How to Save the Euro? Lessons from the US

by Jacques Melitz © VoxEU.org

Earlier this year, the fiscal situation in Greece caused turmoil across Europe. This column examines why the financial difficulties of several state governments in the US are not having similar impacts on its economy.

The problems of the Eurozone this year brought to light some failures of the system. Nevertheless, the resulting drop in confidence in the system has gone further than we might have expected. Questions have even arisen about the survival of the system (see Baldwin 2010 and Blejer and Levy-Yeyati 2010 for discussions). Yet monetary systems do not tend to dissolve simply because of faulty performance. On the contrary, as a rule they endure even when they function very badly. It takes a political force majeure to bring about the break-up of a single currency area, typically without connection to monetary performance. Why, then, has the possible default of a country engaged in irresponsible fiscal policy and accounting for only 3% of the Eurozone’s GDP raised questions about ‘saving the euro’ and the survival of the Eurozone?

The issue has not received the attention it deserves. It is often simply taken for granted that the departures from the Stability and Growth Pact provide a sufficient reason for the earthquake that has shaken the whole currency area. Yet if we look around the world past and present, the mismanagement of finances by regional governments has no particular tendency to bring down entire monetary systems, far from it. In line with the usual – I think superficial – diagnosis of the ailment, proposed remedies for the Eurozone centre on strengthening the Pact, increasing joint political control over fiscal policy, and providing joint insurance against government default, or some mixture of the three. But what if a vital element of the problem is really the official doctrine that sovereign default is incompatible with the euro? What if the scale of the crisis that took place this year has resulted from financial markets’ conviction, based on this doctrine, that the future of the euro was at stake? What if assuring the long-run sustainability of the euro means convincing those markets, quite differently, that nothing as manageable as a Greek default can upset the Eurozone?

Lessons from the US

That is precisely what the US example would suggest and what I will defend. With this idea governing beliefs, the right road ahead looks quite different. It means shifting the emphasis away from avoiding government defaults toward assuring the stability and the solvency of the banking system at all times, regardless of the financial difficulties of some member governments.

In the US, default on state and municipal contractual obligations is very much a possibility whenever lower-level governments are in financial trouble; bailout cannot be taken for granted. New York City defaulted in 1975, the biggest default of all by a lower-level government unit since World War II took place in 1983 when the Washington Public Power Supply System went into bankruptcy, and Orange County defaulted in 1995. Various municipal governments have been on the verge of default at times in the last few decades, including Philadelphia and Cleveland. There is also no Stability and Growth Pact in the US. Yet financial discipline is considerably higher in the US at the state government level than in the Eurozone at the national level. All states except Vermont have balanced-budget rules; but these rules are self-imposed. It is easy to argue that this difference in fiscal discipline on the two sides of the Atlantic is related to the fact that when push comes to shove in the US and a lower-level government unit cannot or will not meet its debt obligations, the lenders can expect to take a big part of the hit.

Some rudimentary analysis is relevant. Consider any government unit unable to print money and without any prospect of a bailout. Theory tells us that credit rationing is very much a possibility. As the interest rate that such a government offers on its debt goes up, extra lending dries up completely at some point as the expected rate of return on the government debt falls. This must happen because higher nominal interest rates impair the government’s solvability and bring default nearer. Risk aversion simply lowers the interest rate at which credit rationing begins.

Suppose we compare the situation in the US and the Eurozone since the 2007-2009 financial crisis in this light. The crisis brought about dire financing problems for many lower-level government units in the US and some national governments in the Eurozone. According to the spreads on credit default swaps, California and Illinois now have a higher probability of non-performance on public debt than Portugal and Spain. This has been true for months. Consider next the difference in response in the States and Europe. Recently Illinois simply stopped paying $5 billion of bills. In June of last year California issued vouchers for wage payments. In addition, savage cuts in public services have begun and are now threatened in various states in difficulty, not only these two. Nevada has made startling reductions in spending on higher education and welfare. In the case of Portugal and Spain, nothing so drastic has happened thus far. There have been occasional spikes in interest rate spreads over German bunds of 100 to 200 percentage-points above usual levels. Both Spanish and Portuguese governments have also been forced to plan greater austerity and reduced government deficit spending. Meanwhile, they have been able and willing to keep borrowing.

Why the difference between the Eurozone and the US?

