Inflating Our Way to Fiscal Stability? Not an Option

Gross debt hit 101 percent of GDP at the end of 2013, the highest since the immediate postwar years. And despite the improved outlook for the next few years, the Congressional Budget Office has consistently argued that, in the long term, debt will continue to grow relative to GDP, leaving elected officials with the difficult tasks of raising taxes and cutting benefits. Noting that both of these options are things that elected officials are loathe to contemplate, some suggest that a third option is far more likely: the Fed will use expansionary monetary policy to produce inflation as a means of lowering the real debt over time. In an interesting new analysis, Ricardo Reis, Jens Hilscher, and Alon Raviv (VoxEU) conclude that there is really no way to inflate our way to fiscal stability:

One way or another, budget constraints will always hold. This is true as much for a household or a firm as it is for the central bank or the government as a whole. If the US government is to pay its debt, then it must either raise fiscal surpluses or hope for higher economic growth; the former is painful and the latter is hard to depend on. It is therefore tempting to yield to the mystique of central banking and believe in a seemingly feasible and reliable alternative: expansionary monetary policy and higher inflation.Crunching through the numbers we find that this alternative is not really there.

Bottom line: there is no easy way out of debt. If the analysis is correct, this only leaves us with difficult choices—precisely the kinds of choices that we seem incapable of making.

6 thoughts on “Inflating Our Way to Fiscal Stability? Not an Option

  1. Q I’ve had for a while but haven’t found the answer to yet, including in this piece: Could the Fed buy Treasuries and simply destroy/retire them? Even if statute currently forbids that, Congress could amend the statute. It would mean that inflation expectations would rocket upward and private buyers would no longer buy Treasuries at reasonable rates, but if the Fed buys them all, you could still get debt monetization. Far-fetched, like their financial repression scenario, but possible.

    1. Or the Fed could just print money and pay it to the government, therefore eliminating the need to issue debt or levy taxes? If we’re going all out, why not just go for that?

      But then where would all the savings go? Government debt serves a valuable purpose of being a stash for savings. When you have less of it then you have a situation like this that makes it harder for the funds market to clear and hurts growth. Given the structure of our financial system and the key role that government debt serves from a collateral standpoint, we need more debt issuance. Not less.

      1. Like what? Name the assets that could soak up all the extra savings and not be counterproductive to the economy? This is kind of the reason why useless tech companies soak up capitol and snapchat is worth $10 billion. In addition, banks cant place their reserves in risky BS like that. What about insurance companies? You’re telling me they’re just going to switch their holdings to Bitcoin? Please! They’ll just hold more cash and the economy and inflation will tank. Nevermind that Clearinghouses need collateral and FB stock sure as hell isn’t going to fill that gap.

        C’mon. You’re a smart guy. I respect you more than the other guys. You know better.

    2. By the way, I’m not pulling this theory out of my ass. Karl Smith at modeled behavior and various writers at FT Alphaville have covered it in depth.

  2. Well in order to inflate away the debt you have to first have inflation. We don’t have that. And people who actually follow the Fed and understand how it works don’t believe they will allow inflation above 2%. You have to have a helluva lot more inflation than that to notice a decline.

    Secondly, if the growth rate of GDP exceeds the annual deficit than your debt burden is actually declining. We could do things to increase growth that might increase the deficit in the short run, but we all know where the deficit scolds stand on that issue.

    But the most annoying thing is that they keep chasing a phantom–a problem that didn’t really exist. Our debt burden has never really been an issue. The vigilantes will never come for us. Why? Because:

    1.) We are the world’s reserve currency. Banks are required to hold our debt. That may change someday, but not anytime in the next few decades. Witness what happens when the Tea partiers pushed it towards default. Demand for US bonds went up, not down.

    2.) We borrow and issue in our own currency. Our only restraints are political, as you’re proving whether you realize it or not.

    As the great Marlo Stanfield once said in The Wire: “You want the world to be one way, but it’s the other.”

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