- Government debt has a critical role to play in the determination of inflation. More specifically, the market’s assessment of the sustainability of government debt and deficits has a direct impact on the market value of the fiat money issued by that society and, consequently, the rate of change in the price level.
- Government has a simple choice when determining how to fund its deficits: issue debt (government debt) or issue equity (base money).
- Money (the monetary base) is a long-duration, special-form equity instrument that represents a proportional claim on the long-term output of society.
- Once government debt accumulates to a point that the market decides that the debt is unsustainable, the market will begin to discount (i) slower future output growth (deficits must be reigned in), and/or (ii) higher monetary base growth (at the margin, more funding needs to be financed by money creation).
- The combined shift in these expectations (lower long-term output growth, higher long-term monetary base growth) puts downward pressure on the market value of money and upward pressure on the price level.
- In this situation, a central bank may quickly become impotent in its fight against inflation as it losses control over long-term expectations.
Introduction: Government Debt and Inflation
This week we are going to explore the idea that the accumulation of high levels of government debt can have severe negative consequences. More specifically, we will analyze the relationship between excessive government debt and inflation.
The view of The Money Enigma is that fiscal policy plays a critical role in the determination of the price level. More specifically, a policy of persistent fiscal deficits combined with the accumulation of excessive government debt will, at some point, trigger a downward revision of market expectations regarding the future path of the “real output/base money” ratio. In turn, this shift in expectations may result in a significant fall in the value of money and an outbreak of high inflation.
At the present time, many economists and market participants seem to believe that there is little relationship between government debt and inflation. People point to the current high levels of government debt in Japan and/or the United States as proof that high levels of government debt (relative to GDP) have little to no impact on inflation.
This perspective ignores the historical experience of many less developed countries that have seen a massive collapse in the value of their currency and accompanied hyperinflation driven by fears of fiscal unsustainability. Unfortunately, there seems to be a view that somehow the Western World is “different” and immune to these forces.
Perhaps of greater concern is the fact that most economists believe that there is little to no relationship between government debt and inflation. “Too much government debt” barely rates a mention as a cause of inflation in most economics textbooks.
Feel free not to trust me on this point. Rather, read the following article, titled “Inflation and Debt” written by one of the leading economists of our time, John Cochrane, Professor of Finance at the University of Chicago Booth School of Business.
Professor Cochrane’s article is notable for a couple of reasons. First, it provides a simple, but intellectual, exposition regarding the current thinking on the causes of inflation. Second, it provides a great overview of the shambles that is current mainstream macroeconomic thinking: lots of different models (Keynesianism, Monetarism, Fiscal Theory) none of which work well on a standalone basis and none of which easily integrate with the other models.
For our purposes, the key point made by Professor Cochrane is that Keynesianism, the dominant school of economic thought, sees little role for government debt in the determination of inflation. The view of Keynesianism is that “too much demand” is a primary cause of inflation. Hence, the imperative on central banks to slow down economic activity as the economy approaches full capacity.
To be fair, Keynesianism has been modified to include an “inflation expectations” component, largely due to the failure of the old Keynesian model to explain the stagflation in the 1970s. In this New Keynesian world, government debt can only impact inflation if either (a) fiscal spending leads to an overheated economy, or (b) for some reason, higher levels of government debt lead to higher “inflation expectations”. While the first issue is obvious, the many proponents of Keynesianism have done a poor job of explaining how higher levels of government debt may lead to higher “inflation expectations”.
This week we are going to examine an economic model that can clearly explain how higher levels of government debt can lead to what Keynesians would call “higher inflation expectations”. More specifically, we are going to look at a theory of money that can explain how excessive government debt can lead to a fall in the value of fiat money and a consequent rise in the price level.
The Relationship between the Monetary Base and Government Debt
In order to understand the relationship between inflation and debt, we need to start by thinking about a much more simple relationship: the relationship between the monetary base (“money”) and government debt (“debt”).
The most obvious and well-recognized relationship between money and debt is that they are the two key elements of the “government budget constraint”. The government budget constraint states that the budget deficit in any particular period must equal the sum of the change in the monetary base and the change in government bonds held by the public during that same period.
In other words, the government has only two choices when it considers how to fund a budget deficit: either it can issue debt or it can create money.
This is very similar to the choice faced by a corporation that is trying to finance its operations. A corporation can either issue debt (a fixed claim over future profits) or issue equity (a variable claim over future profits).
The view of The Money Enigma is that we can extend this analogy.
Ultimately, society generates only one primary source of economic value that it can use to finance public spending: real output. When society does not wish to fund public projects by taxing current output, it can create (using the legal structure of government) claims on future output. Just as a corporation can create fixed and variable claims to future cash flows, so society (via government) can create fixed and variable to claims to future output that it can use to finance current deficits.
The fixed (or at least, pseudo-fixed) claim on future output is government debt. The variable claim on future output is money. In this sense, money is the equity of society.
The notion that money is a form of equity instrument and a proportional claim on the future output of society was discussed at length in a recent post titled “Money as the Equity of Society”.
The view of The Money Enigma is that we accept money as payment for our services because we, as a society, recognize that it represents a variable claim over the future output of society. Just as a share of common stock represents a proportional claim over the future cash flows of a corporation, so one unit of the monetary base (e.g., one dollar) represents a proportional claim over the future output of the society that issues that currency.
A government has only two choices when it wants to fund a budget deficit: either it can issue debt (a pseudo-fixed entitlement to the future output of society), or it can issue money (a special-form equity instrument that represents a long-duration, variable entitlement to the future output of society).
