The gains of debtors needing to pay less than expected, will likely be balanced by the losses of the debtors of the future, who will be less likely to get a loan whatsoever. That is the biggest cost of inflation, in my view.
The article by Aizenman and Marion didn't mention this (unless I missed it in my skimming) but one reason inflation helped so much with the post-WW2 debt was that Treasuries had a maximum cap of 2.5% interest. There was no market at work and basically nobody wanted to buy bonds and the Federal Reserve was left holding the bag.
The whole thing led to a civil war between the Federal Reserve and the Treasury which wasn't resolved until a detente in 1951.
(This whole 1942-1951 era is probably my favourite weird Federal Reserve trivia.)
Another important point missed is that post WWII the driver of deficits and debt had ended with the end of the war. In our case, those drivers of debt (entitlements) are just kicking in.
The tail winds of the 50's are now head winds making our current course even more dangerous.
If everyone pays the same total effective tax rate, then as wages rise due to inflation, taxes rise directly in proportion to those wages. So a fixed government debt goes down in significance as a fraction of tax revenue.
The feature that used to exist was bracket creep, where inflation wouldn't just increase everyone's income at the same total effective tax rate, but would push them into new brackets so that they paid higher effective tax rates. Under that sort of system, tax revenues increased *more* than proportional to inflation. But with inflation-indexed tax brackets, it seems that it should still increase proportionally to inflation, which is the only effect he claimed in the main text.
Increased cost of spending, and increased interest rates on government debt are significant, but only increase the growth in debt, and not the whole stock of existing debt.
For sure, those reforms of the 1980s complicate the simple story. Actually, I wonder how much of a role they have inadvertently played in anchoring low inflation expectations? After all, it is much harder now for the government to "inflate debt away" due to the factors you outline, which maybe means people lower their inflation expectations?
I think your saying Gov. worried less about debt pre-80 thinking they can always inflate away if it gets too high. Post-80's they thought that they better be more responsible because they can't any more. But I don't think that has been true.
How could you forget that Inflation bought down debts? Basically the whole reason the UK was able to pay off its WW2 debts was thanks to the inflation of the 60s
Re: "So the pain from rate hikes will hopefully be temporary and limited."
The last time we were in this situation the economy stagnated for 40 years. I'm guessing that the powers that be want an encore. We'll have to see if anyone learned anything in the 2060s.
While this may be a little true right now since inflation is probably too high, this is bad language usually used by people against inflation even when it's not true. In the 2010s the too low inflation and zlb interest rates resulted in effectively the opposite, basically a subsidy for the rich and a tax on the poor's debt. When inflation started rising, it was effectively a removal of that subsidy, not the introduction a tax.
This subsidy was incredibly damaging and needed to be removed. It subsidized divestment and economic inactivity. It was basically subsidizing the layoff of employees and the hoarding of cash and government paper instead of keeping businesses going. It's not nice to kick employees to the curb at the same time as an effective tax is added on their debt.
Remember Bernanke had estimated at some point that the neutral interest rate inline with markets was about -4%. The rich were getting a 4% subsidy on their assets by holding government debt at or above 0%.
Now with 7% inflation and 0% interests, an effective -7% real rate is probably too low, but remember, the wealthy are not forced to hold government assets. They can buy private assets if they want better than -7% real returns. The fed real rate is a floor for returns. That floor should always be bellow private asset returns or it puts the market for private assets in a gridlock. I won't shed a tear for the wealthy who lost their government guaranteed returns floor. Let them invest their wealth in businesses and hire employees if they want a return.
The extra government money is also not all "jubille" debt renegotiation. There are more people working, more people paying taxes, fewer people needing benefits than if inflation had been lower. This is a real increase in productivity helping to pay off government and private debt. Working to pay debt is not a jubilee, it's the way debt should be paid. The opposite we lived through in the 2010s of destroying jobs and asking the jobless to help subsidize assets was crazy.
Now I do wish central banks were not over doing it like it seems they are.
Back in the 70's Saturday Night Live did this column with Jimmy Carter explaining that "Inflation is your friend". I saw it live and it was a good laugh.
Pity YouTube took it down about the time last year when it became relevant again.
Inflation, if it lasts, eventually causes nominal interest rates to rise. One reason is because lenders now expect higher inflation going forward, and raise the interest rates they charge borrowers in order not to continue getting screwed. A second reason is that the Fed will typically raise interest rates to contain inflation (as indeed it is expected to do this year).
What happens in Turkey where the central bank doesn't raise interest rates in face of inflation? It is a scenario in which you can see if the first reason has any importance (I doubt it. As long as you expect to get cheap money from the central bank it is an arbitrage game)
The gains of debtors needing to pay less than expected, will likely be balanced by the losses of the debtors of the future, who will be less likely to get a loan whatsoever. That is the biggest cost of inflation, in my view.
Perhaps. But rate hikes and the inflation itself will probably be temporary!
"less likely to get a loan whatsoever"
What are you basing that on?
The article by Aizenman and Marion didn't mention this (unless I missed it in my skimming) but one reason inflation helped so much with the post-WW2 debt was that Treasuries had a maximum cap of 2.5% interest. There was no market at work and basically nobody wanted to buy bonds and the Federal Reserve was left holding the bag.
The whole thing led to a civil war between the Federal Reserve and the Treasury which wasn't resolved until a detente in 1951.