Part of the explanation may be that Portugal and Spain are more able to raise tax revenues than US states. But another part is the higher probability of a bailout in Europe. The example of Greece is to the point. Greece has been able to continue borrowing this year at interest rates typically around 200 percentage-points above Portugal and Spain on 10-year government bonds (and since May more than 500 percentage-points higher than German bunds). If you do the math, it is clear that this could never have happened without a high probability of a bailout. In fact, you do not need to do the math: there have been occasions in February/March and particularly May when some Greek issues would clearly have failed without the assurance of public lending and ECB support. If Greece can borrow on the probability of a bailout, so could Portugal and Spain.

Based on this evidence, the current Eurozone strategy of treating government default as anathema permits member governments to sink into deeper waters, weakens the forces that would otherwise exist toward self-imposed budget restraints, and thereby raises the probability of a bailout. But an actual bailout is perhaps the most likely setting for the breakdown of the Eurozone. If taxes ever need to rise all over the Eurozone in order to bail out a member government, one can easily imagine a pullout by Germany, followed by the Netherlands and Austria (if no others), in order to form a separate monetary union.[1]

What are the dangers of the opposite strategy of mimicking the US instead and moving toward heavier reliance on markets to discipline member governments and to price sovereign risk? The answer lies in the external effects of government default on the payment system and the banks, and this problem would be aggravated by contagion. But those dangers exist in the US as well. If the US federal government were to allow Illinois or California to default on state government debt in today’s circumstances of widespread financial difficulties across the states, there is a serious threat that interest premia would go up on the debt of most state governments and a wave of state defaults would follow. For this reason, the federal government might well step in. But if we look at the institutional manner in which the US deals with the problem, we find the answer to lie in country-wide prudential rules for banks and central bank powers of lender of last resort. There is no general announcement that state government default is incompatible with the dollar. Instead there is a strict separation of the issue of joint support of the financial system and joint support of financing by the sub-government units in the country. Would Europe not be wise to adopt the same strategy and to cease to conflate the two issues?

Tweaking the Pact

What this would mean, of course, is adopting Eurozone-wide prudential rules on banks, providing the ECB full powers of lender of last resort, and, very significantly, dismissing the idea that the Stability and Growth Pact is the pillar on which the whole Eurozone project stands. This idea is highly perilous.[2] Markets believe it, and at times of financial precariousness, what markets believe is extremely important. According to my proposal, the Pact could still be upheld as a code of good behaviour which improves public finances in Europe and facilitates the task of the ECB. But the basic philosophy would be that if any individual member government in the Eurozone engages in irresponsible fiscal conduct, contrary to the Pact, the creditors and its taxpayers would bear the brunt of the consequences. Everything would be done to assure the stability of the financial sector in the Eurozone and the lack of repercussions on the risk premiums that the more financially responsible member governments need to pay. Banks might be bailed out but not governments. Any aid to member governments, if it came, would not concern the euro system but the IMF or if any aid did come from the EU it would be part of a programme that could as well have existed had the euro never appeared and would be clearly sealed off.

VoxEU Editors' note: This article will appear as a roundtable discussion in Miroslav Beblavy, David Cobham and Ludovit Odor, eds., The euro area and the financial crisis, Cambridge University Press, forthcoming.

References:

Baldwin, R (2010), A re-cap of Vox columns on the Eurozone crisis” VoxEU.org, 13 May.

Blejer, M and Levy-Yeyati, E (2010), Leaving the euro: What’s in the box, VoxEU.org, 21 July.

Economist (2010), Can pay, won’t pay, June 19.

Poterba, J (1996), Do budget rules work? NBER Working Paper 5550, April.

Public Bonds (2010), Municipal bonds and defaults, downloaded 23 August.

Reinhart, C M and Rogoff, K (2009), This time is different: eight centuries of financial folly, Princeton: Princeton University Press.

Sinn, H-W (2010), Rescuing Europe, CESifo Forum, special issue, August.

Notes:

[1] Many would say that Greece has already been bailed out. But so far no holder of Greek debt has yet suffered a credit event. Further, no one outside of Greece has yet paid any taxes to fulfil a claim on Greek debt. Thus, according to my usage, no bailout has happened. However, none of the argument hinges on this choice of words.

[2] If we really think that a government default would bring the euro under, we must conclude that the euro has no long-run future ahead – that it is doomed. A reading of Reinhart and Rogoff (2009) should convince anyone.

