High National Debt and Potential Inflation

There is a lot of nonsense being spoken, by people who should know better, about the level of Federal Debt and its impact on both inflation and interest rates. These people point to the recent run up in US Treasury bond yields as the market issuing a stern warning that we have reached a maximum debt load and that anything more is reckless. They also warn of bond rating downgrades, runs against the dollar, hyperinflation, and all the other consequences of negligent fiscal policy.

Niall Ferguson I am looking at you.

First let me frame the debate.

The combined efforts of the US Treasury and the Federal Reserve Board have resulted in a dramatic surge in US national debt. It has risen from about 40% of GDP and probably will top out around 80% when the dust settles. There is a risk it may go even higher. That opens up all the threats I listed above which are now being trotted out by the so-called fiscal conservatives. In particular they argue that this huge debt load places a terrible burden on future taxpayers either through unbearable tax rates or through equally unbearable inflation and interest rates.

The major point of evidence they offer is the recent rise in US bond rates and the fact that some of the recent bond auctions have been received poorly.

I myself have noted both these things.

But my interpretation differs.

I do not see the run up in rates as a warning sign that the market is expecting inflation in the future. Bonds that mature in a few years time have much higher risk than bonds maturing in the near term. One of those risks is that of a rise in inflation. So investors typically ‘price in’ an allowance for their ‘expected level’ of inflation. Don’t forget that inflation reduces the value of debt because you are paying back whatever you borrowed in dollars that are worth less: inflation has eroded the purchasing power of those dollars. In order to offset this reduced purchasing power investors need to be rewarded a yield on their investments over and above the short term and ‘risk free’ rate. So longer term bonds have an inflation offsetting component in them. Indeed so accepted is this that we sometimes use the bond price as a measure of expected inflation. I will explain how in a moment.

So people like Ferguson have begun to chirrup about the rise in bond yields as a sure sign of inflationary expectations building.

Why should inflation be a problem related to huge debt loads? Because governments are notorious for using the debt reducing action of inflation to avoid having to raise taxes to pay back the debts. Historians like Ferguson can point to countless such episodes of ‘inflating your way out of debt’. Using inflation this way is so common that it is almost normal procedure. And that sends shivers down the spines of long term investors: they’re the ones who lose when governments tolerate inflation because of the lost purchasing power it implies.

If you are a fiscal conservative therefore it is only natural to cringe when there is a surge in debt. And if you are skeptical fiscal conservative you cringe even more because your expectations of government policy is so low to begin with.

But.

We are not living through normal times. This is Ferguson’s big mistake.

US bond rates have been ridiculously low recently. The ‘safe haven’ effect I have mentioned before, which is created when foreign investors rush to by US debt because it is safer than any other debt, has driven US interest rates well below any ‘normal’ level. Indeed, it is well nigh impossible to tell what ‘normal’ would have been over that past six to nine months. Now, however, there are enough signs of improvement in the world economy that the safe haven effect is diminished. People are beginning to liquidate their US bond portfolios and invest in higher yielding securities elsewhere. This has had the effect of raising US bond yields, and depressing US bond prices, which is the same thing, and which is why the Chinese are reportedly concerned about their investments here.

So this is an entirely different interpretation of what’s going on in the bond market: in fact it is very positive. It says that all those expensive efforts to bail out and stimulate the economy are beginning to have an effect on the credit markets. The policies are beginning to work. Great. We would expect yields to return to higher levels once this happens.

But have rates risen higher than this positive effect? Do they also reflect higher inflationary expectations?

No.

The Federal Reserve Board has let it be known that it would like an inflation rate of between 1.5% and 2%. That is tolerable and consistent with healthy growth. One of the reasons they announced this was the fear of deflation, which as you may recall, was very urgent as recently as earlier this year. So the Fed pegged its own desired inflation rate as a way of nudging the markets to build that level into its long term expected inflation rate. Has the Fed’s approach worked? Yes. One way of checking this is to look at the credit markets and see what the value of ‘inflation-proofed’ bonds are yielding. These bonds are priced in such a way that there is no loss of purchasing power in them because each year their value is altered to reflect that year’s inflation rate. Thus their yields don’t need to have an expected inflation component in them. So if we compare these inflation-proofed bonds with the run of the mill kind the difference in yield, or ‘spread’, between them should give us an accurate measure of what inflation expectations are. Last I looked this spread was 1.6%. Exactly where the Fed wants it to be. And not anywhere near an indicator of impending doom.

