Tag Archives: inflation

Could the US Default?

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One claim that I often hear around the blogs and tweets is that the US could never default because it borrows in its own currency. Greece defaulted because it borrows in Euros, and other EU countries have strong objections to the ECB printing money to pay off Greece’s debts. However, when the US debt comes due, the worst case scenario is that the Fed prints up the funds to pay off the debt. Problem solved.

I don’t think the US monetary-political system works that way at all. Let’s run through some back-of-the-envelope calculations. According to Wikipedia, before Greece’s default, it owed around €350 billion; the default constituted a €107 billion reduction in debt. Let’s call that ratio 30%.

Let’s suppose that the US had to print enough money to weather a Greek-style crisis. Could it cover 30% of its outstanding debt simply by printing the funds? According to the Treasury, as of last Friday, the US owes $10,820,230,118,370.38 to the public. To do so, it would have to print and introduce into circulation $3.25 trillion.

What would that do to the economy? According to FRED, as of last Wednesday, there are currently less than $1.1 trillion in circulation at the moment. So printing enough money to weather a Greek-style crisis would result in almost a quadrupling of the number of dollars in circulation. In the long run, if velocity is determined basically by technological factors, that means that we would expect prices to almost quadruple. This would represent a seizure of assets from holders of future nominal claims, which would be damaging to the economy. However, in the short run, the story is even worse. If I were concerned that the government was going to print $3 trillion, I would try to get rid of all my cash holdings and hoard real resources. So would everyone else. This could cause a hyperinflation even before the Fed starts printing money. Banks, too, would want to convert their nominal assets into real ones. And since real resources would be hoarded, they would not be available for use in investment projects. It would be an economic disaster.

If you want to salvage the hypothesis that the US could never default, you would make two points. First, the government need only credibly commit to printing money to pay off its debts if necessary. The fact that markets believe it would do so means that interest rates on Treasurys never get high and the fiscal burden of interest payments are bearable. Second, the economic effects of a default would also be pretty bad. Since an economic collapse is unavoidable either way, it is better if politicians credibly commit to printing the money if necessary.

However, I’m not sure that the government can credibly commit to printing instead of defaulting. Almost half of the US debt is held by foreigners. If you were a politician seeking reelection, would you not counter a proposal to inflate away $3.25 trillion of debt with a suggestion to default on debts held by foreigners? This would wreak economic havoc, but the worst damage would be borne by China and Japan, not by your own beloved constituents. I’m not saying this is a good idea, but to my mind the US political system, defective as it is, cannot credibly commit to not doing this.

The other factor that makes the situation worse for the US than for Greece is that Greece has an international consortium as a backstop to make credible loan guarantees. These guarantees are worth hundreds of billions of dollars. By no one can credibly guarantee the US’s trillions of dollars of loans. This means that while Greece’s crisis has played out as a slow and steady collapse, a US crisis would be more severe because it would happen much more suddenly.

My claim is not that the US is likely to default. Rather, my point is a narrow one: people who say that the US could never default because it borrows in its own currency are mistaken. They should either stop saying that or tell me why I’m wrong, which I would be happy to be.

CPI Bias and Stagnation

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Tyler has been defending his stagnation hypothesis with an intuitive argument about when the CPI is most skewed. I’m not 100% persuaded of Tyler’s intuition.

There is a severe conceptual problem that plagues any measure of inflation. It seems easy enough to measure the change in price of a basket of goods, but real-life consumers do not buy the same basket of goods from year to year. Entirely new goods get introduced, and even goods that seem nominally the same tend to improve in quality. These both introduce biases.

Suppose you’re starting with a basket of goods that contains x and y. Then new good z gets introduced. You don’t have the period-ago price of z, so you might continue for a period assuming that consumers are just buying x and y. You add z to the bundle in the following period when you can make a price comparison for z. This is going to cause CPI to overstate inflation, because in the period where z was available on the market but not included in the basket, consumers had greater choice with a given amount of money than the index suggests.

Now suppose you’re starting over, again with a basket of goods that contains x and y. Instead of adding a good z, assume that in some period x and y are replaced on the market by x’ and y’, which are improved versions of x and y. Consumers buy x’ and y’ in roughly the same quantities that they bought x and y, respectively. Since x and y are no longer on the market, there is no price comparison that can be made across periods. One way around this is to assume naïvely that x’ = x and y’ = y. Once again this is going to cause CPI to overstate inflation, because a given amount of money can buy more quality than the index suggests.

Tyler claims that the first problem is more severe in practice than the second. I am not so sure. One reason that we can never be sure is that statisticians at the BLS attempt to correct for both kinds of problems. This is a confounding factor that takes simple intuition out of the picture. How can we know whether net of statistical correction one problem is worse than the other?

But even assuming naïvely that the statistical corrections are equally effective or ineffective, it’s not obvious that the first problem is the most severe. In the periods when truly new goods first get introduced, they typically do not make up a large fraction of the real-world consumption bundle. This is an inherent limit on how much damage they can do to the index. In contrast, secular improvements in goods tend to affect the whole bundle. There is much bigger scope for damage to the index from quality improvements than from the introduction of new goods.

Tyler has been advancing the differential CPI bias argument to amplify, not make, his core argument, but if he has it backwards, that CPI bias has been worse in the post-1973 period than in the pre-1973 period, then his whole stagnation hypothesis crumbles. I’d like to see more discussion of his CPI intuition.

Update: Bryan has more.

Are There Two Inflation Regimes?

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Arnold Kling tentatively postulates that central banks can, at most, select between a low-stable inflation regime and a high-variable inflation regime. Bryan Caplan proposes a quick test, which I hereby supply. Below are some scatterplots of inflation variance versus inflation means for 176 countries. The data is from the World Bank, which gets it from the IMF (gated). The data begins in 1961 for some countries, but later in others. If we observe two clusters, then that is strong evidence for Kling’s hypothesis.

The first scatterplot uses all available data.

It’s clear that there is a strong correlation between inflation means and variances (r=0.77, in fact) and an even stronger one, r=0.92, for means and standard deviations (see how the data appears to be quadratic?). But I don’t observe any evidence of clustering.

Because most of the data appears on the lower left, it may be helpful to zoom in. I repeat the plot for those countries where the mean is less than 150 percent. I also exclude the countries that have less than 15 observations.

Once again, there don’t appear to be discrete clusters. Just to make sure, let’s zoom in one more time on the lower left.

While Caplan’s proposed test does not support the Kling hypothesis, I am not sure that it effectively captures what Kling is postulating. For one, what counts as high and variable in the US is not the same as what counts as high and variable in Israel, Chile, Russia, or Zimbabwe. Secondly, if central banks have a choice between the two regimes as Kling postulates, then countries that spend time in both regimes are going to appear on the scatterplot in between the two hypothetical clusters (is this what we observe?). You can’t use a scatterplot of aggregated data to detect structural breaks. I’ll leave it to someone else (maybe one of my commenters?) to propose a better test.

Update: At Bryan’s request, here are three more graphs, zoomed in further on the lower left. Continue reading →