Using Inflation to Erode the US Public Debt, by Joshua Aizenman and Nancy Marion, NBER
The huge increase in public debt in the US as a result of the policies adopted to combat the financial crisis has led to a lot of concern about the ability of the government to service its debt and the willingness of foreigners to continue to buy US government bonds. The US dollar too has been under pressure, primarily because of worries that the US administration will succumb to the temptation of inflating away a part of its debt. In their recent paper Using Inflation to Erode the US Public Debt, Joshua Aizenman of the University of California at Santa Cruz and Nancy Marion of Dartmouth College look at the historical record of the US in inflating away its debt and analyse the factors that may induce the government to do so now.
The researchers point out that the outstanding federal debt at the end of 2009 is about 90% of GDP. In 1946, at the end of World War II, gross federal debt was 121.7% of GDP. Within a decade, however, this ratio was cut by half, partly due to growth and partly on account of inflation. The authors say that inflation reduced the debt to GDP ratio by almost 40% within a decade.
They say that the current fiscal situation in the US shares two features with the immediate post-War period: “It starts with a large debt overhang and low inflation. Both factors increase the temptation to erode the debt burden through inflation.”
But there are also important differences between the two periods. One of them is the fact that while foreign creditors held no US debt at the end of World War II, they now hold 48%. That increases the temptation to inflate, because a lot of the pain would fall on foreigners. But then, today’s debt maturity is less than half of what it was in 1946 and shorter maturities reduce the temptation to inflate. The paper says that these two competing factors offset each other. The conclusion: a moderate inflation of 6% could reduce the debt to GDP ratio by 20% within four years. The risks: “unintended acceleration of inflation to double digit levels in the future may have unintended adverse effects, including growing tensions with global creditors and less reliance on the dollar.” Given India’s high inflation and large public debt, there are many lessons the Indian government can take away from this paper.
Monetary Cycles, Financial Cycles and the Business Cycle, by Tobias Adrian, Arturo Estrella and Hyun Song Shin, Federal Reserve Bank of New York
The shape of the yield curve has long been known to have predictive properties about the economy. When the yield curve is inverted it predicts a downturn; when it is steep, it predicts growth. (The yield curve plots the yields of bonds of the same credit rating and of various maturities at a point in time.)
An inverted yield curve is seen as reflecting expectations of low future short-term rates which, in turn, are attributed to weakness in expected credit demand and central bank policy in response to subdued economic conditions.
But does monetary policy work because it raises or lowers interest rates and therefore affects the demand for credit or because it affects the slope of the yield curve? Tobias Adrian, Arturo Estrella and Hyun Song Shin of the Federal Reserve Bank of New York, in their paper Monetary Cycles, Financial Cycles and the Business Cycle, argue that monetary policy works through changing the slope of the yield curve.
The authors argue, “Banks and other financial intermediaries typically borrow in order to lend. Since the loans offered by banks tend to be of longer maturity than the liabilities that fund those loans, the term spread is indicative of the marginal profitability of an extra dollar of loans on intermediaries’ balance sheets.” The term spread is the difference between short- and long-term interest rates. As this spread is squeezed it will affect the net interest margin of banks, leading them to curb lending to marginal borrowers. The supply of credit to the economy therefore comes down, leading to a slowdown in growth in the real economy.
The researchers say, “In our view, a tightening of monetary policy induced by higher short-term rates does not require that long-term rates rise as well in order to obtain real effects. The flattening of the yield curve produced by a rise in short-term rates may be sufficient to affect bank profitability, bank lending, and subsequent real economic activity.”
But surely liquidity matters? The authors say it does, but “liquidity should be defined as the growth rate of assets on key intermediary balance sheets, not the quantity of money.”
Illustrations by Jayachandran/Mint
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