Now I too am a fiscal conservative. I realize that the current fiscal easing cannot go on forever else we would end up in the mess that Ferguson and his ilk are imagining we are already in.

Plainly I am not as skeptical as Ferguson. Why not? I think there are ways of re-introducing fiscal restraint when appropriate so that the run up in debt is limited to only that necessary to solve our current problems. And I believe that the US still has sufficient credibility to be seen as responsible enough to rein in spending and raise revenues when needed. This is a major point: in large part markets react to the credibility of the policy makers who will determine whether a government will try to inflate its way out of debt. Governments with a poor track record don’t get the benefit of the doubt and the bond market punishes them immediately upon seeing a surge in debt.

A responsible policy maker starts to signal to the markets that there is a clear understanding of the limits to the amount of debt that can be issued. Central bankers are always making speeches and statements in order to signal such policy matters to the markets. This kind of communication is an essential tool in the arsenal of policy makers: not only does it reinforce their fiscal credibility it also signals a potential change in course.

So this morning’s intonement by Ben Bernanke during his regular Congressional report becomes important. He issued a strong call for restraint in debt loads. This is from the man who was a primary architect of the debt run up. And it exactly fits my interpretation of what to expect. Bernanke wants to communicate to all quarters that the US has very intention of working its debt down responsibly. Excessive inflation fears, he is saying, are unwarranted.

And as I pointed out above, they’re not even there. Except in the heads of the folks like Ferguson who disliked fiscal stimulus to begin with.

This I think is the central issue of Ferguson’s argument: he is so opposed to Keynesian economics that he has latched onto to the ‘impending inflation disaster’ as a way to lambast people like Paul Krugman who have emerged as strongly pro-Keynes.

There’s a lot at stake here.

For the past few decades Chicago school monetarism has dominated economic theorizing. In part because of the supposed ‘defeat’ of Keynesian school back in the late 1970’s. I say supposed because I disagree with the diagnosis of the issues and policy results back then. Nonetheless if you are a true monetarist, as Ferguson apparently is, you must be horrified at the prospect of success for fiscal policy. You don’t think fiscal policy works. You think it is self defeating because of something called ‘Ricardian Equivalence’ – which is a theory held by monetarists that says taxpayers are so smart they will automatically increase savings to offset future taxes whenever the government runs a deficit, thus the deficit is robbed of its stimulus properties and has no effect. And, so, you think the only outcome of fiscal stimulus is future inflation, and national ruin. The lens through which you view the world is so restrictive that you are unable to accommodate a pragmatist like Bernanke, let alone a Keynesian like Krugman.

I don’t recall Ferguson lambasting the Reagan or Bush deficits as inflation inducing disasters. But I may just have not been paying attention. Perhaps he did. Nor do I recall inflation leaping uncontrollably after those two bouts of fiscal recklessness. Again I may have missed the run against the US bonds that surely must have followed.

In any case Ferguson is totally wrong now.

Keynesian fiscal policy was our only weapon in the recent fight because monetary policy was already exhausted – interest rates are near zero and can’t go any further down. It also happens to work. And there is no one for one correlation with fiscal stimulus and future inflation as long as fiscal policy reverts to balance when the crisis abates, and as long as demand in the economy is so far away from its long run potential – you will usually stoke inflation if you run deficits when the economy is at or above its potential. But if the actual versus potential demand gap is wide the fiscal deficit stokes demand not inflation. Which is exactly the Keynesian point. It is only when demand gets back close to potential capacity of the economy that fiscal stimulus needs to be reversed. This is when the recovery is well on track.

So the final dispute I have with Ferguson seems to be how we model the end game. That is how do we fix the budget once we have saved the economy? There seems to be plenty of time for that debate: it is far too premature to tighten just yet. That of all things is a lesson we learned, or should have learned in Ferguson’s case, from the Great Depression: you don’t hit the brakes too soon, otherwise you plunge back into an even deeper crisis.

Let’s get out of intensive care before we worry about physical therapy.

An let’s not see ghosts that aren’t there.