Category Archives: Financial Crises

Can we count on the Fed to hold down inflation?

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Jason De Sena Trennert writes,

The Fed’s policy of quantitative easing injures middle-class savers. People without financial assets get kneecapped by the policy known as “financial repression”—purposefully attempting to pay for government spending by keeping interest rates below the rate of inflation. This policy has been a boon for the wealthy but a disaster for average people, who earn no return at all on their savings.

…Total financial assets in the U.S. now represent 565% of gross domestic product.

…A remarkable 50.9% of U.S. sovereign debt matures in the next three years. The weighted average cost of America’s outstanding debt is only 1.38%. With more than $22 trillion of that debt owed to the public, relatively small changes in short-term interest rates could greatly increase the federal deficit.

His point is that the Fed will be under tremendous pressure not to raise interest rates, because of the devastation it would bring to financial assets and the cost it would impose on the government deficit. My thoughts:

Interest rates are low either because (a) the Fed has the power to control them and is keeping them artificially low; or (b) the natural forces of supply and demand favor low interest rates (global supply of savings is high, global demand for investment is low, and/or preferences  for low-risk assets are high).

I think that (b) is more likely to be the case.

If (a) is true, then it seems pretty certain to me that we will get lots of inflation over the next few years.
I also think we are headed for inflation if (b) is true, but it might take longer to get rolling and be much, much harder to stop.

I agree with the thrust of the story, that the Fed will be under intense pressure to keep nominal interest costs low.  If it had the means to stop inflation, it might not have the will.  But I don’t think it even has the means–it’s up to Congress to stop running up the debt.

Inflation, thinking in bets

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I wrote this essay.

Do you disagree that inflation is likely to remain elevated over the next eighteen months, as GDT leads me to predict? If so, what theory do you prefer? The theory that high inflation is transitory? A theory that the Fed will step in and keep inflation at low levels? The theory that I here associate with Modern Monetary Theory, that inflation will only rise when there is hardly any unemployment? A theory that we will have another recession in the months ahead, due to COVID or some other factor?

UPDATE: John Cochrane writes,

The well-respected Taylor rule (named after my Hoover Institution colleague John B. Taylor) recommends that interest rates rise one and a half times as much as inflation. So, if inflation rises from 2% to 5%, interest rates should rise by 4.5 percentage points. Add a baseline of 2% for the inflation target and 1% for the long-run real rate of interest, and the rule recommends a central-bank rate of 7.5%.

He makes the same point that I would, namely:

Monetary policy lives in the shadow of debt. US federal debt held by the public was about 25% of GDP in 1980, when US Federal Reserve Board Chair Paul Volcker started raising rates to tame inflation. Now, it is 100% of GDP and rising quickly, with no end in sight. When the Fed raises interest rates one percentage point, it raises the interest costs on debt by one percentage point, and, at 100% debt-to-GDP, 1% of GDP is around $227 billion. A 7.5% interest rate therefore creates interest costs of 7.5% of GDP, or $1.7 trillion.

Read the whole thing.

A government debt crisis?

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I write,

a debt crisis is always an improbable scenario. If we could be sure that a debt crisis will occur, then we would already be in one. If investors thought that the U.S. would have difficulty rolling over its debt next week, then they would stop buying bonds today, and the U.S. would have trouble rolling over its debt today, so that the crisis would take place today.

Dependency ratios and inflation

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In a podcast with Rob Johnson of George Soros’ Institute for New Economic Thinking, Charles Goodhart and Manoj Pradhan offer an unusual explanation for secular trends in inflation. They say that a decline in the dependency ratio creates excess supply of workers relative to consumer, putting downward pressure on prices. This trend has started to reverse, so we will see upward pressure on prices. They say that this upward pressure will become visible soon after the virus crisis is over.

Think of this in worldwide terms, with the dollar as the universal unit of account. Over the last several decades, the world labor supply rose because of population trends and the inclusion of more countries, notably China, in the world production system. The share of consumers in the population remained steady, as a decline in birth rates offset population aging by reducing the growth of young dependents.

Going forward, the labor supply will grow slowly and population aging will outpace any further decline in birth rates. So the world dependency ratio will rise, and this will put upward pressure on wages and prices.

Note that money plays no role in this story. What about “Inflation is, anywhere and everywhere, a monetary phenomenon”? Perhaps if you include the hypothesis that the real mission of the central bank is to hold down government borrowing costs, you can tell the story in a way that Milton Friedman would not object. That is, as dependency ratios were falling, there was enough worldwide saving to keep down interest rates, and central banks did not have to monetize a large share of government debt, so that inflation fell. Going forward, worldwide saving will fall, and central banks will face a dilemma. As inflation appears, they will want to stop it by raising interest rates. But if they do that, governments won’t be able to afford the interest cost on their debt, so central banks will be forced to monetize a large share of debt.

Toward the latter part of the podcast, they are asked about why markets differ from their forecast. Basically, they say that markets are extrapolating forward based on the past, in which demographic pressure on inflation was downward. It will take markets a while to realize that we are in a new regime.

