It´s not a “Fiscal Trap” but an “Inflation Targeting Trap”

A foursome of macro/monetary heavyweights, including a former Fed Governor (Mishkin), come out in public to warn of the inflation dangers from runaway public debt ratios that loom ahead:

Annual budget deficits have surged past $1 trillion and, according to the International Monetary Fund, gross U.S. government debt is currently at 107% of GDP. The good news: Congressional Budget Office estimates suggest that as a result of declining deficits, the level of debt relative to GDP will stabilize over the next several years. The bad news: Debt levels will then resume a relentless climb, with the debt-to-GDP ratio exceeding 150% in 25 years, assuming that long-term interest rates do not rise above 5.2%.

There is uglier news. Research we have recently presented at the U.S. Monetary Policy Forum leads us to conclude that, as debt grows relative to GDP, rising interest rates could bring the debt-to-GDP ratio up to 176% in 25 years, and even higher under less favorable assumptions about unemployment and the current-account deficit.

The reason? Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders about fiscal sustainability lead to higher government bond rates, which in turn make debt problems more severe. Using statistical methods, case studies and a wealth of recent data on fiscal crises, we have found that countries with gross debt above 80% of GDP and persistent current-account deficits—as is currently the case in the United States—face sharply increasing risk of escalating interest payments on their debt. This means even higher budget deficits and debt levels and could lead to a fiscal crunch—a point where government bond rates shoot up and a funding crisis ensues.

A fiscal crunch would force a central bank to pursue inflationary policies, a situation that’s called fiscal dominance…

Given the Federal Reserve’s greatly expanded balance sheet, which has ballooned from less than $1 trillion at the end of 2007 to more than $3 trillion today, there is an additional factor that could exacerbate inflation expectations…

The grave scenarios we outline here do not have to happen. Since the debt-to-GDP ratio is likely to stabilize over the next few years, there is time to avoid the dire potential problems we have highlighted. But with the gross-debt-to-GDP ratio already well above the 80% threshold—and likely to resume a steady climb by the end of this decade—the clock is ticking…

Not a single word about how monetary policy could have been different over the past five years or even how it can be still be different in the future and how this could change the ‘doomsday debt scenario’.

I show how things could have been very different if monetary policy hadn´t allowed aggregate spending (NGDP) to tank in 2008. The chart below indicates the actual path of NGDP (blue line), the “Great Moderation” trend path (with NGDP growing around 5% yearly – dotted red line) and an alternative 4% growth path (green line)starting in early 2008 (presuming a fall in ‘potential growth’ and 2% ‘desired’ inflation) . In fact, 4% is almost exactly the median growth since the start of the ‘recovery’ in mid-2009.

The next chart shows the actual and ‘alternative’ paths of the debt/NGDP ratio, where the alternative path is relative to the level of NGDP that comes out from the green line in the first chart.

The ‘alternative’ Debt/NGDP ratio is significantly smaller, but still above the 80% threshold that is thought could get you into all sorts of trouble. But note that if NGDP had been kept close to the green line, actual debt would be much lower because the configuration of government expenditures and receipts would have been very different, certainly leading to a much lower increase in nominal debt.

I have no beef with the view that there looms a big debt problem, but in addition to the proposed ‘debt control’ plans, there is an important role to be played by monetary policy. Unfortunately it appears not even a former Fed Governor is willing to acknowledge it. But we know that Mishkin is an “IT freak”!