Wednesday, December 1, 2021

Inflation speculation

I'm working madly to finish The Fiscal Theory of the Price Level. This is a draft of Chapter 21, on how to think about today's emerging inflation and what lies ahead, through the lens of fiscal theory. (Also available as pdf). I post it here as it may be interesting, but also to solicit input on a very speculative chapter. Help me not to say silly things, in a book that hopefully will last longer than a blog post! Feel free to send comments by email too. 

Chapter 21. The Covid inflation 

As I finish this book's manuscript in Fall 2021, inflation has suddenly revived. You will know more about this event by the time you read this book, in particular whether inflation turned out to be ``transitory,'' as the Fed and Administration currently insist, or longer lasting. This section must be speculative, and I hope rigorous analysis will follow once the facts are known. Still, fiscal theory is supposed to be a framework for thinking about monetary policy, so I would be remiss not to try. 

Figure 1. CPI through the Covid-19 recession.

Figure 1 presents the CPI through the covid recession. Everything looks normal until February 2021. From that point to October 2021 the CPI rose  5.15% (263.161 to 276.724), a 7.8% annual rate.

What happened, at least through the lens of the simple fiscal theory models in this book? Well, from March 2020 through early 2021, the U.S. government -- Treasury and Fed acting together -- created about $3 trillion new money and sent people checks. The Treasury borrowed an additional $2 trillion, and sent people more checks. M2, including checking and savings accounts, went up $5.5 trillion dollars. $5 trillion is a nearly 30% increase in the $17 trillion of debt outstanding at the beginning of the Covid recession. Table 21.1 and Figure 2 summarize. ($3 trillion is the amount of Treasury debt purchased by the Fed, and also the sum of larger reserves and currency.  Federal debt held by the public includes debt held by the Federal Reserve.)

M2, debt, and monetary base (currency + reserves) through the Covid-19 recession.

Some examples: In March 2020, December 2020, and again in March 2021, in response to the deep recession induced by the Covid-19 pandemic, the government sent ``stimulus'' checks, totaling $3,200 to each adult and $2,500 per child. The government added a refundable child tax credit, now up to $3,600per child, and started sending checks immediately. Unemployment compensation, rental assistance, food stamps and so forth sent checks to people. The ``paycheck protection program'' authorized $659 billion to small businesses. And more. The payments were partly designed as economic insurance, transfers from people doing well during covid to those who had lost jobs or businesses, and efforts to keep businesses from failing. But they were also in large part, intentionally, designed as fiscal-monetary stimulus to boost aggregate demand and keep the economy going. The  massive ``infrastructure'' and ``reconciliation'' spending plans occupied the Congress through 2021, adding expectations of more deficits to come.  

From a fiscal-theory perspective, the episode looks like a classic fiscal helicopter drop. There is a large increase in government debt, transferred to people, who do not expect that debt to be repaid. It is a``fiscal shock,'' a decline in surpluses s_t, with no expectation of larger subsequent surpluses. Of course it led to inflation! 

We might try to think of the episode as a rise in debt B_t without future surpluses that raises expected inflation. But this does not look like expected inflation. The Fed, Administration, survey expectations, low interest rates, and private forecasts were completely surprised by inflation. As of the end of 2021 the Fed and Administration continue to proclaim it ``transitory,'' i.e. not expected to continue, and interest rates remain low. Survey expectations have risen. The divergence between  survey expectations and bond markets is intriguing, and the expectations hypothesis is known for its failures at short-run forecasting. But even this rise only came in the middle of the event, not with the bond sales as a rise in expected inflation would do. 

But the frictionless model is too simplistic to track an episode. We must think of the event with at least some sticky prices and long-term debt in mind. As a start, one might think of the fiscal shock with no interest-rate response and sticky prices of Figure 5.6. That model quickly resolves a first discrepancy: In the frictionless model, a fiscal shock does not raise the value of debt, and an AR(1) fiscal shock results in a lower value of debt. In the event, the value of debt rose. But the value of debt also rises in the sticky-price model of Figure 5.6. Higher inflation with constant nominal interest rates lowers the real rate, so the discount-rate effect accounts for the higher value of debt despite lower surpluses. In this view, the higher debt-to-GDP ratio is transitory and will be slowly inflated away. (The figure posits that 40% of a fiscal shock is inflated away, and 60% is eventually repaid. This event looks like a larger fraction will not be repaid. But the Figure still gives a first sense of dynamics.) 

In the model, Figure 5.6,  inflation starts immediately, while there was a year delay in the data. One might want a different model of price stickiness, or model the anecdotal evidence that people waited a year to start spending their newfound money. Most likely, the first stimulus checks did not fully reveal to people how large the final fiscal expansion would be. My expectations suffered several shocks in the same direction; I did not expect $5 trillion when it started. Or, perhaps the expectation that the debt would not be repaid took some time to settle in. Perhaps the debate over the large ``build back better'' bill cemented expectations on that score. 

A monetarist might object that this event was (finally) proof of MV=PY. Helicopter yes, but helicopter money, not helicopter bonds. M2 rose $5.5 trillion, the rest is irrelevant.  But we can ask all the questions of Section 14.1 about helicopter drops: Suppose the M2 expansion had been entirely produced by purchasing existing Treasury securities, with no deficits. Would this really have had the same effect? Are people starting to spend their M2 because they don't like the composition of their portfolios, which have too much M2, paying 0.01% (Chase), and not enough one-year treasurys paying 0.1%?  Or are they simply spending extra ``wealth?'' Suppose the Federal Reserve had refused to go along, and the Treasury had sent people Treasury bills directly. Would that not have stoked the same inflation?  The fiscal expansion, the wealth effect, is the natural interpretation of this episode.  