Is financial repression an option for the U.S.?

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Timothy Taylor writes,

the US political system has been unwilling to restructure big spending programs like Medicare and Social Security; a large-scale restructuring or default on US debt seems like a highly unlikely last resort; and US inflation has been stuck at low levels for 25 years now, for reasons not fully understood. Thus, I suspect the US economy may be headed, by fits and starts, to a period of what Reinhart and Sbrancia call “financial repression.” By this term, they mean a set of policies that invole much greater government management of the financial sector, including policies that focus on keeping interest rates very low and also limit other options available to investors–so that the government will find it easier to keep borrowing at low interest rates.

Financial repression means that government dictates how people save, essentially forcing them to finance government debt at artificially low rates. I can see doing this in a backward country that lacks financial markets that would allow people to get better interest rates than they can from the government. I cannot see how this would work in the United States. I think that we will get inflation instead.

Right now, people are bidding up the prices of assets, especially in the stock market. I think of an asset boom as deferred inflation. Eventually, people will sell assets and buy goods and services, and that is when we will see the inflation.

A Grumpy outlook on the debt

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John Cochrane writes,

The danger the US faces the danger we should repeat and keep in mind, is a debt crisis. We print our own money, so the result may be a sharp inflation that wipes away the value of debt rather than an even more disruptive default, but the consequences will be almost as dire.

Read the whole essay. The counter-argument, which the market clearly accepts, is that the inflation-worriers have been with us for decades, and inflation has only trended down. Please do not repeat that argument in the comments. To me, it is the classic case of jumping out of a 10-story window, and as you pass the 2nd floor saying, “See, it’s all fine so far.”

In a subsequent post, Cochrane writes,

The main worry I have about US debt is the possibility of a debt crisis. I outlined that in my last post, and (thanks again to correspondents) I’ll try to draw out the scenario later. The event combines difficulty in rolling over debt, the lack of fiscal space to borrow massively in the next crisis. The bedrock and firehouse of the financial system evaporates when it’s needed most.

Basically agreeing with John, I recently wrote,

for the next several years the Fed will be focused on the task of enabling the government to continue to borrow. The conduct of what economists call monetary policy will be subordinated to that objective. The Fed will be expected to finance as much government borrowing as is necessary to keep interest costs under control. But regardless of how active the Fed is in purchasing government bonds, I believe that the United States will slide into a regime of high inflation.

My previous essays on the topic include How a Sovereign Debt Crisis Might Play Out and Guessing the Trigger Point for a U.S. Debt Crisis. As the latter paper points out, a debt crisis has to come as a surprise to the typical investor. That is why your confidence that there won’t be a debt crisis is not going to persuade me that it will never happen.

So you don’t have to

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I read Stephanie Kelton’s The Deficit Myth and wrote a review.

It is indeed correct to say that when the government is bidding for resources, the risk of inflation is low if those resources are idle. It is also correct that unemployment is an indication of idle resources. But just because some resources are idle does not mean that the government can spend wherever it would like without affecting prices. The government would have to be an especially perspicacious and adroit entrepreneur to advance its priorities while only using idle resources.

By the way, as I read the market for U.S. Treasuries, investors are betting that Kelton is right.

The paradox of accountability

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Accountability means having our ideas and actions evaluated by others, with those evaluations having consequences. The paradox of accountability is that everybody needs it but nobody wants it.

Everybody needs accountability in order to stay on track. Without effective accountability, individuals and organizations become weak and corrupt.

Nobody wants accountability, because it limits our autonomy. Whether our intentions are good or not, our autonomy is constrained by those who hold us accountable.

Because nobody wants accountability, we try to counteract mechanisms that are designed to create accountability. A CEO is supposed to be accountable to shareholders via the board, but the CEO tries to get around this by “stacking the board.”

Some remarks:

1. With any organization, you can study its accountability mechanisms. Who set them up? What concerns were they trying to address? How well do the mechanisms work? What are their weaknesses?

2. One can interpret institutional history as an evolutionary struggle to establish and evade accountability mechanisms. Organizations respond to corruption by trying to adopt more robust accountability mechanisms. Individuals try to increase their autonomy by finding ways around those mechanisms.

3. The 2008 financial crisis exposed a weak link in the accountability system in an unexpected place: the credit reporting organizations, like Moody’s and Standard and Poor’s. The buyers of mortgage securities were looking for AAA ratings for regulatory purpose only, not because they truly wanted to be certain that the securities were highest quality. The regulators treated the AAA-rated securities very leniently in terms of bank capital requirements, thinking that the credit reporting organizations were more accountable than was actually the case.

4. It seems to me that our society is collapsing because accountability mechanisms are falling apart.

Professors don’t give students bad grades, and students wish to abolish grading entirely. When they graduate, they long to work in the non-profit sector, where for the most part you are accountable for intentions and not results.

The professors themselves are not accountable for doing rigorous work. They just have to worship the diversity religion.

We are losing the small-business sector, which is most accountable to customers. We are replacing it with large corporations that are accountable to government for bailouts and to the social justice mob for approval.