Republished with permission of VoxEU.org

Is Austerity Worse than Default?

The following comments under the pseudonym, “Capitalistic,” appeared in The Atlantic in response to an article entitled, Is Austerity Worse than Default? (2011):

1. Default is better than austerity. Governments don't function like businesses.
2. Governments can default because they do not like the terms of their loans.
3. Austerity favors debt holders, not governments.
4. When a country's economy contracts, austerity is the worst thing a government can implement. It leads to stagnation.
5. A country can default, wipe out their debt, and raise new capital with higher interest rates.
6. There's no proof that austerity works.

The commentary above is succinct and instructive for those still considering the implications of austerity for a society. We the people should be quite careful what we wish for...

Source: Indiviglio, D (2011, June 21), Is Austerity Worse than Default? Atlantic.

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What About the Default Option…?

The US has but three methods for restoring economic growth: austerity measures (as in spending cuts and tax increases), monetary expansion (as in “printing money”), or default (as in not paying back on the various bills, notes, and bonds issued by the US Treasury). The national debate regarding the merits of both austerity measures and monetary expansion is well underway in the public domain. However, the default option has still to be fully considered as an alternative to austerity or monetary expansion.

To start the discussion, consider the following advantages of defaulting on the national debt:

1. The people would enjoy a $13 trillion dollar windfall from principal reduction in the national debt that would never be paid back.
2. The people would enjoy a windfall from the $400 billion dollars a year in interest payments that would no longer be required.
3. The “banksters” would have to abandon their looting operations in Washington, DC and return to regional and local limited purpose banking in order to compete for new investments in small businesses and Main Street.
4. The government would lose its ability to borrow in the future due to zero creditworthiness and would therefore have to end deficit spending and henceforth, balance the budget.
5. Mega-banks would likely split up and reorganize into regional and local service operations in order to redirect their marketing and lending activities toward small businesses on Main Street.
6. The government would have to lay off most of the Federal workforce due to lack of money – these workers would become available to join Main Street investment activities lead by small businesses.
7. The trade deficit would be solved because foreign manufacturers would cease exporting to the US as the world would no longer accept US treasury paper as payment for goods and services. 
8. The Federal Reserve would be bankrupted and closed permanently.
9. Washington politicians would have to redirect their concerns away form Federal issues and toward regional, state, and local politics in order to stay current and involved in the reemergence of small businesses and Main Street politics.
10. Small business on Main Street would be back in business as the centerpiece of American enterprise, employment growth, capital formation, and production of goods and services.

A default on the national debt by the US is an option separate from monetary expansion and austerity measures. I encourage the public to at least consider the default option more fully as part of its discourse on methods and possible courses of action for economic recovery.

Comments welcome below...

Geithner on Default

What follows is Congressional testimony by Treasury Sec Tim Geithner regarding his views on Federal default:

Default by the United States would precipitate a crisis worse than the one we just went through. I think it would make the crisis we went through look modest in comparison. It would force us of course to cut critical payments to our seniors and it would be a reckless, irresponsible act to this country. I find it inconceivable that the Congress would not act to increase the limit.

It would be catastrophic. I mean, if you call into question the willingness of the government of the United States to meet its obligations, you will shake the basic foundation of the entire global financial system. It is inconceivable that America would do that. And of course I am totally confident that Congress will act to avoid that.

It will raise dramatically the borrowing costs permanently for all Americans. Every business for a very long period time would face a much higher cost of borrowing. Every family would face a much higher cost of borrowing. Unemployment would rise dramatically. Thousands if not hundreds of thousands of businesses would fail. And of course you would shake the confidence of the world in U.S. financial assets and Treasuries. It would be a deeply irresponsible act, again inconceivable.

Clearly, Tim Geithner is not in favor of a national default -- that leaves austerity measures (as in spending cuts and tax increases) and monetary expansion (as in inflation) as the only remaining courses of action for fiscal policy-makers. The future of Federalism hangs in the balance...

Source: Geithner: Raise Debt Ceiling or Risk Another Financial Crisis (2011, April 5), Martinsville Media.

PS: I suppose the US could instead "eat" its way out of this economic crisis by building new businesses that can compete in the global marketplace, but that's just a suggestion...

