The pandemic will leave Western nations carrying the biggest public-debt pile as a percentage of gross domestic product since World War II. To deal with it, they will need a better grasp of inflation.
So far, fears about high debt-to-GDP ratios have been proven repeatedly wrong. Even so, officials are already trying to set limits. In the eurozone, deficit caps will likely return. In the U.K., Treasury chief
has dubbed the path of public finances “unsustainable.”
If activist fiscal policy is to survive, new rules are required. Should they aim to stave off “bond vigilantes,” or simply not stoke inflation?
The latter focus has been popularized by the contentious school of thought known as Modern Monetary Theory, but the divide isn’t what it seems. Even vociferous opponents of MMT share the assumption that inflation is the true constraint on fiscal policy. The differences concern how inflation works.
Among the traditionalists, ex-Treasury Secretary
recently wrote that debt hasn’t been a problem because interest rates are so low. Governments can spend, they argued, as long as their net interest payments stay below 1% of GDP, adjusted for inflation.
For former International Monetary Fund chief economist
the key is that government bond yields are lower than expected GDP growth rates. Even if a one-off stimulus leads debt-to-GDP to shoot up, forward-looking investors then know that the math will eventually bring it down—as happened after WWII.
Both arguments raise the specter of market forces: Loose debt issuance is allowed now but may not be in the future. Since 1881, bond yields have been above growth rates about 40% of the time, including most of the post-1980s era.
But, as Mr. Summers himself recently underscored, bond yields are also linked to inflation. If governments keep borrowing too much, the theory goes, interest rates will rise. At some point, printing money will be the only alternative to a default, creating inflation. By contrast, MMT advocates see inflation as a result of too much spending, regardless of whether it is financed by money or debt. This is the real clash.
So far, the latter theory seems to fit the facts better, given that central banks have spent a decade buying trillions of dollars of bonds without triggering inflation.
Many economists argue that this is yet another result of rates being suppressed by social and market forces, but this is also suspect. Inflation-adjusted long-term yields have historically tracked central-bank policy, even in periods when central banks weren’t focused on growth and inflation, such as under the 1880-1914 gold standard. The fact they are deeply negative now says much more about Federal Reserve policy than economic fundamentals.
If interest payments on the debt are themselves broadly determined by policy makers, they can’t be a good canary in the coal mine. Fiscal policy could be both too tight and too loose and still comply with such a rule.
What indicators should policy makers follow then? Inflation itself is a good bet, though consumer-price baskets are crude—they often obfuscate specific supply shortages, as happened this year. Governments will need to monitor and control consumer spending and industry bottlenecks, as well as automatically link stimulus programs to persistent increases in unemployment, rather than leaving them to officials’ discretion. Outside of the U.S., much more attention should be devoted to the exchange rate, since depreciation can create inflationary spirals.
It is understanding inflation, not bond markets, that will set fiscal policy free.
Write to Jon Sindreu at [email protected]
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