\”
As Cochrane readily states, his analysis of the threat of a fiscal inflation is unconventional, and I\’m not yet a convert. But I do think that his analysis hits a number of key points that deserve serious consideration.
The current path of federal borrowing is unsustainable–not this year or next year, but probably in the middle-term and certainly in the long term. Investors are not going to be eager to hold these burgeoning levels of debt. If the very low nominal interest rates and negative real rates that such debt is currently paying continue, investors will start looking for other assets. (Gold, anyone?) If the interest rates on federal debt start rising, the federal debt problem will become much more severe in a hurry–and investors will continue to be less interested in investing. In this setting, the Federal Reserve is likely to be in an unpleasant pickle. The Fed has already taken up, at least in part, the task that it had during and after World War II of making it cheaper for the government to borrow–if necessary, by having the Fed buy Treasury debt directly. There will be heavy political pressure on the Fed to keep doing this–in effect, protecting the U.S. government from the costs of heavy borrowing by printing money. This scenario could play out as inflation, although I\’m less confident of that prediction than Cochrane. It might result in a heavy shock to the U.S. financial system, which is still struggling to recover from the problems of 2008 and 2009.
The bottom line is that the government needs to enact actual policies–not vague promises about policies that could be enacted in the future–that will reduce the path of future budget deficits. I\’d start with some steps that should be relatively (if not actually) easy, like phasing in a later retirement age a month per year over the next few decades. This step would make a substantial difference to Social Security and a modest difference to Medicare (because such a large share of Medicare expenses happen later in life, not in the year or two right around retirement). A next step might be to resurrect many of the recommendations of the National Commission on Fiscal Responsibility and Reform–the so-called Bowles-Simpson commission–that President Obama first appointed, but then ignored. I don\’t know whether Cochrane is correct that the federal debt problems will cause an inflation problem in the next few years, but on the present path, federal borrowing is going to bring a highly unpleasant crunch of some sort.