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Greece Through the Rear-View Mirror

by Domingo Cavallo and Miranda Xafa © VoxEU.org

Thursday's EU summit in Brussels announced new plans for tackling the Eurozone crisis. This column says that restructuring of Greece's debt will reduce Greece's access to external financing without reducing its debt burden to sustainable levels. It suggests additional financial support contingent on larger haircuts.

European officials have struggled for weeks to reconcile the competing priorities of Germany and other surplus countries with those of Greece. Until Thursday's summit, the EU treated the debt crisis as a liquidity problem rather than a solvency problem. This contributed to the market turbulence and allowed the crisis to spread to Italy. This undermined confidence and threatened the stability of the euro itself.

Recognising that “re-profiling” of the debt by pushing maturities into the future is no longer sufficient, EU leaders reached an agreement that tries to address medium-term debt sustainability concerns while keeping the resulting losses for banks manageable.

The Deal is Probably Not Enough

The deal implies a 21% reduction in the net present value of debt owed to bondholders, which constitutes about 70% of Greece’s total public debt. This implies a reduction of 15% in total public debt, which would bring it down from 156% to 132% of GDP. With most analysts estimating the needed debt reduction closer to 50%, this deal is unlikely to ensure debt sustainability even if Greece fully implements the medium-term fiscal plan it has just voted into law.

Since it is impossible to have a fully voluntary scheme that shifts part of the financing burden to bondholders while keeping Greece’s funding costs at sustainable levels, Greece will almost certainly get a “selective default” rating. Such a rating would complicate Greece’s access to ECB financing without ensuring that Greece will emerge from default with a sustainable debt burden.

Analogies with Argentina

The situation confronting Greece today is similar to Argentina’s situation in the summer of 2001. The economy was in recession and credit spreads had widened as market participants realised that fiscal tightening was becoming less palatable economically and politically.

At the request of the Argentine government, which still wanted to avoid what would have been considered a selective default by the rating agencies, the IMF proceeded with a substantial augmentation of the financial support already committed under the existing three-year stand-by agreement. Argentina thus missed the opportunity to restructure its debt while it still had ample reserves and bank deposits remained near peak levels.

With the benefit of hindsight, the financial resources of the international community used to bail out private creditors should instead have been used to deal with the consequences of an orderly debt restructuring, including the provision of ample liquidity and capital to the banking system.

Greek Choices

Greece is facing the same choices now. With Greece’s dim prospects for market re-access in 2012-13, the EU/IMF-supported programme has been augmented with new EU resources, with more to come from the IMF, to make up for the shortfall in private financing.

But this additional financial support is likely to be wasted on what is a lost cause. The sustainability of public finances remains in doubt, as evidenced by the still-wide credit spreads (wider than in Argentina a month before it defaulted) and the large withdrawals of bank deposits, which continue even after the approval of the medium-term fiscal plan by parliament in early July. In view of the above, IMF participation in the financing of a new programme for Greece should be conditioned on a debt restructuring involving a significant haircut.

A Lasting Solution: Debt Buyback at Market Prices

A lasting solution to the Eurozone’s debt crisis would call for the European Financial Stability Facility (EFSF) to issue AAA-rated bonds in exchange for the outstanding bonds of the countries that need to restructure their debt, taking as collateral their assets under privatisation. Greece, Ireland, and Portugal could capture the discount on the debt that the markets have already reflected. The mechanism would be a massive repurchase of the old bonds at the current market price. The cost for European taxpayers will be much lower than that associated with continuation of the ongoing bailout. The most costly scenario is that of a disorderly Greek default that would have spillover effects on other countries, very similar to the contagion generated by the collapse of Lehman Brothers in the US.

The EU and the IMF should help Greece ensure that the debt restructuring will not destabilise the banking system and will not force conversion of financial assets and obligations into a new Greek currency. Otherwise a run on the banks with large holdings of Greek debt will force “de-euroisation” in Greece in the same traumatic way that it forced “de-dollarisation” in Argentina in 2002.

The latest IMF staff report on Greece shows that public and external debt sustainability “hinges critically on full and timely implementation of fiscal, privatisation, and structural reforms... and the restoration of market access at reasonable terms in the post-programme period.” In cases where restoration of market access within the programme period is judged to be unrealistic, IMF rules encourage “comprehensive debt restructuring, to provide for an adequately financed programme and a viable medium-term payments profile.” It’s an idea whose time has come.

