The political roots of debt and inflation

Each week, Symposium Magazine invites an author to guest-blog. This week’s featured piece is Why Central Bank Transparency May Be Overrated by Brigitte Granville.

After reading the heated blogosphere discussions of Alan Greenspan’s new book, The Map and the Territory, I am now catching up with the book itself. My long-standing interest in monetary policy and inflation led me straight to the section where Greenspan cautions that the Fed’s present and “unprecedented” attempts to push inflation higher could result in double-digit inflation rates. Inflation seems such a distant threat for now, compared to sluggish growth and high unemployment, that it is important to recall how the present economic situation carries the seeds of a future inflation shock.

In a nutshell, the period since the 2008 crash represents the turning point in a long-term debt cycle. In the upswing of such cycles, debt and spending rise faster than income and productivity. This process becomes self-reinforcing because rising spending generates rising incomes and net worth across different parts of the economy, which in turn relaxes collateral constraints, allowing more borrowing and greater consumption. However, since debts cannot rise faster than money and income forever, there are limits to debt growth, and the long-term process ends in dramatic reversals. Before the present-day experience of deleveraging, the most infamous such episode was, of course, the Great Depression of the 1930s.

One explanation for both the extremities of debt cycles is political expediency. On the upswing, credit creation-driven growth models are tempting for governments and easy to implement. They enable equality of consumption among the different parts of the economy and therefore mask income inequality. A good example is the government-driven expansion of mortgage lending in the US in the 1990s and 2000s – as many commentators have pointed out, notably Raghuram Rajan in his excellent 2010 book Fault Lines. Debt-fueled growth also enables a country’s growth performance not to be constrained by productivity potential.

However, the price to pay for unsustainable growth models is volatile deleveraging episodes. And when such downswings come, private sector debt burdens quickly shift to the public sector balance sheet, at which point the choice becomes one between fiscal consolidation (a.k.a. “austerity”) and defaults, or eroding public debt by inflation and financial repression (that is, keeping interest rates below the rate of inflation). In almost all cases, the latter choice of inflation is the path of least political resistance.

The present Fed plan is to stimulate the growth rate back to escape velocity, which would in turn bring about an automatic improvement in the public finances without risk of inflationary deleveraging. My next post will explain one of the reasons why this is much more easily said than done.


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