Stories to Watch: Unsustainable Fiscal Policy
Live with High Debt?
Serkan Arslanap and Barry Eichengreen write, (hard to link to. try going here and searching the page for Eichengreen)
Public debts have risen for reasons both good and bad, good in that governments have financed needed responses to macroeconomic, financial and public-health emergencies, bad in that they have borrowed imprudently and failed to retire debt in good times. The result has been increases in debt ratios worldwide, on average from 40 to 60 percent of GDP since the Global Financial Crisis. In advanced countries, debt ratios have risen still higher, to nearly 85 percent of GDP on average. In the United States, federal government debt in the hands of the public is approaching 100 percent of GDP. In other advanced economies, debt ratios are even higher.
Our message is that debt reduction, while desirable in principle, is unlikely in practice. Primary budget surpluses achieved through a combination of tax increases and spending economies will be difficult to sustain on a scale and for the duration needed to significantly reduce debt ratios – to bring them back down to [2007] levels, for example.
Pointer from Timothy Taylor.
Maybe countries can live with today’s high debt ratios, and maybe they cannot. The problem, which the authors mention briefly but do not address, is that in the absence of significant policy changes, the outlook—at least in the U.S.—is for debt to rise exponentially, because of demographics. The ratio of elderly dependents to working-age people just keeps heading higher, and health care spending just keeps rising faster than inflation.
Can inflation itself cure the debt problem by enabling the government to pay back debt in cheaper dollars? Arslanap and Eichengreen say that the consensus from many studies is not favorable.
The literature on the impact of inflation on debt reaches a consensus on several points. Moderate inflation has only a modest impact on the debt ratio; any favorable impact via the increase in seigniorage revenues and the GDP deflator tends to be offset by higher interest rates and the negative impact of inflation on economic growth. While the first (favorable) effects dominate on impact, the second (unfavorable) effects take over after two or three years. On balance, these effects are small and by most measures statistically insignificant. Only unanticipated inflation is significant. An inflation surprise has to be large to make a serious dent in the debt ratio.
And we also must reckon with the fact that a lot of our government spending, including for entitlements, automatically goes up with inflation.
At some point, the U.S. will go into a doom loop: to pay for interest on the debt, the government will have to issue more debt; this will fuel inflation, and interest rates are likely to rise; this will force interest payments even higher.
This year, with interest rates elevated to previous years, we may have already entered the doom loop.
Have a nice day.*
*Back in 2008, as bad financial news emerged, I began to end my mostly pessimistic blog comments with “Have a nice day.” Loyal long-time readers are familiar with that trope.
If default is inevitable, the responsible thing is to allocate as many resources to your friends and allies as possible so they are prepared to emerge from the default on better footing.
Hence, I propose we pass sweeping child tax credit/incentives to boost the birth rate regardless of whether we can pay for it. If that bankrupts SS/Medicare faster so be it, give the money to the kids before the olds get it. When the reset comes, lets have more kids around.
People don't seem to realize that the fiscal impact of all the entitlements we have created and other spending may be well be beyond the possibility of financing through taxation. Any politically feasible taxation sufficient to address the problem, focused as it would be on hitting savings and investment rather than consumption, would wreck the economy and thus be self-defeating. Even if all the income and assets held by the rich were confiscated, it would only have a temporary effect, and would also wreck the economy. We have been in this situation for some time now, and most other developed nations are too. This is why central bank balance sheets have ballooned. They have been forced to buy their bonds to kept their interest rates from rising to levels that would wreck their economies. To make it worse, they have artificially depressed the rates to ridiculously low levels in order to hold down interest expense which would otherwise consume budgets.
Central banks can hold down interest rates if they are willing to buy unlimited amounts of issuance, and I stress unlimited. The recent rise in rates has been due to the Fed's attempts to dampen inflation by allowing a bit of a rise in the hopes of depressing the economy, or at least those portions most affected by interest rates, sufficient to slow its pace.
At the same time, there is no effort to control spending on the fiscal side. So far, it looks like the Fed is having little real impact on inflation, contrary to widespread propaganda to that effect. It may be that the Fed can't do it alone. Current rates are unsustainable due to the size of the federal debt; if kept up interest costs overwhelm other budgetary items (entitlements, defense, discretionary) further ballooning the deficit and requiring yet more issuance and Fed purchases, i.e., debt monetization. This heads toward a situation in which the central bank is the majority, or even the only holder of such debt, as others flee it, anticipating its loss of value through inflation.
It would seem there is a substantial risk that we head into hyper-inflation, which feeds on itself because of the impacts to normal productive relations. For example, instead of normal activity, everyone spends his time figuring out how to preserve himself from the loss of value of money. Scenes from Weimer Germany come to mind.
Have a nice day, indeed!