The Fiscal Inflation Predicament
When are deficits inflationary? And a link to Cochrane-Kling
John Cochrane and I discuss what we don’t like about Alan Blinder’s 1970s macro. But note that I do not agree with John that 1990s macro is much better.
In a 1981 paper, though, Thomas Sargent (like Mr. Friedman a future winner of the Nobel Prize in economics) and Neil Wallace challenged this orthodoxy: A government that runs unsustainable deficits will, one day, fail to sell enough bonds, at which point the central bank will have to finance the shortfall by printing money. The central bank may initially try to control inflation by raising interest rates sharply. But this will widen deficits further and ultimately make inflation even harder to control.
In 1975, I took an exam written by William Poole of Brown University (Swarthmore used outside examiners). One of the questions was “What happens if the government uses fiscal policy to try to keep unemployment below the natural rate?” I answered that there would be ever-accelerating inflation. Poole chided me, “I didn’t go to Chicago for nothing. Inflation is a monetary phenomenon.” Six years later, the Sargent-Wallace paper appeared, and I have always wanted to tell Poole, “See, I was right.”
But the official Fiscal Theory of the Price Level is part of what I call 1990s macroeconomics, which I scorn. In the FTPL, as long as people think that the government will find a way to repay the debt without printing money, interest rates and inflation will remain tame. Ip’s article cites John Cochrane.
Japanese savers are willing to lend to their own government at rock bottom interest rates, which makes future debt service and deficits less burdensome. Rising debt after 2008 did put upward pressure on inflation but that usefully offset the threat of deflation from soaring unemployment, he said; the balance of these opposing forces yielded a low, positive inflation rate. Mr. Cochrane acknowledges FTPL doesn’t provide a clear-cut debt level at which inflation takes off: “You get more inflation when you get more government debt than people think the government can or will repay.”
I think about inflation differently. I start with the view that households and businesses develop habits regarding inflation. This leads to two regimes.
There is a “good regime,” in which inflation is low and steady. When people are used to that, it becomes self-reinforcing. Firms resist exorbitant wage increases and households resist price increases. The velocity of money is low and steady, because nobody is worrying about missing out on earning interest on every dollar they have in a low-inflation environment.
There is a “bad regime,” in which inflation is high and variable. When people get used to that, it becomes self-reinforcing. Firms believe that they can pass through large wage increases into prices, and when households see higher prices, they just shrug. The velocity of money is high and variable, because people realize that inflation is eroding the value of money that does not pay interest. The “bad regime” itself adversely affects productive capacity, because it messes with people’s ability to figure out relative prices and to calculate the value of long-term investments.
Changing regimes is difficult. You have to change people’s habits.
The transition to the bad regime comes when the discrepancy between nominal wealth and real productive capacity becomes too high. Government deficits contribute to this discrepancy. The government is giving people checks but not producing anything. Too much nominal wealth chasing too few goods.
The U.S. left the Bretton Woods gold standard in 1971, at a point where the discrepancy between nominal wealth and productive capacity was high. The transition to a bad regime ensued. Getting back to the good regime required a lot of deregulation to increase productive capacity (John Cochrane also stresses “supply-side” policy). It required higher interest rates that reduced nominal wealth.
The timing of regime shifts is difficult to predict. I thought that the orgy of deficit spending starting in 2008 would cause a shift to the bad regime much sooner than it did.
Today, it seems that we are seeing nominal wealth reduced in the stock market and in the housing market. But will that be enough to produce a transition back to regime of low and stable inflation, or do we need to see government deficits reined in?
researchers at the Fed think that unfortunately there is still, in fact, a glut of cash to the tune of $1.7 trillion in excess savings (i.e. savings above pre-pandemic trends). Those savings are helping keep consumers well afloat
This “excess savings” relates to my idea of nominal wealth that exceeds productive capacity. It comes from the checks that the government wrote (not just directly to households, but in all sorts of other bailouts) during the crisis of 2008 and again during the pandemic.
Unless the government keeps running larger deficits (and note that higher interest rates push up the deficit because the government has so much short-term debt outstanding), at some point the ratio of nominal wealth to productive capacity will be low enough to suppress inflation. Then we can get back to the good regime.
There are several aspects to: "at some point the ratio of nominal wealth to productive capacity will be low enough to suppress inflation".
1) We are decreasing the real wealth of all US dollar holders around the world with negative real interest rates, but this doesn't impact the internal nominal wealth.
2) The theft of value by negative real interest may be locally significant to an individual's retirement, but that is a trivial amount relative to big factors like government deficits or imaginary "investments" like crypto as part of nominal wealth. With M2 at 21 T$ levels and -3% real interest rate, you are only decreasing nominal wealth by 0.6 T$/yr with inflation while the imaginary crypto market is about 1 T$ market cap that could crash overnight by government actions.
3) The 9 T$ California housing market is an unstable oscillating market that can easily decrease up to 20 to 40% or 2 to 4 T$ in nominal wealth decrease. This would be a large reduction of nominal wealth. California is no longer adding population, and that phenomenon is combined with our unstable housing market created by the required time delays of government/regulation. Our very slow supply responses to demand increases make California the most likely to lead the parade of nominal wealth loss. https://www.dropbox.com/s/7go8mum7wmgljsg/Realestate%20oscillation%20Ca.pdf?dl=0
4) A 10-20% or so decrease in the total value of stocks could decrease nominal wealth by 5 T$ which would make a good hit on nominal wealth / production ratio.
5) Perhaps a better way to solve inflation would be to increase production. Allowing pipelines to be completed is truly shovel ready and will increase energy supply putting pressures on OPEC. Fast tracking permissions on critical materials mines (Lithium, rare earth minerals, etc.) would be of great help, as would making activists and regulators liable for delays created by law suits and rules which legally fail or are proven to be junk science. A recent example is the attempt to get permission to build a desalinization plant in water-short Southern California. Even after 14 years of paying ex-senators, lawyers, and lobbyists, in addition to making massive political contributions, they were denied permissions and lost all their risk money. However, even had the permission been granted, the costs of that time and the permission risk required the developers to charge 3 times the world price for the same system with the same design and equipment as other countries. Such bureaucratic hurdles are undeniably diminishers of nominal wealth.
6) Innovation is the key to long term wealth generation, but innovation as measured by economists is not just good ideas but ideas which can be turned into reality. We have evolved into being a society which won't grant permissions for anything. We have become a "vetocracy" in which the "stakeholders or regulators have veto power". Silicon valley didn't require permission to make a new chip design, and wealth expanded accordingly. But try to coax the California Costal Commission to permit anything innovative, such as a large fish farm floating in the ocean out of sight of land. That particular wealth-generating innovation is taking place outside the US. We import 90% of our seafood, half of which are products of aquaculture.
Arnold quoting Ip:
"Japanese savers are willing to lend to their own government at rock bottom interest rates, which makes future debt service and deficits less burdensome."
How much of the government's debt do Japanese savers actually hold after 20 years of QE and yield curve control? Something on the order of 4-5 trillion dollars of US government debt has been financed by the Fed over the last 13 years, and one can't help but suspect this number will be 20-25 trillion in another 13 years. We are f*****, we just don't see the ultimate effect yet. I used to think I would be dead before the currency's demise, but I now think there is a 50% chance I live to see it happen.