Why did this stimulus cause inflation, and that of 2008, or the deficits  from 2008 to 2020, did not do so? Federal debt held by the public doubled from 2008 to 2012, as inflation went nowhere. (Figure 5.6.) From the fiscal theory point of view, the key feature is that people do not believe this debt will be paid back. (In principle discount rates or real interest rates could be different, but in this case they are nearly the same.) So why, this time, did people see the increase in debt and not infer higher future surpluses, while previously they did? Several speculations suggest themselves.

First, we can just look at what politicians said. In 2008 and following years, the Administration continually offered stimulus today, but promised deficit reduction to follow. One may take those promises with a grain of salt. But at least they bothered to try. This time there was no talk at all about deficit reduction to follow, no policies, no plans, no promises about how to repay this additional debt. Indeed, long-run fiscal policy discussion became focused on how low interest costs, r<g, and modern monetary theory allow painless fiscal expansion.  The discussion of tax hikes in the spring and summer of 2021 focused entirely on paying for some of the ambitious additional spending plans, not repaying the Covid helicopters. 

Second, much of the expansion was immediately and directly monetized and sent to people as checks. The previous stimulus was borrowed, and funded government spending programs that have to gently work their way into people's incomes. Following 2008, M2 did not rise as much as debt. The QE operations were mostly confined to a switch of bank assets from Treasury debt to reserves, as we see from the contrast between the monetary base (currency + reserves) and M2 in Figure 2. (Note the base is on a different scale.) 

Money and bonds may be perfect substitutes, but who gets the money or debt and how can still matter. Traditional buyers of Treasury debt have savings and investment motives. (Think of an insurance company.) If the Fed instantly buys the debt, and Treasury sends reserves (checks) to people, the larger debt  goes quickly to people who are likely to spend gifts quickly. Debt sold to traditional bond purchasers, who show up at Treasury auctions or buy from broker-dealers, sends a different signal than money simply created and sent to people. This statement implies some slow-moving capital frictions and heterogeneity, but most of all it echoes the idea that the institutional context of debt expansion matters to expectations of its repayment. We distinguished Treasury actions as a share issue and reserve creation as a split, differing only in the expectations of repayment that each engenders.  We distinguished ``regular budget'' and ``emergency budget'' deficits, likewise signaling backed vs. unbacked expansions. Since the desire was stimulus, and stimulus requires the government to find a way to communicate that the debt will not  be repaid, one can regard the effort as a success at its goal, finally overcoming the expectations of repayment that made previous stimulus efforts fail, guilty only of having overdone it. 

Third, the Covid-19 economic environment was clearly different. The pandemic and lockdown shock is fundamentally different from a banking crisis and recession shock of 2008. GDP and employment fell faster and further than ever before, and then rebounded most of the way, also faster than ever before. From a macroeconomic point of view,  the Covid-19 recession resembles an extended snow day rather than a traditional recession. One might call that a ``supply shock,'' as the productive capacity of the economy is temporarily reduced, but demand falls as well, for the same reasons that people don't rush out to buy in a snow day either. (I write ``from a macroeconomic point of view.'' A million people died in the U.S., an ongoing public-health disaster. Many people suffered lost jobs and businesses.) Roughly speaking the economy was operating at its reduced ``supply'' capacity all along, not needing extra ``demand.''  Providing that ``demand'' could reasonably spill more quickly to inflation. 

Will inflation continue? You'll know the answer, and I don't. But it's worth writing how one might think about the question. The $5 trillion total fiscal expansion is an approximately 20% expansion in debt. If the expansion came with no change at all in expected future surpluses, that will result in a cumulative 20% price-level rise, once we work through all the dynamics. Several commentators view this outcome positively: An unexpected crisis is met with a Lucas-Stokey state-contingent default, a wealth tax, via inflation. Whether that optimal tax argument extends to stimulus payments rather than insurance or war-fighting is a bit more tenuous. But the effect will be to have financed the stimulus payments by a wealth tax on government bonds. 

But that's it. Whether inflation continues depends on future fiscal and monetary policy, and whether people have changed their expectations of future repayment and the underlying monetary-fiscal regime. If people regard the stimulus payments as ``emergency budget'' expenditures that will not be repaid, but the existing 100% of GDP debt still to be repaid, and the additional borrowing of the years ahead  back to the ``regular budget,'' that will be repaid, fiscal inflation need not continue. If, however, having changed their expectation that greater debts, especially those that finance cash transfers, are now not to be repaid, additional deficits will lead to additional inflation, and additional debt issues will just raise nominal interest rates. 

The models remind us though that bad fiscal news can only affect unexpected inflation, though sticky prices, long-term debt, and endogenous policy responses can smear out that basic logic over many years. Once Covid passes, the U.S. will likely be back on the previous track of trillion dollar deficits in good times and $5 trillion in each crisis. Not sustainable, but not news. Thus, if the 2020s are the decade of fiscal inflation, that will likely come from changing expectations of repayment, or a changing (higher) discount rate, not particularly important news about short-term deficits. Such expectations can shift slowly, hope triumphing over experience several times in a row, which along with the smoothed dynamics can lead to a decade of inflation, not a one-time price-level jump. 