Republished with Permission of VoxEU.org

America's Fiscal and Monetary Policy Options

Let's consider America's fiscal and monetary policy options at this point:

• Austerity in the form of government spending cuts [ruled out by most Democrats]
• Austerity in the form of tax increases [ruled out by most Republicans]
• Default in the form of debt renunciation [ruled out as unconstitutional]
• Default in the form of monetary expansion leading to inflation

Looks like the US is running out of policy options...

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Repairing Sovereign Indebtedness: Get Ready...

Sovereign indebtedness in democratic states can only really be resolved via three methods (or some combination thereof):

1. The default route (cancellation of debts)
2. The austerity route (drastic spending cuts and tax increases)
3. The inflation route (“printing” money)

The Course Forward

Given that governments will not risk losing their sovereign borrowing power, the default option becomes unlikely. Moreover, given that voters will never consent to significant cuts in public programs or dramatic increases in taxes, the austerity route becomes equally unlikely. This leaves the inflation route (or “printing” money) as the most likely course forward for democratic states. Note that an important side-effect and key attraction of the inflation route for sovereign governments is to reduce the size and scale of public debt and entitlements through the inflation mechanism itself.

Best Advice

My best advice for workers is to get ready for inflation. Once the government embarks on the inflation route, unemployment will increase and remain high for the duration. Also, cost-of-living increases in pay and benefits will lag the inflation rate significantly. Even a 6-9% inflation rate over 7-10 years could mean at least a 40% reduction in real wages (and fixed pensions). Convert all existing debts (and especially mortgages) to fixed rate notes now, and eliminate all variable rate debt from your life, including credit cards. The greatest challenge for workers during periods of inflation is the risk of unexpected unemployment as firms and governments alike reduce real spending and investment under inflationary pressures. Again, get ready...

Related Posts:

How High Can Inflation Go...?

Using Inflation to Erode the US Public Debt

Implications of the Financial Crisis

Spending Less versus Taxing More

Note that the debate about "spending less" versus "taxing more" is really an argument about how to implement "austerity" -- that this debate has ended in an impasse (in the US, Europe, and even California) highlights why austerity fails, which is the chronic lack of a public mandate -- austerity proposals are failing in the US and all over the world, which leaves only two other macroeconomic ways forward: default or monetary expansion -- we will see whether the US falls into default or monetary expansion in the coming months...

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Populist Majority versus True Majority in America

According to Treasury Sec Timothy Geithner, the US would have to implement drastic fiscal cuts should Congress precipitate a Federal default by not increasing the US debt ceiling by July 8, 2011. In Geithner's words:

If Congress failed to increase the debt limit, a broad range of government payments would have to be stopped, limited or delayed, including military salaries and retirement benefits, Social Security and Medicare payments, interest on the debt, unemployment benefits and tax refunds.

Of course, most Americans receive not a penny from any of these government spending programs, which means only a minority of Americans would suffer directly from the cuts Sec Geithner says would be necessary.

Here is my question: Is the populist majority in America, which enjoys the lion's share of government entitlements, heading for a political collision with a true majority of the nation's voters who could care less about government entitlements at this point?

Source: Indiviglio, D (2011, April 22), Will the US Really Default in May if the Debt Ceiling Isn't Raised? Atlantic.

Responding to Fiscal Crisis in America

The Congressional Budget Office (CBO) recently published a report in which available responses to the fiscal crisis in America are detailed. Specifically,

If a fiscal crisis occurred in the United States, policy options for responding to it would be limited and unattractive. In particular, the government would need to undertake some combination of three actions: restructuring its debt (that is, seeking to modify the contractual terms of existing obligations); pursuing inflationary monetary policy (that is, increasing the supply of money); and adopting an austerity program of spending cuts and tax increases.

The essence of the CBO's proffered solutions to a fiscal crisis can be summarized as default, monetary expansion, or austerity. In the end, each of these options eventually leads to inflation, albeit with varying degrees of deflation either in advance or along the way. In other words, a period of inflation in America is imminent. I continue to advise the public to get ready...

Source: Federal Debt and the Risk of a Fiscal Crisis (2010, July 27), Congressional Budget Office.

Related Posts:

Deflation or Inflation...?

Using Inflation to Reduce Public Debt and Rout Entitlements

How High Can Inflation Go...?