While this theory of money may seem complex, it does have one great advantage: it allows us to build a valuation model for money. More specifically, the theory allows us to build a discounted future benefits model for the value of money, just as one might build a discounted future cash flow model for a share of common stock.
Building a valuation model for money is a compelling aspect for this theory because it allows us to think about the impact on various shifts in expectations upon the current value of money. Importantly, a valuation model for money provides us with a framework for thinking about how rising levels of government debt may impact the current value of money.
But before we launch into an analysis of the valuation model for money, let’s think more generally about how rising debt impacts the value of equity.
How Does Rising Government Debt Impact the Value of Money?
The view of The Money Enigma is that once government debt reaches a critical level, market expectations regarding the future path of real output begin to fall and market expectations of the future path of the monetary base begin to rise. These two factors (diminished expectations for long-term output growth and heightened expectations for higher base money growth) combine to negatively undermine the value of money.
Rather than launch into the more technical aspects of how shifting expectations can impact the value of money, let’s return to our simple “money versus common stock” analogy.
Consider a company that is listed on the stock exchange. How does rising corporate debt impact the value of the shares of that company?
It’s not a simple question to answer. Why? Well, it depends on the underlying profitability of the company and how much debt that company already has. For example, if the company is highly profitable with low levels of debt, then taking on a bit more debt may have little or no impact on the stock price. Indeed, a little more debt could enhance the value of the shares if investors believe the money raised will fund highly profitable new projects.
However, what about a situation where the company is already highly indebted? Maybe our company lost money during the recession and had to take on a lot of debt. What would be the impact on the value of the shares of that company if the company announced it was going to take on even more debt?
Clearly, at some point there is a tipping point where equity investors will decide that the company is taking on too much debt and the value of the shares will fall. The fall in the stock price will be accentuated if it also becomes clear that the underlying health of the company is not as strong as believed (the company has been raising debt to cover up its weak cash flow problems).
Now, let’s think about this in the context of a society that can issue debt (government debt) and equity (base money). What is the impact on the value of the equity of society (money) as the outstanding debt of society (government debt) begins to rise?
Again, it depends upon the particular circumstances.
If the economic health of society is strong and the existing debt levels are low (government debt is less than 20% of GDP), then it seems reasonable to believe that an increase in government debt may have little or no impact on the value of the equity of society.
However, if a society already has high levels of public debt (100%+ of GDP) and then seeks to issue even more debt (issue more “fixed” claims against its future output), then this could place significant downward pressure on the value of money.
So, why is this case?
Money is a proportional claim on the future output of society. There are two primary variables that drive the value of money: the expected future output of society and the number of expected claims to that output (the future size of the monetary base).
As the expected growth of future output rises, all else equal, the value of a variable entitlement to that output will rise. Conversely, as the expected growth of the monetary base rises, all else equal, the number of future claims to output rises and the value of each claim falls.
As government debt levels reach a certain tipping point, markets will begin to revise their expectations for both of these key factors.
If the markets decide that the current path of fiscal policy is unsustainable, then there are only two ways in which this can be resolved. Either government deficits are reigned in, leading to lower levels of future real output, or the government will be forced to increase the pace of monetary base growth in order to finance those deficits (remember our government budget constraint from earlier).
We can think of the value of money in terms of slices of pie. As government debts rise to a critical point, then one of two things will happen. Either the pie itself will shrink (less output), or the pie will be cut up in to more pieces (more money). Either way, markets begin to anticipate this and the market value of money falls.
In more technical terms, the market value of money (as measured in absolute terms) depends upon the expected future path of the “real output/base money” ratio. Higher government debt can trigger a sharp downward revision in the long-term expected path of the “real output/base money” ratio, leading a sharp fall in the market value of money.
In summary, the value of money depends upon a complex set of long-term expectations regarding the future real output growth and future base money growth. Excessive government debt can lead to a sudden shift in these expectations, a shift that may have a severely negative effect on the value of the fiat money issued by our society.
Excessive Government Debt and Inflation
Finally, we need to close the loop regarding the relationship between government debt and inflation. So far we have concentrated on the relationship between excessive government debt and the market value of money. It has been argued that if government deficits and debts become unsustainable, then the market will begin to anticipate lower levels of future output and higher levels of future base money.
The combination of these two factors will place downward pressure on the value of money. Why? The market value of money will fall because money (each unit of the monetary base) represents a variable entitlement to the future output of society. If there is less expected output in the future, then the value of a claim to that future output will fall. Similarly, if the market anticipates more money will be created, then there are more claims on the future output of society and, all else equal, the value of each claim will fall.
But why does a fall in the value of money lead to higher prices? The answer to this question is simple. The market value of money is the denominator of every “money price” in the economy: as the market value of money falls, the price level rises.
We have already covered this theory in many previous posts, but those that are new to The Money Enigma should read “Every Price is a Function of Two Sets of Supply and Demand”, a post which explains the basics of price determination.
In summary, government debts and deficits do matter. The currently fashionable notion that government debts do not matter to inflation ignores the important role of expectations regarding the long-term path of real output and base money in the determination of the price level.
On a final note, the point that should be of most concern to policy makers is that once these long-term expectations regarding output and base money shift, it may be very difficult to bring them back to more previous levels and therefore difficult to control inflation.
While the current market view is that central banks are omnipotent in their control of the global economy, the fact is that it is almost impossible for a central bank, at least singlehandedly, to control an outbreak of inflation that is created by reckless fiscal policy. The only way to control this type of inflation once it occurs is for fiscal and monetary policy makers to work together. Inevitably, this involves an end of the “good times” as fiscal deficits are reduced, the monetary base is brought under control and interest rates are raised.