Default or High Inflation?
By David Henderson
I was on a discussion on Facebook yesterday with an economist about default and high inflation.
This economist and I agree that the U.S. federal government has an enormous deficit and debt problem in its future. What we disagreed about is whether there’s much difference between the feds defaulting on their debt or creating high inflation. He saw not much difference. I see a lot.
That motivated me to go back to an article that San Jose State University economist Jeff Hummel and I had published in Independent Review back in 2014 that, for some reason, I don’t seem to have posted about here. It’s titled “The Inevitability of a
U.S. Government Default.” In it, we argue that the feds are likely to default, that money creation as an alternative is not likely to get them out of their fiscal fix, and that default is actually better economically than massively high inflation.
I recommend that you read the whole article if you want both to comment and to maximize the probability that I will pay attention to your comment.
The problem is this. Three components of the federal government budget–Social Security, Medicare, and Medicaid–are highly likely to take an increasing share of gross domestic product (GDP). Overall federal government spending, including interest on the debt, could exceed 40 percent of GDP by 2050. For more than sixty years, overall federal revenues as a percentage of GDP have almost always been within a narrow range. They have never gone over 21 percent of GDP and have almost never gone below 17 percent. Even during the crisis years of World War II, they never exceeded 22 percent of GDP (White House 2013).1 The result, if the government does not change policy, will be annual deficits of approximately 20 percent of GDP. This is unsustainable.
The question then becomes: What will change? This is difficult to predict. But we give the following predictions in decreasing order of certainty.
First, federal government revenues are unlikely to be more than 22 percent of GDP for more than a few years.
Second, well before spending reaches 30 percent of GDP, the federal gov- ernment will face a renewed, more serious fiscal crisis.
Third, likely cuts in the growth of Medicare and Medicaid spending would at best delay, but not prevent, this crisis.
Fourth, the probability is therefore fairly high that the federal government will be forced to default on some or all of its debt.
Fifth, outright default on the federal debt will occur despite any increasing inflation.
Why Seigniorage Won’t Do It
Assuming that revenues from explicit taxes remain capped at 20 percent of GDP, whether for structural or political reasons, and that politicians will have little incentive to cut spending, seigniorage would have to come up with the difference. Given that 10 percent inflation during the 1970s generated revenue amounting to 0.5 percent of GDP in the United States, a straight-line extrapolation suggests that covering the growing fiscal shortfall would require more than a tripling of the price level year after year after year. Within three years, the dollar would be worth only about 2.5 percent of its value just three years earlier. Such continual triple-digit inflation would be unprecedented, the highest the United States has ever experienced outside of its two hyperinflations. Moreover, seigniorage itself faces its own Laffer Curve (known as the Bailey Curve, after economist Martin Bailey). In order to avoid higher taxes on their real-cash balances, people spend money faster as inflation rises, thereby exacerbating the price increases. Higher rates of inflation thus generate proportionally ever-smaller revenue increases. Once we also acknowl- edge that the CBO’s projections are probably too optimistic, we can see why our estimate that financing the explosion in Social Security, Medicare, and Medicaid payments will necessitate a 246 percent annual inflation is probably too low. How likely is it that governments in any developed country will be willing or even able to unleash such appalling currency depreciation? Recall how politically unpalatable the mere double-digit inflation of the 1970s was. The bottom line is that inflation’s implicit tax on real-cash balances will not be much more able to resolve the escalating budgetary problems of the U.S. government than would an excise tax on chewing gum.
To be clear, we are not denying that a Treasury default might be accompanied by some inflation. Inflationary expectations, along with the fact that part of the monetary base is now de facto government debt, can link the fates of government debt and government money. This is all the more reason for the United States to try to break the link between U.S. currency and debt. We still may end up with the worst of both worlds: outright Treasury default coupled with serious inflation. We are simply denying that such inflation will forestall default.