Wednesday, November 25, 2009

Public debt and inflation in US

In a series of excellent recent posts, Paul Krugman has nicely indicated why the US public debt and inflation are not the concerns, and unemployment and deflation is the more imemdiate challenge.

As share of GDP, while the US debt has been rising, it is still comfortably placed compared to the high rates the Japanese and Italian governments have been running for the past few years.

The chart below which shows the interest rate predicted by Taylor rule (minus 6.7% with the present inflation and unemployment) versus the actual rate on 3-month T-bills, clearly indicates that the economy is trapped in a protracted low interest zero-bound liquidity trap. The need of the hour is a commitment to more inflation than any increase in interest rates.

And worryingly, unemployment continues to rise unabated and given its lagging nature, is likely to keep rising.

The bond market worries about inflationary expectations due to rising debt, federal borrowing crowding out private borrowing and/or increasing doubts about US solvency, and the resultant apparent widening of yield spreads may not convey the full story, though it does convey market uncertainty. Interestingly, as the graphic shows, the nominal bond yield is about what it was in early September, while the real bond yield has fallen (due to weak expectations about the economy or some other reason).

Treasury Inflation Protected Securities (TIPS), whose payouts are indexed to consumer prices, give an objective, market-based measure of expected inflation (and therefore insure against inflation). The steep decline in TIPS in the aftermath of the failure of Lehman was a result of the Fed's aggressive market intervention to purchase more than $1.5 trillion worth of Treasury bonds and government-guaranteed securities linked to mortgages, so as to lower long term interest rates. The latest TIPS rates shows declines and that too at lower than trend rates, clearly reflecting deflation than any inflation.

The nominal rates too are stable at well below the pre-crisis levels.

In an uncertain economic environment, the risk-averse private sector is piling up on the liquidity of cash and short-term T-Bills, and the public sector is sustaining demand with deficit spending, financed by long-term debt. Some financial players are bridging the gap between the short-term assets the public wants to hold and the long-term debt the government wants to issue, through a form of carry trade.

It is felt, among others also by the bond markets, that these carry trade players who are borrowing cheap money short-term, and using it to buy long-term bonds, are badly vulnerable to interest rate increases. Higher rates will lower the prices of their long term bond investments (since their yields will rise) and leave them with losses and another vicious circle of collapsing balance sheets.

However, Paul Krugman describes this a 'maturity mismatch', and says that even if this happens, it would be a financial system problem and not a deficit problem, "It would basically be saying not that the government is borrowing too much, but that the people conveying funds from savers, who want short-term assets, to the government, which borrows long, are undercapitalized. And the remedy should be financial, not fiscal. Have the Fed buy more long-term debt; or let the government issue more short-term debt." And what is more, this carry trade is exactly what you would expect to see with undercapitalized financial market players who borrow short and lend long, even if fiscal policy were on a perfectly sustainable trajectory.

Brad De Long though feels that the thin nature of the long term Treasury market means that the price signals conveyed by it may not be an accurate reflection of market expectations and any unwinding of the carry trade could have very bad consequences. And as one of the comments makes the point, all financial institutions engage in some type of inter-temporal arbitrage using some form of carry trade, and any rate increase could therefore adversely affect all the financial market actors. This may have boxed the Fed into a debt-financed low interst rate environment.

Update 1
Mark Thoma has an excellent summary and status report on the problems facing the US economy on its burgeoning debt and possible inflation edxpectations by drawing a distinction between policies implemented by the Fed and Treasury in an attempt to bailout and stabilize the banking system, and the policies passed by Congress and signed into law by the president in an attempt to jump start the economy.

Update 2
The net interest payments as a percentage of GDP is no higher than during the eighties and nineties, even assuming the present burgeoning debt burden.

Update 3
An NBER working paper by Joshua Aizenman and Nancy Marion finds that despite the fact that shorter debt maturities reduce the temptation to inflate while the larger share held by foreigners increases it, in the years ahead, public debt in America is likely to be offset by inflation. They write about impact of a large nominal debt overhang on the temptation to inflate,

"When economic growth is stalled, the US debt overhang may trigger an increase in inflation of about 5 percent for several years. This additional inflation would significantly reduce the debt ratio, even with some shortening of debt maturities... a moderate inflation of 6 percent could reduce the debt/GDP ratio by 20 percent within 4 years."

However the unintended consequences of inflationary expectations getting out of control makes the strategy fraught with danger.

Update 4
Nouriel Roubini writes on the dangers of monetization induced inflationary pressures to erode public debt burden - inflation tax on lenders.

Update 5
Catherine Rampell points to Alan Auerbach who argues that since the major portion of US public debt is either indexed to inflation or is internally held within the government (e.g., the Social Security trust fund, etc), there is no possibility of inflating them away.

Update 6
Paul Krugman draws attention to the Cleveland Fed 'trimmed' inflation measures, which exclude outlying large price movements (the ultimate trim is the median, the rise in the price of the median category), which tells a story of dramatic disinflation in the face of a week weak economy.

Update 7 (23/3/2010)
Mark Thoma examines the possibility of various types of tax increases in the US in order to service the massive public debt burden and meet the growing expenditure requirements.

Update 8 (18/11/2010)

Core inflation — that is, the change in the cost of a basket of consumer goods, excepting the volatile categories of food and energy — was at its lowest level on record in October since the government began collecting such data in 1957.

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