What of monetary policy? The episode and the decade will likely offer different interpretations, which may help to sort out the fiscal theory plus rational expectations view, and the traditional adaptive expectations view, in which higher interest rates reliably lower inflation, interest rates rather than fiscal affairs are the main cause of inflation, and swift more than one-for-one response is necessary to keep inflation from spiraling out of control. 

From the traditional perspective, the Fed's monetary policy in 2020 and 2021 is a significant institutional failure. The Fed was caught completely by surprise. The Fed claims that supply disruptions caused inflation. But the Fed’s main job in the conventional reading is to calibrate how much ``supply'' the economy can offer, and then adjust demand to that level and no more. A central bank offering supply as an excuse for inflation is like the Army offering that the enemy chose to invade as excuse for losing a war. If the Fed is surprised that containers can't get through ports, why does it not have any of its thousands of economists calculating how many containers can get through ports? The answer is that the Fed's ``supply'' modeling is pretty simplistic, relying mainly on the non-inflationary unemployment rate (NAIRU) concept. More deeply, the Fed worked with Treasury on the stimulus in the first place, misdiagnosing the economy's fall as simple lack of ``demand,'' not disruption due to a virus and lockdowns. 

More broadly, the general policy discussion involving Fed, Administration, politicians and pundits relating inflation to specific markets and supply shocks, like containers stuck in ports, confuses relative prices for inflation. Supply shocks cause relative price changes. Strawberries are more expensive in winter. That's not inflation. Aggregate supply is the relationship between the rise of all prices and wages together, and the total amount produced in the economy.  That is a question about the nature of shocks to the Phillips curve, which may or may not have anything to do with supply restrictions of individual markets. Inflation is a decline in the value of the dollar. In that sense all inflation comes from ``demand.'' Blaming inflation on microeconomic shocks, corporate greed,  producer collusion, speculators, hoarders, middlemen, price-gougers, and other hunted witches goes back centuries.  Trying in vain to talk or threaten down prices goes back centuries. The Roosevelt Administration tried to cure deflation by creating monopolies to raise prices. Kennedy, Johnson, Nixon and Ford all pressured companies to lower prices and unions to lower wages. None of it worked. The Biden Administration's effort to attack oil companies for collusion will fail just as predictably.  

Going forward, in this conventional reading of monetary policy, the Fed seems primed to repeat the mistakes of the 1970s. The Fed of the early 1970s also blamed inflation on price shocks, and declared inflation to be transitory. The Fed's 2020  strategy review practically announces a return to 1970s policy. The Fed will deliberately let inflation  run hot for a while, running down a static Phillips curve, in an effort to boost employment. The Fed will wait until inflation persistently exceeds its target before doing anything about it.  The Fed will return to filling ``shortfalls'' rather than stabilization, a return to the belief that even at the peaks the economy can never run too hot.  The Fed understand “expectations” now, unlike in 1971, but views them as a third force,  amenable to management by speeches, rather than formed by a hardy and skeptical experience with the Fed’s actions, a durable ``rule'' or ``regime.''  And the ``strategy'' is so flexible that pretty much any discretionary action can be justified. To be a bit charitable, this strategy was developed before 2020 and is designed to ward against zero-bound deflationary spirals with ample inflationary forward guidance.  But if inflation continues, that will now be an exquisite Maginot lineThe absence of contingency planning for inflation will be laid bare. In the conventional reading,``anchored'' expectations come from one place only: belief that the Fed will, if needed, replay 1980: Sharp persistent interest rate increases that may cause a painful recession, but the Fed will stick with them as long as it takes. But though our current Fed says  it has “the tools” to contain inflation, it's remarkably reticent to state just what those tools are. Do people believe our Fed will do it? 

But the simple fiscal theory models in this book are kinder to the Fed. The Fed could tamp down inflation by swiftly raising rates, and exploiting whatever mechanism lies behind a negative short-run effect. And we have seen that rate rises are useful to smooth fiscal shocks, producing slow steady inflation rather than sharp price-level jumps. But the emphasis on a greater than one-for-one response, and the view that failing to promptly follow that policy will lead to instability is gone. 

Indeed, if the rational expectations versions of the models in this book are right, inflation is stable under an interest rate target. If the Fed left the interest rate alone, inflation would eventually return, though transitory may take a long time and involve a lot of short-run dynamics on the way. All the hedgeing of Section 5.3 still applies. The Fed would have to say this is its strategy, which it certainly does not do, and stick with it while short-run dynamics and fiscal shocks run their course. If people think that after a certain amount of inflation the Fed will give in and raise rates, then inflation will start up in advance and the strategy would fall apart. Still, history may be kind to the Fed and suggest that it worked its way to such a strategy by ``as-if'' experience-based action, even though the Fed's models and theories say otherwise. 

Suppose inflation does surge in the 2020s. What will it take to stop it? The traditional view demands a sustained period of high real interest rates. If expectations are adaptive or mechanistic, that period of real interest rates must cause a fairly deep recession. 

The fiscal theory plus rational expectations view offers more possibilities. A period of high real interest rates will likely be the policy choice, using whatever the short-run negative response is to quickly push inflation down, and then nominal rates can quickly fall to the new lower expected inflation. Whether it works, and how much recession is involved depends on that mechanism. The long-term debt mechanism we have explored requires that the higher rates are unexpected and credibly long-lasting. But financial friction or other mechanisms may have other preconditions, and we will learn what those mechanisms are. 

The model, and Sargent's timeless analysis of the ends of inflations, opens another possibility: A credible joint fiscal, monetary, and microeconomic reform, can allow a relatively painless disinflation, and one in which nominal interest rates fall immediately in Fisherian fashion. 