Repairing Sovereign Indebtedness: Get Ready

Using Inflation to Erode the US Public Debt

Implications of the Financial Crisis

Using Inflation to Erode the US Public Debt

by Joshua Aizenman and Nancy Marion © VoxEU.org

As the US debt-to-GDP ratio rises towards 100%, policymakers will be tempted to inflate away the debt. This column examines that option and suggests that it is not far-fetched. US inflation of 6% for four years would reduce the debt-to-GDP ratio by 20%, a scenario similar to what happened following WWII.

Since the start of 2007, the financial crisis has triggered $1.62 trillion of write-downs and credit losses at US financial institutions, sending the American economy into its deepest recession since the Great Depression and the global economy into its first recession since World War II. The US Federal Reserve has responded aggressively. Fiscal policy has become expansionary as well. The US is now facing large deficits and growing public debt. If economic recovery is slow to take hold, large deficits and growing debt are likely to persist for a number of years. Not surprisingly, concerns about government deficits and public debt now dominate the policy debate (Cavallo & Cottani 2009).

Many observers worry that the debt-to-GDP ratios projected over the next ten years are unsustainable. Assuming deficits can be reined in, how might the debt/GDP ratio be reduced? There are four basic mechanisms:

1. GDP can grow rapidly enough to reduce the ratio. This scenario requires a robust economic recovery from the financial crisis.

2. Inflation can rise, eroding the real value of the debt held by creditors and the effective debt ratio. With foreign creditors holding a significant share of the dollar-denominated US federal debt, they will share the burden of any higher US inflation along with domestic creditors.

3. The government can use tax revenue to redeem some of the debt.

4. The government can default on some of its debt obligations.

Over its history, the US has relied on each of these mechanisms to reduce its debt/GDP ratio. In a recent paper (Aizenman & Marion 2009), we examine the role of inflation in reducing the Federal government’s debt burden. We conclude that an inflation of 6% over four years could reduce the debt/GDP ratio by a significant 20%.

The facts

Figure 1 depicts trends in gross federal debt and federal debt held by the public, including the Federal Reserve, from 1939 to the present. In 1946, gross federal debt held by the public was 108.6%. Over the next 30 years, debt as a percentage of GDP decreased almost every year, due primarily to an expanding economy as well as inflation. By 1975, gross federal debt held by the public had fallen to 25.3%.

Figure 1. Debt as a share of GDP

The immediate post-World War II period is especially revealing. Figure 2 shows that between 1946 and 1955, the debt/GDP ratio was cut almost in half. The average maturity of the debt in 1946 was 9 years, and the average inflation rate over this period was 4.2%. Hence, inflation reduced the 1946 debt/GDP ratio by almost 40% within a decade.


Figure 2. US debt reduction, 1946-1955

In recent years, the debt/GDP ratio has increased dramatically, exacerbated by the financial crisis. In 2009, it reached a level not seen since 1955. Figure 3 shows three 10-year projections, indicating debt held by the public could be 70-100% of GDP in ten years.


Figure 3. America’s projected debt burden

A government that has lots of nominal debt denominated in its own currency has an incentive to try to inflate it away to decrease the debt burden. If foreign creditors hold a significant share of the debt, the temptation to use inflation is greater, since they will bear some of the inflation tax. Shorter average debt maturities and inflation-indexed debt limit the government’s ability to reduce its debt burden through inflation.

Figure 4 shows the share of US public debt held by foreign creditors. The foreign share was essentially zero up until the early 1960s. It has risen dramatically in recent years, particularly since the 1997-98 Asian financial crisis, and was 48.2% of publicly held debt in 2008. Thus foreign creditors would bear about half of any inflation tax should inflation be used to reduce the debt burden, with China and Japan hit hardest.