(This whole 1942-1951 era is probably my favourite weird Federal Reserve trivia.)
Another important point missed is that post WWII the driver of deficits and debt had ended with the end of the war. In our case, those drivers of debt (entitlements) are just kicking in.
The tail winds of the 50's are now head winds making our current course even more dangerous.
Those entitlements are called tax cuts. We're still paying for those of the Reagan years.
There was also that inflation pushed people into higher tax brackets. So taxes went up automatically without any act of Congress.
Brackets now automatically adjust for inflation—not sure when that started though.
Don't remember the exact year but likely part of Reagan's tax cut. I am old enough to remember it.
>If inflation can be contained, it could help make the national debt more sustainable over time
You should have addressed:
1. Income tax rates are indexed to inflation. So rising inflation won't bring in the $$ it did in the 70's.
2. The biggest drivers to deficit are entitlements which are indexed to inflation.
3. Higher interest rates quickly affect not only the debt, but adds to the deficit making even more borrowing at higher rates necessary.
Taken together inflation increases the need for borrowing and doesn't bring in the $$ you expect.
If everyone pays the same total effective tax rate, then as wages rise due to inflation, taxes rise directly in proportion to those wages. So a fixed government debt goes down in significance as a fraction of tax revenue.
The feature that used to exist was bracket creep, where inflation wouldn't just increase everyone's income at the same total effective tax rate, but would push them into new brackets so that they paid higher effective tax rates. Under that sort of system, tax revenues increased *more* than proportional to inflation. But with inflation-indexed tax brackets, it seems that it should still increase proportionally to inflation, which is the only effect he claimed in the main text.
Increased cost of spending, and increased interest rates on government debt are significant, but only increase the growth in debt, and not the whole stock of existing debt.
For sure, those reforms of the 1980s complicate the simple story. Actually, I wonder how much of a role they have inadvertently played in anchoring low inflation expectations? After all, it is much harder now for the government to "inflate debt away" due to the factors you outline, which maybe means people lower their inflation expectations?
Interesting thought. But it kind of assumes that politicians will plan long term and not the next election. Bit of a stretch?
No, it doesn't assume that.
I think your saying Gov. worried less about debt pre-80 thinking they can always inflate away if it gets too high. Post-80's they thought that they better be more responsible because they can't any more. But I don't think that has been true.
How could you forget that Inflation bought down debts? Basically the whole reason the UK was able to pay off its WW2 debts was thanks to the inflation of the 60s
Ha great piece! I’m glad I asked.
Re: "So the pain from rate hikes will hopefully be temporary and limited."
The last time we were in this situation the economy stagnated for 40 years. I'm guessing that the powers that be want an encore. We'll have to see if anyone learned anything in the 2060s.
Another great post. Here some quibbles.
"tax for the rich, jubilee for the poor".
While this may be a little true right now since inflation is probably too high, this is bad language usually used by people against inflation even when it's not true. In the 2010s the too low inflation and zlb interest rates resulted in effectively the opposite, basically a subsidy for the rich and a tax on the poor's debt. When inflation started rising, it was effectively a removal of that subsidy, not the introduction a tax.
This subsidy was incredibly damaging and needed to be removed. It subsidized divestment and economic inactivity. It was basically subsidizing the layoff of employees and the hoarding of cash and government paper instead of keeping businesses going. It's not nice to kick employees to the curb at the same time as an effective tax is added on their debt.
Remember Bernanke had estimated at some point that the neutral interest rate inline with markets was about -4%. The rich were getting a 4% subsidy on their assets by holding government debt at or above 0%.
Now with 7% inflation and 0% interests, an effective -7% real rate is probably too low, but remember, the wealthy are not forced to hold government assets. They can buy private assets if they want better than -7% real returns. The fed real rate is a floor for returns. That floor should always be bellow private asset returns or it puts the market for private assets in a gridlock. I won't shed a tear for the wealthy who lost their government guaranteed returns floor. Let them invest their wealth in businesses and hire employees if they want a return.
The extra government money is also not all "jubille" debt renegotiation. There are more people working, more people paying taxes, fewer people needing benefits than if inflation had been lower. This is a real increase in productivity helping to pay off government and private debt. Working to pay debt is not a jubilee, it's the way debt should be paid. The opposite we lived through in the 2010s of destroying jobs and asking the jobless to help subsidize assets was crazy.
Now I do wish central banks were not over doing it like it seems they are.
Back in the 70's Saturday Night Live did this column with Jimmy Carter explaining that "Inflation is your friend". I saw it live and it was a good laugh.
Pity YouTube took it down about the time last year when it became relevant again.
NBC still has it up: https://www.nbc.com/saturday-night-live/video/jimmy-carter-on-inflation-cold-open/3007609
Inflation, if it lasts, eventually causes nominal interest rates to rise. One reason is because lenders now expect higher inflation going forward, and raise the interest rates they charge borrowers in order not to continue getting screwed. A second reason is that the Fed will typically raise interest rates to contain inflation (as indeed it is expected to do this year).
What happens in Turkey where the central bank doesn't raise interest rates in face of inflation? It is a scenario in which you can see if the first reason has any importance (I doubt it. As long as you expect to get cheap money from the central bank it is an arbitrage game)
Turkey, to put it bluntly, is in deep shit. https://noahpinion.substack.com/p/turkey-you-were-doing-so-well