Which of these will happen? A repeat of 1980 will be harder this time. Most obviously, the willingness of our government to sustain a deliberate, bruising and persistent recession, with monetary stringency rather than the monetary largesse of 2008 and 2020, seems much weaker. However, a decade of inflation may change that, as it did in the 1970s. 

But no matter which theory applies, fiscal policy will place a greater constraint on monetary policy based on high real interest rates. In 1980, the debt-to-GDP ratio was 25%. In 2021 it is 100%, and rising swiftly. If our government wishes to repeat 1980, it will first of all have to pay four times larger real interest costs on the debt. 5% real interest rates mean 5% of GDP additional deficit, $1 trillion 2021 dollars, for each year that the real interest rates continue. That amount must be paid by higher primary surpluses, immediately or credibly in the future.  Will our government do it? The last time debt-to-GDP was 100\%, in the aftermath of WWII, the government explicitly told the Federal Reserve to hold interest rates down to help finance the debt. 

Second, the government will have to raise surpluses further, to pay a windfall to long-term bondholders, as it did in the 1980s. People who bought 10-year Treasury bonds in September of 1981 got a 15.84% yield, as markets expected inflation to continue. From September 1981 to September 1991, the CPI grew at a 3.9\% average rate. By this back-of-the-envelope calculation, those bondholders got a 12% annual real return. That return came courtesy of U.S. taxpayers, though largely through growth and a larger tax base rather than higher tax rates. This effect is  now four times larger as well. 

Finally, but largest of all, this time the underlying problem will likely be more clearly fiscal. The U.S. government will have to solve the long-run fiscal problem and convince bondholders once again that the U.S. repays its debt. 

Without the fiscal backing, the monetary stabilization will fail, and that applies to all our theories.  In a fiscally-driven inflation, it can happen that the central bank raises rates to fight the inflation, that raises the deficit via interest costs, and only makes inflation worse. This has, for example, been an analysis of several episodes in Brazil. The simulations of Section17.4.2 make this point explicitly. 

But the chance of any such large fiscal contraction, a thoroughgoing fiscal reform, seems remote in current U.S. politics. Anchoring of expectations from the belief that this will all happen smoothly seems doubtful. 

A successful inflation stabilization always combines fiscal, monetary, and microeconomic reform, in a durable new regime that commits to pay its debts. 1980 was such an event, not just a period of high interest rates. High interest rates can drive down inflation temporarily in all these models, giving time for the fiscal (1986 tax reform) and microeconomic reforms to take effect. In their absence, inflation takes off again. A new inflation stabilization would have to be such an event as well, but in the face of at least four times larger debts, larger structural deficits, and a more deeply entrenched regulatory regime. 

Or, inflation may fade away and all this speculation will apply to 2040 or 2050. 



  1. Very interesting.

    I know this isn't the main area of your focus, but i think the notion that inflation is a tax of bondholders isn't quite so simple. For example, insurance companies are very large owners of bonds. If inflation raises their liabilities relative to their bond holdings then presumably they raise prices. So the tax is ultimately paid by the consumers of insurance products in this case.

    I'd be curious to know if you've thought about who actually pays the inflation tax in any deep way.

  2. What about sterilization and the Fed paying IoR? Didn't that help prevent inflation going off the rails? We don't have a similar mechanism with Fiscal helicopter money, for when there's cash in hand, there's little preventing people from wanting to spend it.

  3. Can I make a comment on the prose? You are using “But” as a transition between a lot of sentences. It makes the argument really hard to follow for me in some places.

    “ As a start, one might think of the fiscal shock with no interest-rate response and sticky prices of Figure 5.6. That model quickly resolves a first discrepancy: In the frictionless model, a fiscal shock does not raise the value of debt, and an AR(1) fiscal shock results in a lower value of debt. In the event, the value of debt rose. But…”

    I have to look up at the diagram. Then imagine the frictionless model. But then immediately switch back. The paragraph has a lot of “But” sentences overall. You also capitalized “In the frictionless model” after the colon. And I found “In the event” to be a confusing transition, it is more commonly used as “in the event of” and because the paragraph keeps changing directions I was confused as to which event it was.

    I hate receiving criticism personally, so hopefully this is actually helpful.

    1. This is great! Thanks so much. But using "but" too often is a bad tic I have that always needs editing out. I like receiving criticism; it helps to make for better prose. Thanks again.

    2. “But if inflation continues, that will now be an exquisite Maginot lineThe absence of contingency planning for inflation will be laid bare. In the conventional reading,``anchored'' expectations come from one place only: belief that the Fed will, if needed, replay 1980: Sharp persistent interest rate increases that may cause a painful recession, but the Fed will stick with them as long as it takes.”

      I’m guessing there was meant to be a colon between “Maginot Line” and “The absence”. Seems like there is a lot of usage of colons in this portion. Next sentence has three clauses connected with two colons.

    3. Thanks. Obvious when pointed out.

  4. Great post - thanks for sharing. Question: where is the evidence that circa 1980 "a durable new regime that commits to pay its debts" emerged? My reading indicates that the Fed was committed to keep nominal rates high, leading to a rise in real rates as expected inflation fell. Other reforms came much later (1985-65) after inflation had already dropped substantially. Was "Volcker's disinflation" a mirage? Was the disinflation made possible by commitment to fiscal rectitude of Reagan's Treasury as the final chapter of the cold war unfolded and military and other spending picked up?