Figure 4. Foreign share of publicly held debt

Figure 5 illustrates the average maturity length for US marketable interest-bearing public debt held by private investors, along with the debt held by the public as a share of GDP. As noted by a number of authors, the US exhibits a positive relation between maturities and debt/GDP ratios in the post-World War II period. Most developed countries show little correlation between maturities and debt/GDP ratios. The US appears to be an exception. Maturity length on US public debt in the post-World War II era went from a 9.4 years in 1947 to a low of 2.6 years in 1976. In June, 2009, the average maturity was 3.9 years. Most of this debt is nominal. (1)


Figure 5. Average maturity length and share of debt held by the public

Inflating away some of the debt burden

Figure 6 illustrates the percentage decline in the debt/GDP ratio under various inflation scenarios.(2) Inflation yielded the most dramatic reduction in the debt/GDP ratio – and the real value of the debt – in the immediate post-World War II period. A 5% inflation increase starting in 1946, for example, would have reduced the debt/GDP ratio from 108.6% to 59.3%, a decline in the debt ratio of 45%. Not only was there a large debt overhang when the war ended, but inflation was low (2.3%) and debt maturity was high. Thus there was room to let inflation rise – and it rose to 14.4% in 1947 before dropping considerably. Average inflation over the decade was 4.2%. Moreover, long maturities allowed inflation to erode the debt burden. Maturities were over 9 years in years 1945-48 and then fell gradually to 8.17 years in 1950.


Figure 6. Impact of inflation on publicly-held debt as a share of GDP

In contrast, inflation would have had little impact on reducing the debt burden in the mid-1970s. That period was characterised by a lower debt overhang, inflation was higher, and debt maturities were shorter (under 3 years). As a result, in 1975 a five-point increase in inflation would have reduced the debt/GDP ratio from 25.3% to 21.9%. The estimated impact of inflation on today’s debt/GDP ratio is larger than in the mid-1970s but not as large as in the mid-1940s. If inflation were 5% higher, the debt/GDP ratio would be about 20% lower, a debt ratio of 43.4% instead of 53.8%. Our computations of the impact of inflation on the debt overhang assume that all debt is denominated in domestic currency, none is indexed, and the maturity is invariant to inflation. Regression analysis confirms that US debt maturities over the period 1946-2008 are not responsive to inflation.

We develop a stylistic model that illustrates both the costs and benefits associated with inflating away some of the debt burden. The model, inspired by Barro (1979), shows that the foreign share of the nominal debt is an important determinant of the optimal inflation rate. So is the size of the debt/GDP ratio, the share of debt indexed to inflation, and the cost of collecting taxes. A lesson to take from the model and the simulations is that eroding the debt through inflation is not farfetched. The model predicts that inflation of 6% could reduce the debt/GDP ratio by 20% within four years. That inflation rate is only slightly higher than the average observed after World War II. Of course, inflation projections would be much higher than 6% if the share of publicly-held debt in the US were to approach the 100% range observed at the end of World War II.

Interpretation

The current period shares two features with the immediate post-World War II period. It starts with a large debt overhang and low inflation. Both factors increase the temptation to erode the debt burden through inflation. Even so, there are two important differences between the periods. Today, a much greater share of the public debt is held by foreign creditors – 48% instead of zero. This large foreign share increases the temptation to inflate away some of the debt. Another important difference is that today’s debt maturity is less than half what it was in 1946 –3.9 years instead of 9. Shorter maturities reduce the temptation to inflate. These two competing factors appear to offset each other, and the net result in a simple optimising model is a projected inflation rate slightly higher than that experienced after World War II, but for a shorter duration.

In the simulations, we raise a concern about the stability of some model parameters across periods, particularly the parameters that capture the cost of inflation. It may be that the cost of inflation is higher today because globalisation and the greater ease of foreign direct investment provide new options for producers to move activities away from countries with greater uncertainty. Inflation above some threshold could generate this uncertainty, reducing further the attractiveness of using inflation to erode the debt.

Moreover, history suggests that modest inflation may increase the risk of an unintended inflation acceleration to double-digit levels, as happened in 1947 and in 1979-1981. Such an outcome often results in an abrupt and costly adjustment down the road. Accelerating inflation had limited global implications at a time when the public debt was held domestically and the US was the undisputed global economic leader. In contrast, unintended acceleration of inflation to double-digit levels in the future may have unintended adverse effects, including growing tensions with global creditors and less reliance on the dollar. (3)

Footnotes

(1) Treasury inflation-protected securities, or TIPS, account for less than 10% of total debt issues.

(2) The calculation assumes that maturity is invariant to inflation. We test and overall confirm the validity of this assumption for U.S. data in the post-World War II period.

(3) For the threat to the dollar from the euro, see Chinn and Frankel (2008) and Frankel (2008).

References

Aizenman, Joshua and Nancy Marion (2009), "Using Inflation to Erode the US Public Debt,” NBER Working Paper 15562.

