Sunday, September 25, 2011

Sunday reading

John Cochrane has written an excellent, though very long, article ("Inflation and Debt") on why the risk of inflation we face comes not from the Fed's monetary policy, but from our projected federal deficits. (HT: Greg Mankiw)

For several years, a heated debate has raged among economists and policymakers about whether we face a serious risk of inflation. That debate has focused largely on the Federal Reserve — especially on whether the Fed has been too aggressive in increasing the money supply, whether it has kept interest rates too low, and whether it can be relied on to reverse course if signs of inflation emerge.
But these questions miss a grave danger. As a result of the federal government's enormous debt and deficits, substantial inflation could break out in America in the next few years. If people become convinced that our government will end up printing money to cover intractable deficits, they will see inflation in the future and so will try to get rid of dollars today — driving up the prices of goods, services, and eventually wages across the entire economy. This would amount to a "run" on the dollar. As with a bank run, we would not be able to tell ahead of time when such an event would occur. But our economy will be primed for it as long as our fiscal trajectory is unsustainable.
Needless to say, such a run would unleash financial chaos and renewed recession. It would yield stagflation, not the inflation-fueled boomlet that some economists hope for. And there would be essentially nothing the Federal Reserve could do to stop it.

Cochrane's central point—one that I have missed—is that it is the dramatic shortening of the average maturity of Treasury debt that creates so much risk of inflation today:

... our government is now funded mostly by rolling over relatively short-term debt, not by selling long-term bonds that will come due in some future time of projected budget surpluses. Half of all currently outstanding debt will mature in less than two and a half years, and a third will mature in under a year. Roughly speaking, the federal government each year must take on $6.5 trillion in new borrowing to pay off $5 trillion of maturing debt and $1.5 trillion or so in current deficits.
As the government pays off maturing debt, the holders of that debt receive a lot of money. Normally, that money would be used to buy new debt. But if investors start to fear inflation, which will erode the returns from government bonds, they won't buy the new debt. Instead, they will try to buy stocks, real estate, commodities, or other assets that are less sensitive to inflation. But there are only so many real assets around, and someone has to hold the stock of money and government debt. So the prices of real assets will rise. Then, with "paper" wealth high and prospective returns on these investments declining, people will start spending more on goods and services. But there are only so many of those around, too, so the overall price level must rise. Thus, when short-term debt must be rolled over, fears of future inflation give us inflation today — and potentially quite a lot of inflation. 

We have no choice but to put our fiscal affairs in order, and as soon as possible. Fortunately, the problem is still relatively easy to solve. Cochrane's solution is familiar to all serious students of what ails our economy today. What we need is 1) real entitlement reform, since "our largest long-term spending problem is uncontrolled entitlements," 2) more revenues, which can be achieved by a pro-growth lowering of tax rates, and 3) a reduction in regulatory burdens.

Cochrane's article is extensive, but written in a manner that should be accessible to just about anyone. He does a good job of explaining, from a monetarist's perspective, the mechanics of how inflation happens. Read the whole thing. 


Benjamin said...

What inflation? What inflation are we worried about?

Dr. Perry, Carpe Diem, has an excellent post on inflation today. There isn't any to speak of. We are deflating by some measures.

John Cochrane must not be aware of what is happening in the TIPS markets. Investors are not expecting inflation closer to 1 percent than 2 percent. As if 2 percent would be the ned of the world. Cochrane is trapped fighting yesteryear's wars.

Even moderate inflation would be welcome now, for various reasons, including sticky wages and debt deleveraging.

I cannot understand the near-hysteria about inflation rates that are at record laws. It is baffling. We are afraid of the 1.4 percent inflation that TIPS investors expect? This is what concerns us?

George Gilder warned of a peevish zeal on the American right in regards to inflation, a fetish for money and gold, that often trumps the greater concerns of prosperity, innovation and growth.

BTW, I totally agree that federal pending should be kept to a ceiling, as a fraction of GDP, such as 18 percent.

Here is a list of employees by federal agency:

Department of Defense 3,000,000
Veterans Affairs 275,000
Homeland Security 250,000
Treasury 115,000
Justice 112,000
Energy 109,000
USDA 109,000
Interior 71,000

Labor 17,000
HUD 10,000
Education 4,487

Will someone ask Cochrane exactly what he proposes to do about federal outlays?

We can reduce Defense outlays to 2 percent of GDP as do most western nations, and then shrink Social Security through later retirement. Medicare will have to require an adult solution that no one wants to talk about---privatize, and give providers the right to pull the plug.

During the GOP debates, I heard no one (except possibly Ron Paul) discuss the need to cut defense, or end Medicare as a"get all the medical care you want, even if elderly and terminally ill" program. And walling off Mexico is a large structural impediment--but let;s not talk about that.

I won't even mention the USDA and the heavy annual tide of rural subsidies.

Ron Paul would be an interesting president, I'll say that. No more FDIC?

Squire said...

I didn't hear any level of hysteria in Cochrane's piece. He is saying there is more risk of it than the professionals think and he gives his reasons. If investors suddenly slow down their purchases of treasuries, a reacion by the FED to print to buy the bonds can be inflationary.