    1. RG,

      "Question: where is the evidence that circa 1980 a durable new regime that commits to pay its debts emerged?"

      There was none. In fact the opposite happened. There was a durable new regime committed to increase the federal debt and the interest payments on that debt.

      You have to remember, 1980 through 1983 was mired by a combination of high inflation and negative real GDP growth (stagflation).

      Growth in federal receipts was negative from 1981 through 1983 while the federal debt (and associated interest payments) rose 50% in the same time period.

      Federal interest expenditures as a percentage of federal receipts kept rising all through the early 1980's reaching a peak of 29% in 1984 and staying around 25-30% through the rest of the 1980's.

      The fiscal corrections began in the early 1990's.

      But then again, why let the facts get in the way of a "good" story.

  5. Well, very well done, excellent observations, IMHO.

    Still, Japan....

    Can the US do a Japan, or maybe even a little better? That is, obtain a moderate 4% to 5% inflation rate for several years, before a receding back to the 2% to 3% range?

    No one wants double-digit inflation. What is low inflation the only metric by which to measure macroeconomic policy?

    Presently the US has the best labor markets, certainly for the bottom half of the labor force, in 55 years.

    Is this accomplishment chopped liver?

    In the real world, are there ways to tame inflation that do not involve decreasing labor shares of income?

    1. "No one wants double-digit inflation. What is low inflation the only metric by which to measure macroeconomic policy?"

      Okay, how about employment to population ratio:
      2000 - 64.3%, 2021 - 58.8%

      Or how about trade balance:

      Or maybe labor share of income:
      2001: 64%
      2019: 59.7%

      "Presently the US has the best labor markets, certainly for the bottom half of the labor force, in 55 years."

      I would consider the bottom half those individuals starting out with their first job.
      2000: 59.9%
      2020: 50.9%

      And in case you haven't heard, inflation hits the bottom half of the labor force the hardest.

      "In the real world, are there ways to tame inflation that do not involve decreasing labor shares of income?"

      Yes, have the federal government sell equity (instead of bonds).
      Yes, bring an end to the welfare-warfare state.

    2. Your point? In case you haven't heard, we suffered through a dramatic pandemic which we haven't fully recovered from. Kids aren't vaccinated yet and are superspreaders. Dummy anti vaxxers are still prolonging the impact. Large swaths of workers are refusing to endanger themselves by staying in a job that endangers themselves and their loved ones.

      Labor share of income drop was in the 2000s. And what happened then. Oh yeah. China happened.

    3. DoDeals,

      "Your point?"

      My point is that there are lots of metrics to measure macroeconomic policy. And they are all pointing in the wrong direction because of cumulative action by both political parties (Democrats and Republicans).

      "China happened."

      Nope, China has been around for millennia. This is what happened:

      With "bipartisan support".

    4. "In case you haven't heard, we suffered through a dramatic pandemic...."

      "Coronavirus disease 19 (COVID-19), originated at Wuhan city of China in early December 2019 has rapidly widespread with confirmed cases in almost every country across the world and has become a new global public health crisis."

  6. Your analysis fascinating to read, but is miles over my head. Would you care to comment on the possibility of a melt-down type of dollar devaluation coming sooner rather than later? thank you.

  7. Perhaps the US government should split its debt obligations into two parts: one with high seniority and the other with low seniority. The role of high-seniority debt is primarily to support the value of the dollar, and the quantity of this debt would be bound by an upper limit (e.g. 60% of GDP). If the government needs to issue more debt, it would have to be low-seniority, and carrying default risk.

    1. Gideon,

      See 14th amendment to the US Constitution. Debt subject to default risk would likely be ruled unconstitutional.

    2. Interesting, I didn't know that. Thanks

    3. Frestly, s. 4 of the 14th amendment does not address default of the U.S. debt. It speaks only to the validity of the public debt. In other words, it prohibits Congress or the courts from ruling that an issue of debt, authorized by law, is invalid. Government default of the public debt is not proscribed by the constitution. You can verify this by reference to the remarks of the Sec. of the Treasury, J. Yellen, this year in relation to the debt limit. By the same token, the public debt is not guaranteed except to the extent that the holder receives payment in full at maturity in dollars of the United States, for whatever those may be worth at that time. J. Yellen's problem is, and continues to be, the availability of U.S. dollars to the U.S. Treasury--she has to find the dollars to pay the interest on the U.S. debt--and that requires sufficient margin between the current debt outstanding and the Congressionally set Debt Limit. Ergo, default on the U.S. debt, though only technical, is not ruled out by the 14th Amendment--i.e., default is not prohibited by the U.S. constitution.

      "Section 4.
      "The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any state shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void."

    4. OEE,

      "Ergo, default on the U.S. debt, though only technical, is not ruled out by the 14th Amendment--i.e., default is not prohibited by the U.S. constitution."

      I disagree. I take the view that when a Congress chooses to default on it's debts it has rendered those debts invalid. In addition, the Congress (under Article 1) is given the power to pay the debts and provide for the common defense of the United States.

    5. Well, you have your opinion, but it it isn't correct. Default comes in several flavors--technical default is one, insolvency is another, strategic default is a third one. Your comment refers to the third form of default, namely, strategic default -- i.e., purposeful dishonor of one's obligations in order to obtain better terms than the debenture agreement currently offers. The 14th amendment at part 4 precludes your notion of an act resulting in the invalidation of the public debt. The language in part 4 is clear in plain English. J. Yellen was concerned for technical default through the legislative inability to raise the debt ceiling. She would have made the debt service payments first before paying any other obligations, such as payments to the Social Security Administration. Doing so doesn't invalidate the debt to the SSA; but, it postpones the payment by a matter of a few days or a week or possibly, in extremis, a month.

