Inflation Won't Cure Our Debt Woes

My colleague James Fallows is dismissive, not to say derisive, of Standard and Poor's report on the US debt outlook yesterday.

1) To repeat Clive Crook's point, S&P knows nothing more about U.S. budget prospects than you or I do. They're saying they have an opinion on the state of Congressional-White house dealings on the budget. Fine. Go on a talk show or start a blog.

2) To repeat James Galbraith's different but also true point, as long as the U.S. government doesn't tie itself up in debt-ceiling insanity, it is not going to default on dollar-based bonds. It can't. It controls the "means of production" for the dollars to pay off those bonds. If you're worried about inflation, fine. But that's a different matter, with a lot of other variables that count for more than S&P's feelings.

Of course Standard and Poor's does not have access to special, secret information about the US debt situation than we do; that sort of thing is, thankfully, public knowledge.  And given the performance of the ratings agencies on mortgage-backed securities, I think we are justified in being skeptical that this represents some revolutionary new piece of information.


S&P is certainly entitled to their opinion--for all their failings, they do spend a great deal of time analyzing government finances, much more than James or I do.  You make think that their opinion is crap, in which case you should say so--but I cannot understand why we'd quibble with the format in which that opinion is issued.  S&P has been issuing these sorts of things for a long time, and I don't think it would make much difference if they started doing so in blog form.

Moreover, their opinion does actually matter, since previous rounds of financial regulation have embedded financial agency ratings deep in the structure of our financial markets.  Institutions like insurance companies have strict regulations about the quality of the assets they can buy, and S&P ratings, among other things, are the proxy that we use to judge credit quality.  If James or I scream that the US debt picture is unsustainable, we will not move markets.  If S&P downgrades US debt, this will trigger a sell-off, even if the people selling disagree with their assessment.  Nor is there any easy way around this; the nature of regulation is to require hard metrics and bright lines, even if those metrics aren't very good.

And I cannot disagree too strongly with the notion that the US can't default because we can always print money.  It isn't even technically true--Zimbabwe eventually ran out of hard currency to buy the ink it needed to print the money to sustain its hyperinflation.

To be clear, I do not think that  a classical default*, with or without hyperinflation, is very likely.  But that is not the same thing as saying that it is impossible.  Moreover, the dismissive way that Galbraith treats this problem looks only at the stock of debt, not the flow of funds.  Inflation is only a good way to get out of your debts if you aren't planning to borrow any more money.  Otherwise, investors simply recover their losses--and then some--by requiring higher interest rates on all your new borrowing.  "All your new borrowing" eventually includes all of the money you borrowed before, because unless you're running a surplus, you're going to have to roll over every penny of that old debt into new loans as it matures.

Inflation was a good way to ease the burden of our World War II borrowing--once the war was over.  But it is not a good way to ease the burden of an increasingly expensive entitlement program that shows no signs of winding down.  Especially since these days, the debt markets are much more efficient than they were in 1948; information about the money supply is transmitted very quickly to potential buyers of our bonds.  You can pull all sorts of tricks to force bondholders to eat some losses on the money they lent you--but you can't pull them over and over.  America was able to wriggle its way out of a substantial portion of its WWII debts in large part because it was otherwise pretty fiscally sound.

Debt held by the public is in the range of $9 trillion, or about 64% of GDP.  The average maturity of our public debt holdings is under 5 years, meaning that roughly half of our debt will have to be rolled over within that time frame.  You can see how short-lived our ability to inflate away our debt would be--and how quickly the budget could be severely compromised by higher interest costs, even if we are using our "means of production" to the hilt.

But what I find most disturbing about Galbraith's formulation is that it seems to imply that inflation is somehow a less worrying solution to the problem of debt than default is.  But inflation merely redistributes the pain; it doesn't really eliminate it.  You can argue that a small amount of inflation is preferable to the alternatives, distributing the pain very broadly in order to avoid the intense dislocations of a sudden shock.  I might even agree with someone who argued this. But small amounts of inflation are not going to rid us of $10 trillion in debt.  And the pain of large amounts of inflation is extremely painful--arguably, more so, not less so, than technical default.

Indeed, in large amounts, inflation is just default by another name.  And it retains many of the problems of default.  Either way, we'll be forced to suddenly slam on the brakes of our deficit finance--either because no one will lend to us, or because the higher interest rates they demand will make such borrowing impractical.  (Just look at Ireland).  Either way, the economy will suffer from sudden dislocations as the government scrambles to balance its budget.  Either way, investors--many of whom are pension funds and insurance companies, not Scrooge McDuck--will lose money, slamming vulnerable people on fixed incomes.

So I do worry very much about default--de facto or de jure.  I worry about the pain that will follow.  And no, I didn't need S&P to tell me that it's a problem.  But I'm still happy that they're speaking up.  I wish more people would.

* Refusal to pay, or forcible restructuring of debt along lines less favorable to creditors.