The article is educational. To me.

Mark Gerber said...

Thanks for posting this. This is the argument I have been tyring to make for some time now. I am glad to see Cochrane has been able to put for this argument in a manner that has led you to finally acknowledge the dangerous situation we are in.

What I can't understand is how you can write: "Fortunately, the problem is still relatively easy to solve." It may be relatively easy for you or me to solve, but do you really expect our government to solve it? The people want their SS and Medicare/Medicaid entitlements and there is no way that this economy can pay for them as the current law requires. So, we will see QE3, QE4, QE5, QE6 ... and the inflation will come and that will be that.

Dr William J McKibbin said...
This comment has been removed by the author.
Benjamin said...


If there is serious concern about inflation,. explain long-term interest rates. These are professional, institutional buyers, largely.

Cochrane's piece is well-written, not shrill in tone--only in antique content.

Read Carpe Diem today (written by another right-winger, btw). Inflation is weaker than the Los Angeles Dodgers' bullpen.

Charles said...


I don't think you understand Cochrane. He is not concerned about current Fed policy causing inflation. Nor is he especially concerned about cyclical deficits. He contends that in the current environment bonds and money are interchangeable and that the fed is powerless to affect the economy through open market operations. He is, on the other hand, concerned that QE effectively shortens the maturity of federal debt and that there are risks to this. If we financed the public debt exclusively through T-bills and if markets lose faith in the ability of the economy to service that debt, then a sudden, rapid inflation would ensue that the fed would be powerless to contain. So Cochrane favors extending the maturity of the debt so that when and if this crisis of confidence occurs there will be time for policy makers to respond.

The threat of inflation arises from the magnitude of our entitlement liabilities and government policies that damage the long term health of the economy.

Frozen in the North said...

Interesting argument that in the long term inflation will occur. But of course in the long run we're all dead. More interesting is the analysis that lower taxes will lead to higher revenues.

Didn't happen under Reagan, or Bush (although one could argue the temporary nature of the Bush tax cuts), still reducing tax rate will not increase tax revenues -- huge canard

Squire said...


Last week the FED pulled down inflation expectations and the stock market plunged because it wanted inflation because if apparent growth is all you have , it is all you have. Gold plunged because of the portion that gold is bought as an inflation hedge. Bonds are a deflation hedge and soared. So I agree with you that inflation isn’t currently a concern and rates support that.

The stagflation of the late 70’s & early 80’s was especially painful to me. I think Cochrane’s view that deficits and debt can be the catalyst of future inflation puts me on alert. But then again, I just think borrowing and spending on consumption is close to being immoral anyway. Of all the bad thinks that can happen because of excessive debt, possible inflation wasn’t one of the things I considered. While I am pretty negative on the economy, I will give though to stagflation as a possible future.

Frozen in the North,

After the Bush tax cuts, tax revenues were flat. There is no way to prove it, but tax revenues might likely have fallen without the cuts. (Like Obama’s we created or saved jobs). I don’t think demand side or supply side solutions will work now that we are at the end of the debt cycle. Only massive radical reform of taxes, healthcare, energy, social engineering, environmental engineering, trade, and education will make the economy grow again. None of these things have anything to do with fiscal or monetary policy.

Bill said...

Frozen: Your information is incorrect.

Under Reagan, federal tax receipts increased from $1,251.4 billion (in 2005 dollars) in 1981 to $1,494 billion in 1989.

Under Bush, federal tax receipts increased from $2,215.3 billion (again in 2005 dollars) in 2001 to $2,286.8 billion in 2008 before falling dramatically to $1,898.3 billion in 2009 as a result of the economic crash.

These figures by the way are from the Brookings Institution, a liberal think tank.

The trouble has never been that the federal government did not take in enough revenue. The trouble has always been that it has consistently spent far more than it takes in.

John said...

Reagan cut taxes AND increased spending, especially on defense. He had room to do so because bracket creep brought in enough revenue to drive government debt to historic lows, as a percentage of GDP. The next president will have no such luxury.

Benjamin said...


I enjoy your commentary, and we all could wish for less structural impediments (including the GOP ban on immigration).

But we probably have less structural impediments today than in the 1970s. Lower marginal tax rates, more global trade, less regulation (transportation and finance---remember Req Q?).

The fifty states are raising or lowering their own structural impediments (licensing lawyers and professions, land use laws) so it is hard to say we have more or less structural impediments than before. On whole, I say less. Jeez, Nixon tried wage and price controls.

Try reading an excellent blogger, Scott Sumner.

I lived through stagflation too. But you can't fight yesteryear's wars. With unemployment at 9 percent, growth tepid, and inflation dead, I just can't fathom the mindset of the Chicken inflation Littles.

Yes, someday we might have inflation--so we should do a Japan instead>

Benjamin said...

Another right-wing blogger who understand we actually have a very tight Fed right now.

TradingStrategyLetter - Weekly Summary said...

Massive inflation on the way. Policy makes and central banks will have us begging for it. The table is being set. Buy all the sub $30/oz silver u can get your hands on.