    6. OEE,

      "Your comment refers to the third form of default, namely, strategic default -- i.e., purposeful dishonor of one's obligations in order to obtain better terms than the debenture agreement currently offers...."

      If Congress refuses to raise the debt ceiling, is this not a strategic rather than technical maneuver?

      "J. Yellen was concerned for technical default through the legislative inability to raise the debt ceiling."

      The Legislature ALWAYS has the ability to raise the debt ceiling. They can strategically choose not to do so.

      And my initial reply was to this suggestion:
      "If the government needs to issue more debt, it would have to be low-seniority, and carrying default risk."

      I believe that it would be unconstitutional for the Congress to issue low-seniority debt that carries inherent default risk.

    7. In addition, under Article II, Section 3 of the US Constitution:

      "The President SHALL take care that the laws are faithfully executed."

      Failure to do so would be grounds for impeachment.

      Any default (strategic, technical, or otherwise) would be a Constitutional violation that can be laid at the feet of the Executive Branch of Government.

      Nothing in the US Constitution dictates that the Legislature must borrow under any circumstance (deficit, surplus, or otherwise).

    8. Your last observation in your second posting would require a positive covenant in the constitution, where the framers preferred negative covenants.

      In your first posting, I was indeed aware of the original commentator's proposal for tiered debt. I don't see anything innately 'unconstitutional' in the proposed two-tiered debt structure, but I do see objections from the perspective of the bond and investment markets to such a proposal. If Congress agrees to (i.e., approves by vote) a two-tiered debt structure, I don't see that violating the 14th Amendment (Part 4), or the Article II, Section 3) provisions in the Constitution.

      When you say, "Any default ... would be a Constitutional violation that can be laid at the feet of the Executive Branch... ", you are ignoring the separation of powers between the three branches of government. Failure of Congress to raise the "debt ceiling" would not be a fault of the Executive Branch. J. Yellen's statements suggest just the opposite--the Executive Branch was preparing to faithfully follow the law and curtail borrowing to avoid breaching the "debt ceiling". If that resulted in a technical default, or as you contend (incorrectly), a strategic default, that is not a fault of the Executive Branch and Article II, s. 3, would not have been violated. Nor would the 14th Amendment have been violated--the validity of the public debt would remain valid even in default. Congressional machinations around the "debt ceiling" were entirely of a political character, as clearly shown by the final resolution of that issue this month.

    9. This comment has been removed by the author.

    10. OEE,

      "Your last observation in your second posting would require a positive covenant in the constitution, where the framers preferred negative covenants."

      The positive covenant exists under directions to the Executive Branch of government under Article II, Section 3:

      "The President SHALL take care that the laws are faithfully executed."

      Meaning, the President in fulfilling his office doesn't have a choice in the matter. If Congress orders an expenditure, then refuses to borrow, tax, or coin money to pay for it, it is up to the President and the rest of the Executive Branch to come up with the funds and follow through with that expenditure.

      " are ignoring the separation of powers between the three branches of government."

      Nope, I am distinguishing between the Congress can choose to do what the Executive MUST do.

    11. OEE,

      "Your last observation in your second posting would require a positive covenant in the constitution, where the framers preferred negative covenants."

      The Bill of Rights (Amendments 1 thru 10 - ratified in 1791) relied heavily on negative covenants.

      Amendment I
      Congress SHALL MAKE NO law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the government for a redress of grievances.

      Amendment II
      A well-regulated militia, being necessary to the security of a free state, the right of the people to keep and bear arms, SHALL NOT be infringed.

      Amendment VIII
      Excessive bail SHALL NOT be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.

      The original Constitution (Ratified in 1788) to my knowledge does not.

    12. Frestly, Congress can't repudiate the debt except under the circumstances enumerated in the 14th Amendment. Congress can fail to pass an amendment raising the 'debt ceiling', if that is its intention. It is not unconstitional to do so. What are the implications for the funding of government operations if Congress fails to raise the 'debt ceiling'? Well, clearly there are several, but importantly, the first is the growth in spending is curtailed by the Treasury to stay within the limits imposed by the 'debt ceiling'. Secondly, Congress must then find additional sources of revenue (e.g., "government equity", however that is defined; or new tax levies or excise taxes, etc.) to meet the government's obligations. Alternatively, Congress can adopt legislation that curtails expenditures, e.g., social security, medicare/medicaid, and other social transfers, and the defense establishment, etc. That fiscal contraction would be a "shock", in J.C.'s vernacular, and it would throw the international economy into a bit of a tailspin. As we've seen, the drama queens in the Senate spun the possibility out as far as they could reasonably expect to do without tipping the economy into a recession, and then pulled a proverbial rabbit out of the proverbial top-hat, and "saved the day". It's all of a piece. And, next year we will have the privilege of watching the spectacle re enacted again when the next cliff hanger of a vote is staged for the benefit of the media and the evening news networks. Merry Xmas!

    13. OEE,

      "Well, clearly there are several, but importantly, the first is the growth in spending is curtailed by the Treasury to stay within the limits imposed by the 'debt ceiling'."

      Nope, spending is determined by Congress - not by the Executive Branch of government (Treasury) - see US Constitution Article 1, Section 1. Sure the President can veto a spending bill, but that veto can be overridden by Congress.