Barro, Robert (1979), “On the Determination of the Public Debt,” Journal of Political Economy, 87, 940–71.

Cavallo, Domingo and Joaquín Cottani (2009), “A Simpler Way to Solve the 'Dollar Problem' and Avoid a New Inflationary Cycle,” VoxEU.org, 12 May.

Chinn, Menzie and Jeffrey Frankel (2008), "Why the Euro Will Rival the Dollar,” International Finance, 11(1), 49-73.

Frankel, Jeffrey (2008), "The Euro Could Surpass the Dollar within Ten Years,” VoxEU.org, 18 March.

Republished with permission of VoxEU.org

The European Union is not the United States

German Chancellor Angela Merkel's recent agitations for global austerity measures should be kept in perspective by the deficit hawks in the US. For example, it is quite easy to imagine Germany turning its back on Greece in her hour of need. However, I doubt seriously that the US would be able to turn its back on California or New York should these states fall into default. The European Union is not the United States.

Germany (green) and Greece (orange)

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Roubini: Monetary Expansion Best Choice for Eurozone

Regarding the future of the Eurozone, Prof Nouriel Roubini urges monetary expansion as the best way forward:

Symmetrical reflation is the best option for restoring growth and competitiveness on the eurozone’s periphery while undertaking necessary austerity measures and structural reforms. This implies significant easing of monetary policy by the European Central Bank; provision of unlimited lender-of-last-resort support to illiquid but potentially solvent economies; a sharp depreciation of the euro, which would turn current-account deficits into surpluses; and fiscal stimulus in the core if the periphery is forced into austerity.

The monetary and fiscal challenges in Europe and the US can only be resolved through one or more of the following multiple avoidance options: (a) default; (b) austerity (e.g., spending cuts and/or tax increases); and (c) monetary expansion (i.e., "printing" money leading to inflation). Prof Roubini is for monetary expansion, which is likely to be the only remaining option once the people make clear that austerity is unacceptable, and governments make clear that defaults are out of the question.

Prof Nouriel Roubini (1959- )

In my opinion, monetary expansion is in the future, both for the US and the Eurozone. Follow the link below to learn more about Prof Roubini's views on the global economy.

Roubini Global Economics

Source: Roubini, N (2011, November 11), Down with the Eurozone, Project Syndicate.

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Economic Policies in Dystopia

I have previously written about the near-term monetary and fiscal policy options that were available to decision makers for responding to the then emerging economic crisis in Implications of the Financial Crisis as offered by Dr George Cooper (2008, “The Origin of Financial Crises,” Vintage). The policy options he offered at the time included the “free market route,” which entails allowing the credit contraction and underlying asset deflation to play out. His second option was for policy-makers to continue applying fiscal and monetary stimulus in an effort to trigger a new economic expansion that might have the power and momentum to negate the current credit contraction. Dr Cooper’s final option was for policy-makers to “unleash the inflation monster,” which means simply “printing money” in order to negate debt through either state-funded handouts or deliberate inflationary spending policies. Of course, none of these options is particularly attractive. My conclusion at the time was that the US had probably already set out on a course towards inflation.

Since last December, Western countries have implemented an unprecedented array of fiscal and monetary initiatives designed to expand the economy and mitigate the severity of the ongoing economic crisis. Almost all of these initiatives entail heavy spending and borrowing by governments. The scale of these actions suggests that Western nations have elected to embark on programs to stimulate the global economy in an effort to restore capital flows and financial stability. The good news is that there are at least some indications that the economic crisis has bottomed-out, but no one really knows at this point.

However, should the stimulus programs eventually fail to place the global economy on track to a robust recovery, then the looming question will become how Western governments might eventually pay for the spending spree they gleefully embarked upon. Prof Kenneth Rogoff (2009, The Confidence Game, Project Syndicate) suggests that governments may have few policy options remaining:

Within a few years, Western governments will have to sharply raise taxes, inflate, partially default, or some combination of all three.

If Prof Rogoff is correct in suggesting that Western governments may soon have to choose from these dreary options, then the economic future for society is arguably bleak. None of these policies would be popular or easy to implement. Nevertheless, there is a certain reality found in the multiple approach-avoidance content of these choices, and it may be time for policy-makers (and voters) to begin thinking about which option (or combination of options) they might prefer.