David Andolfatto explains why a worldwide shortage of safe, liquid assets may help the U.S. to avoid the inflationary consequences of high debt levels:
Why the Growing Level of U.S. Debt May Not be Inflationary, by David Andolfatto: History shows that high levels of government debt are frequently associated with inflation. The reason for this seems clear enough. At some point, maturing debt needs to paid back. At high enough levels of debt, rolling the debt over is no longer feasible. Cutting back government spending and raising taxes is politically difficult. The easy way out is simply to print new money. As the money supply expands, inflation results.
Let us consider the U.S. Unlike most other economies, there appears to be a huge worldwide demand for U.S. Treasuries and U.S. dollars (which can be thought of as zero-interest Treasuries). A large scale increase in the supply of these government debt instruments need not lead to a depreciation in their value if there is a correspondingly large scale increase in the worldwide demand for these objects. What is the evidence that this may be happening?
But why should this be so? What accounts for what appears to be an insatiable demand for US debt, especially in the wake of the recent financial crisis?
Ricardo Caballero of MIT offers some hints in a very interesting piece entitled: On the Macroeconomics of Asset Shortages. After reading this paper, I started thinking in the following way. Tell me what you think.
There is a high and growing demand for low-risk assets, both as a store of value, and as collateral objects in payment systems (e.g., repo and credit derivatives markets). This growth has exploded over the last 20 years or so; and stems from the demand from emerging economies and innovations in the financial sector. There is a worldwide "shortage" of good quality (low-risk) assets, like U.S. Treasuries (which explains their relatively low yield). Indeed, many of the innovations in the financial sector can be interpreted as the private sector's response to this shortage: the creation of "low-risk" tranches of MBSs allowing these objects to substitute for U.S. Treasuries as collateral in the rapidly expanding repo market. ...
If this is more or less true, then the implication is this: The massive increase in the supply U.S. Treasury debt may very be "socially optimal" in the sense that the U.S. government is simply supplying the world with an asset that is in very high demand (which, in turn, means that the demanders obviously find some value in the existence of such an asset). To the extent that this "new demand regime" remains stable, the added supply of U.S. Treasuries will impose no financial burden on the U.S. (indeed, they make off like bandits, as the Treasuries are ultimately purchased by exporting goods and services to the U.S.).
The million dollar question, of course, is whether the high world demand for U.S. debt will persist long into the future (and whether the U.S. government will "overissue" debt beyond what is called for by this new high-demand regime). Who knows what will happen. But it appears to me that IF the U.S. government plays its cards right, it may very well enjoy its higher debt levels without the prospect of inflation. U.S. citizens will benefit (from the sales of Treasuries for goods) and the world will be grateful to hold a stable asset.
Well, maybe. But that was a big IF. What could possibly go wrong?
The future level of the debt in the U.S. is not a worry if we get effective health care reform (rising health care costs are the major source of projected future deficits). But if a debt problem does exist, I'm not sure the main risk is inflation since I expect the Fed to hold the line on debt monetization. If so, if the Fed does hold the line, then the pressure would be on government spending and taxes. If congress cannot solve the debt problem by cutting spending and/or raising taxes, the result would likely be high interest rates that crowd out private investment. In any case, what this says to me is that to the extent that this demand for safe assets exists, debt levels can be carried at a lower interest rate than otherwise, and this reduces concerns about crowding out (perhaps this is one of the reasons why long-term interest rates have remained relatively low, financial markets recognize this demand exists, believe the demand is large enough to matter, and believe it will continue for some time into the future).
"Tell me what you think."
[On the relationship between debt and inflation, much of the evidence comes from developing countries. Here's one story about why debt and inflation might be related. Often a developing country will decide to run a government deficit to, say, build new roads, bridges, dams, etc. They are trying to build up the infrastructure. The idea is that the future growth that will come from this spending will allow the debt to be paid off. It's an investment in the future of the country -- borrow now, invest the money in needed infrastructure projects, and then use the resulting increase in future economic output to pay for spending (though much less noble motives for increasing debt exist as well).
How can this debt be paid for in the interim, i.e. during the time period when the projects are being built and before the expected growth is realized? The alternatives are to increase taxes, print the money, or borrow the money.
The countries can't increase taxes, these are developing countries and the tax base is insufficient. The whole point of the infrastructure projects is to begin to change that through economic growth.
If they can't tax, then can they borrow the money? Probably not domestically since, again, they are a developing country with little wealth. The necessary funds aren't available domestically. So that leaves borrowing from foreigners. Is that possible? Not if they have defaulted in the past. If they have defaulted, nobody may be willing to take the risk of lending them money, and if the money comes from international agencies such as the IMF, it may come with so many restrictions that it does no good. And even if the money can be borrowed, at some point it must be paid off, and if the promised growth does not materialize (and overly optimistic promises make this likely), investors will be unwilling to allow the debt to be rolled over. The point is that, for developing countries, supporting government spending through taxes or borrowing may not be feasible. This leaves only two choices, giving up on the spending projects, or printing money to pay for them. Printing money - and the inflationary consequences that follow - is often the choice that is made.
Developed countries are not so constrained. They have much more latitude to borrow from their own citizens or from foreigners, they have the ability to raise substantial sums through taxation, and often their infrastructure and other needs aren't as dire. In addition, they can generally count on future growth to help to pay for the borrowing. For all these reasons, developing countries aren't necessarily forced to pay for spending by printing new money and creating inflation.]