      "Secondly, Congress must then find additional sources of revenue (e.g., government equity, however that is defined; or new tax levies or excise taxes, etc.) to meet the government's obligations."

      Nope again. There is no positive covenant in the Constitution declaring that the Congress MUST do anything (my original point).

      The only party that MUST do something is the Executive Branch (Treasury) under US Constitution Section 2, Article III.

      "Alternatively, Congress can adopt legislation that curtails expenditures, e.g., social security, medicare/medicaid, and other social transfers, and the defense establishment, etc."

      Sure the Congress can choose to curtail certain expenditures, or they can choose not to.

      "And, next year we will have the privilege of watching the spectacle re enacted again when the next cliff hanger of a vote is staged for the benefit of the media and the evening news networks."

      Maybe, maybe not.

      "Merry Xmas!"

      Back at you.

  8. The initial inflation after the Spring of 2020 is a monetary phenomenon due to the action of the Fed and the huge fiscal stimulus. Had we not had an intervention at that time, we would have experienced a deflation instead of the inflation, due to a drop in production when the international community locked down as well as a drop in aggregate income due to the unemployment spike of over a 10% rise in just the month of April 2020. The stimulus helped to stabilize aggregate demand; but it could do nothing for the productive capacity taken out of service.

    The inflation we have been experiencing since February 2021, to use your dates, is being driven by the imbalances in the supply system resulting from a lagging performance of the manufacturing and distribution system, which is reflected in the Producer Price Index (PPI).
    You show the rise in the CPI from February 2021 to October 2021 of 5.15% – – but the PPI rose almost three times more (14.1%) during that same period, and actually started to sharply take off a couple months before.

    It is the PPI which is driving the CPI increase. If you look at prior years since 2008, the two are out of sync – the sharp rise of the PPI is not affecting the moderate rise of the CPI. The Wholesale Sector/Distribution System is absorbing the price increases and not passing them on prior to the pandemic years. Now that is not occurring and the Retail Sector is responding to the price increases.

    Aggregate Demand is leading Aggregate Supply, and the lag in production and distribution results in the PPI leading the CPI. This inflationary cycle is not due to monetary factors, but due to the real, physical economic structure and process – the flow of goods and services have been disrupted. There is little the Fed can do about that; and probably little Central Planning by the government can do.

    Take care of the Big Picture – dealing with the pandemic and restoring an operational framework – and let the individual agents (big businesses and small businesses, and the labor force) figure things out for themselves. Sooner or later order shall be restored, and we will probably be operating at a higher price level, but without the inflationary pressures and back to some sense of stability.

  9. A couple more comments:
    The difference between the Fed action from 2008 and this past year -- Bernanke was pumping money into the Banking System, not the economy -- M2 barely moved, took several years; Powell's actions were directed at the overall economy and the effect was immediate within months. The Banking Sector was in better shape this time, but did require help in specific areas to meet specific needs from the Fall of 2019, not due to the pandemic.

    1. Yes, this is an often misunderstood point. The Fed does NOT print money, certainly not into the economy. The Fed has been altering the composition of the banks balance sheets in order to stabilize the banking system. But the official narrative is the the Fed was trying to 'stimulate' the economy. From here, classical macroeconomics assumes that there is some multiplier effect whereby increasing bank reserves increases lending to the public. Except that banks never 'lend out' their reserves, and their lending is constrained by other factors. Also, it is far fetched to think that one can stimulate the economy by encouraging already indebted folks to pick up more debt. The economy needs a serious fiscal stimulus to grow. However, the stimulus should be designed to incentivize companies to invest, hire and produce, not to buyback shares. Instead, trillions of 'stimulus' money have gone into shares buybacks, much less into real growth.

  10. Another comment --
    The Kennedy Administration did not pressure businesses to lower prices.
    They pressured businesses and labor, in their agreements, to keep prices and wages within productivity gains, and not exceed them -- [some of us are old enough to remember JFK's admonishment of Big Steel at his press conference, as well as Fed agents getting Roger Blough out of bed very early in the morning as a reminder].

    From the mid-1950s and post-Sputnik period to the mid-1960s, and especially during JFK's time, the U.S. economy experienced a high performing economy (good growth in government and private investment, high rates of labor productivity year-over-year, as well as a number of other factors) resulting in an economy operating near peak performance, by 1965/1966. Peak performance being a near doubling of the nominal GDP in the ten years of the 1960s, and increase of over 70% of industrial production during the ten years with capacity utilization operating at 90% at the peak and that is with very big annual increases added to industrial capacity, and rates of productivity increases that were increasing at an increasing rate annually until the peak of 1965/1966. That is why the Debt-to-GDP had a sharp decline, and not because it was due to inflation -- the overall economy was very big (about $550 billion in 1960) and growing at near 5% per year compared to a smaller total national debt ($350 billion) with modest increases. It is the last half of the '60s where the growth rates (for GDP and labor productivity) slow where they are increasing, but at a decreasing rate.

    1. Vic,

      And then along came "guns and butter", "welfare-warfare" Lyndon Johnson to undo a lot of Kennedy's progress.

    2. I thought Amity Shlaes's Great Society: A New History did an excellent job of giving a very good explanation of what happened in the mid to late 60s with regards to the economy and society and how public policy had a devastating effect on many people's finances, especially the poor. One thing that stood out is how LBJ and the Congress of the late 60s decisions carried well in to the 1980s.

