Arnold Kling  

Theory vs. History

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Nick Rowe writes,


If it prints money and is not in a recession, or has inflation, then that is a problem. Printing money will make inflation worse, and that's a problem. But it's a negative feedback problem. The inflation will lower the real value of the existing debt, making it easier to pay off.

That is fine in theory. But things are messier in practice. By the way, thanks to Mark Thoma for the pointer. Thoma also points to an article by Nouriel Roubini in which he makes a similar claim as an aside.

In my article on the history of U.S. post-war debt, I pointed out that we did not grow our way out of debt. The data make an even stronger case that we did not inflate our way out of debt. The inflation surprises of the 1960's and 1970's were severely punished by the Bond Market Vigilantes of the 1980's.

Suppose that for a few years the real interest rate turns out to be low because of unexpected inflation. Rowe writes as if the correction will consist of a return to "normal" real interest rates. In fact, in the historical episode I just described, our real interest rates overshot "normal" by a large amount for a long time. If that were to happen again, then trying to print money to reduce our debt would backfire.


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COMMENTS (4 to date)
tjames writes:

One wonders why the bond traders are not already punishing us. It isn't hard math to see the difficulty that faces us with the deficits we are running. I have to think it's because there aren't a lot of good options. In other words, so long as we can maintain our status as 'tallest pygmy', we can get away with this. If we have inflation, but the Eurozone has it worse as a result of bailing out its ailing members, then maybe we can get away with it.

I wouldn't want to bet on being 'tallest pygmy' forever. I sure hope our goverement officials aren't betting on it either.

Nick Rowe writes:

Arnold: I think you are right. I didn't intend to suggest the opposite. The return to normal could take a long time.

Another way to think of it is that "paying off" the debt by inflating is like "borrowing" against the future, by facing higher future borrowing costs until your reputation eventually recovers.

mulp writes:

Aren't interest rates already excessive?

For millions of loan, mortgage, and bond holders, the outstanding principle is increasing as the payments carry real interest rates and payment schedules that result in the principle owed exceeding the price of the underlying asset by ever increasing amounts.

For credit card debt holders, the principle is increasing as the value of the underlying asset, the personal income, falls. For mortgage holders the debt to asset ratio is still increasing even as the complimentary asset, personal income, income is falling in value. And the bonds secured by those debts see their debt to asset price continue to increase because the principle and interest payments aren't high enough to even pay the interest.

Aren't debtors suffering under the crush interest rates of the Bond Market Vigilantes who are keeping interest rates so high few can repay their debt?

kharris writes:

Whether above-normal real interest rates mean that it is impossible to inflate our way out of debt is not clear, unless we know the maturity of the outstanding debt and the fiscal stance after the initial debt load was taken on. Long maturities and a limited need to raise new cash could allow inflating the country out of debt.

New debtors suffer, but anyone who has taken on debt in the binge period but then stops can duck the consequences of higher rates. This is very much an inter-generational issue, given the tendency to take on debt young, then save later one. Same is true for businesses, which borrow when young and then - in many case - become lenders when the mature.

Missing the importance of timing here weakens you conclusion substantially. It's a little surprising to see an economist leave out the "inter-temporal" element in this day and age.

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