Inflation fears won’t drive US policy anytime soon

In the spirit of these polarized times, views about US public debt are sharply divided. According to one view, there’s simply no problem: The US government can borrow for next to nothing, and that’s not about to change so why worry? According to the other, public debt is out of control, and the consequences will be obvious as soon as interest rates come back off the floor: The day of reckoning is coming soon, and it will be brutal.

The implication of the first view, of course, is that fiscal policy should stay loose. Tightening now will slow the recovery—which is self-defeating from a budgetary point of view. (The debt burden, measured against the size of the economy, will only increase.) The other school says fiscal tightening has to start at once. If the policy deadlock in Washington carries the economy right over the fiscal cliff at the end of this year, it might actually be a good thing. Spending cuts and revenue increases, however stupidly designed, can’t come too soon.

The distance between these views looks vast but it’s small–smaller than either side wants to admit. In the short term the Treasury faces no debt-market pressure: That’s true. Public borrowing at a zero rate of interest is a bargain for taxpayers, especially if the money’s well spent on useful investments or given back to them in lower taxes. With private demand suppressed by post-crash deleveraging, heavy public borrowing is good.

But it’s also true that in the long term the debt will have to come down. Eventually, investors will demand higher interest rates, which will make servicing the debt more costly. US net public debt stands at 84% of GDP, up from 54% in 2008, and is rising fast. Add higher interest rates, and the public sector is on a path to insolvency.

The disagreement is really about timing, not economic fundamentals. The question is not what might happen, but when. With debt still climbing, how much longer can US interest rates stay so low?

It’s hard to say, because the relevant interest rate is not one that the Federal Reserve directly controls. The Fed has promised to keep short-term rates very low through mid-2015. But the Treasury doesn’t want to be forced to borrow at short maturities. Debt service depends on rates at longer maturities. If the Fed keeps short-term rates low (as it can) even when the markets start worrying about rising inflation, long-term interest rates would start rising whether the Fed wanted them to or not. So debt-service costs would go up too,  as maturing bonds were rolled over.

The Fed would soon have a hard choice. It could let inflation rise, which would contain the burden of debt by reducing its value in real terms. Or it could try to cap inflation with higher short-term rates—meaning slower growth, higher unemployment, a still-worsening debt outlook and a fast-approaching fiscal crunch. By then, higher inflation might be the lesser evil, but that’s something the Fed is pledged to prevent and no Fed chairman wants on his record.

So the question of timing hinges on the outlook for inflation—and that depends on the labor market. Unemployment stands at 7.8%. Suppose it could be brought down to 5% before a tighter job market started to push up wages. That might give the next administration the option of another few years of fiscal ease before pressure on inflation and long-term rates began to rise. But if inflation starts to move up at an unemployment rate of 6.5%, say, long-term rates could move up as soon as next year. That could trigger the confidence crisis that the debt pessimists fear.

At this year’s Fed conference in Jackson Hole, Ed Lazear and James Spletzer presented a paper that said the recent sharp rise in US unemployment, which stood at less than 5% in 2007, has been overwhelmingly cyclical rather than structural. In other words, it was caused by lack of demand, and can be reversed without pushing inflation up. If they’re right, with unemployment high, fiscal tightening can—and should—be delayed a while longer.

How long a while? How plausible is it that the US could have, say, a decade or more of low inflation, persistent low interest rates at all maturities, and a seemingly unlimited capacity for sustained high public borrowing? That’s what Japan has experienced. It’s hardly a model to emulate—it depends on slow growth (which the US doesn’t want) and high, captive domestic saving (which the US doesn’t have). For the US, a decade of free public borrowing looks unlikely, even if the ongoing crisis in Europe helps to extend US standing as the world’s preferred debtor.

Lord, make me chaste, but not yet. In fiscal policy, at least, there’s a middle way. That’s the policy Fed chairman Ben Bernanke has been recommending for several years, lately with increasing urgency. Let fiscal policy support demand now—don’t cut the deficit too abruptly—but settle on plans to control borrowing and slowly bring the debt back down over the next 10 years and beyond. That should be the aim of talks to deal with the fiscal cliff. Technically, it’s easy (Simpson-Bowles, passim). Politically, we’ll see.

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