    3. I've listened to Amity Shlaes discuss the Great Depression years as well as the '60s, at great length (for 3 hours on C-SPAN's 'In Depth' -- as well as other presentations) and there is very little I agree with her on, just a few things.

      The Poverty Rate dropped in the decade of the '60s from over 20% to less than 12%. Comparing the Unemployment Rate in the late '60s to the present (2019), before the pandemic -- both at around 3.5%, but Long Term Unemployment (over 6 months) was near non-existent in the late '60s at around 5%, whereas if hovers around 15% to 20% in the 2000s and was at 10% during the best Clinton years.

      I'll agree with her criticism of public housing; but, if she looked more thoroughly we had a few real good public housing units, that were model examples, after the WWII years -- in Philly around the Fox Chase area and there was a project in Baltimore; that's what I know of from being old, and not doing any search. The one in Philly was eventually sold into private investors; and these, and the Baltimore units, were garden apartments, not multi-story monstrosities that she likes to point out.

      If you think she knows economics, listen to her answer to a viewer during the 'In Depth' program when she describes the deflation during the Great Depression as "I thought prices declining were a good thing for the economy".

      What else need I say? She makes a few good points that are insightful; but, the '60s is one of our greatest periods of economic and social progress, and that's including all the turmoil, and to miss that historical analysis is equivalent to saying 1619 is more important than 1776 as a historical marker in history.

    4. Vic,

      Falling prices combined with rising real gross domestic product is considered a good thing - (deflation from increased productivity).

      Falling prices combined with falling real gross domestic product is considered a bad thing - (deflation from a lack of aggregate demand).

      The problem is that economic policy makers (and presumably Miss Shales) don't understand the difference.

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  12. Just a shout out that I love the "Price Level" concept. Too much time has been spent studying inflation, the changes in price level, without understanding how the price level is set in the first place.

    This is not too dissimilar from the way people spend a lot of time researching returns, without understanding pricing in a scientific way. There is no question that market inefficiency is best measured on the level and not on the change, that prices are never perfectly efficient, and that price changes are always expected to gravitate toward efficient prices at the rate that information permeates the market.

    Yet, we find almost no literature on the topic.

  13. Hi John, I've been reading the latest draft of your new book on the Fiscal Theory of Inflation, and have been trying to understand the recent inflationary dynamics going on around the world outside of the US. I think the logic you use to analyze what's going on in the US can be easily applied to Canada as well, as the gov't debt to GDP ratio is similarily high, Canada also had helicopter money dropped to households and firms, the central bank monetized a large percentage of the pandemic deficit and there is similarily no real debate about how the new debt will be paid off.

    However, what about countries like Germany or Poland? They both had lower deficits (as % of GDP) and have overall lower debt levels (as % of GDP), compared to the US and Canada, yet face similar levels of inflation in the past year. Germany even has a constitutional limit on government deficits (0.35% of GDP) and has AAA rated gov't debt. How would you explain the sudden rise in inflation, in Germany, through the lens of the Fiscal Theory of Inflation?

    1. Good question. Of course there the big issue is the euro.

  14. Thanks for the analysis. Please comment if I understand this wrong ... my impression is that much of this analysis is rooted in classical 'University of Chicago' economic theory based on models like DGSE and Monetarist/Keynesian frameworks. Perhaps the biggest issue I have with these theories (and I am a UChicago graduate) is that they never properly develop a theory of Money. Instead, they interpret the relationships between price levels, debt and inflation in terms of equilibrium processes of supply and demand of measurable quantities. I more pedestrian circles, this jibes with the 'bond vigilantes' conjectures.
    The reality is that the demand for US Bonds depends on factors other than 'investors'. Many users of US bonds do not do so because of 'attractive yields', but rather for purposes like collateral management and reserves management. As long as the US remain the World reserve currency, it is likely the US Debt will not matter. We are NOT borrowing money from China and China's need for US Bond depends on everything but the yield.

    I think this framework ultimately fails to explain, never mind predict, some of the observed 'anomalies' in the markets. According to the classical economic model, Japan should have gone bankrupt decades ago, and the US should have experienced massive inflation during the past decade of unprecedented stimulus and near zero rates. And yet, we only see an inflation episode which the coincidence of a fiscal stimulus and a recent disruption in the global supply-chain: clearly a stagflationary episode in an otherwise still weak economy.

    But let's ask ourselves why the economy is still weak. It is easy to always blame the US Government spending and its regulations, but the reality is far bigger than that. Let's take a deeper look, for example, at the increased role of finance in the economy and the decades long pursuit of of short-term profits by corporations, in the name of Shareholder Value creation. Let's also look at the increased influence of corporation to dictate Government policy and regulations (via e.g. Citizens United). US corporation have been allowed to undercut employees for decades while engaging in massive programs of shares buybacks finance by cheap money. At the same time, companies undercutting employees benefits means that the Government has to pick up the slack when it comes to paying for services like healthcare and retirement.

    What has this to do with Government Debt? Because Government Debt is what keeps this financialized economy afloat. Think of Defense spending and the defense industry, or the whole Healthcare behemoth. Every action by the Fed lately has clearly had the main focus of supporting this financialized economy, under the excuse of stimulating it. All the while companies have been allowed to continue to limit wage increases and benefits, which is where you really put money into the economy.

    This is the classic cycle of overly neglected economists like Hyman Minsky. We are in the Ponzi phase of the economic cycle. I think we need more Minsky and less Friedmann ... with all due respect for both.

    1. You should read the book, neither of the two events you mentioned are anomalies in the fiscal theory of the price level.


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