In the last six weeks, Congress has passed with broad support three separate pieces of legislation aimed at offsetting the devastating economic impact of the COVID pandemic. The $3 trillion price tag for these initiatives is three times what the federal government borrowed last year and more than four times the cost of the TARP program Congress approved in 2008 to rescue the nation’s ailing financial sector.
While these programs have helped soften the initial blow of the downturn, many in Congress believe more funding is now needed. House Democrats are looking at another $3 trillion in spending to, among other things, plug the growing hole in city and state budgets. But in public policy circles, fiscal hawks are starting to question the seemingly unchecked level of spending and even some of the voting public is expressing concern. In mid-April, a WSJ News poll found that 48% of Americans were worried about the U.S. spending too much today vs. 40% who were worried about spending too little.
Traditional economic theory has counselled expanding federal debt and money supply during economic downturns and reining it back in once the economy picks up steam. More recently, however, an alternative approach to taming economic cycles, dubbed “Modern Monetary Theory,” has gained traction. This hypothesis suggests that countries can issue ever expanding levels of debt as long as their economies grow at rates that are higher than the interest rate charged on their debt. This approach seems to have been working so far in the U.S. where historically low interest rates and inflation levels have helped the country carry an expanding amount of debt.
The future course of economic growth, inflation and interest rates will dictate the success of this approach going forward. The government’s recent vast injection of money into the economy would normally risk a spike in inflation as more dollars chase a limited number of goods. But weak demand caused by massive job losses has prevented this from happening so far. The risk of falling not rising prices is the Fed’s greater concern today. Excluding the volatile food and energy categories, consumer prices fell 0.4% last month, the largest monthly drop since 1957. Eventually, however, the economy will recover and if the supply of goods cannot keep pace with escalating demand, prices will rise. Supply disruptions either due to bottlenecks or an effort by firms to diversify sourcing could also put upward pressure on prices. Whatever the outcome, the Fed will need to walk a fine line, balancing the twin objectives of price stability with economic growth. The consequences of a policy “mis-step” are particularly severe today given the large amount of debt outstanding. Approximately 9% of federal outlays are now spent on interest payments. A spike in inflation and interest rates would result in budget battles and threaten funding for a wide range of programs.
How then to extinguish this newly acquired mountain of debt? Unfortunately, there will likely be little political support for the obvious remedy of raising taxes and cutting spending. An alternative, more appealing solution turned to in the past may offer some hope. After World War II, debt levels in the U.S. soared to over 112% of GDP. Over the next 10 years (1946-1955), inflation averaged 4.2% per year. Because interest payments are fixed in nominal terms and borrowers pay down debt with inflated dollars, debt burdens shrink naturally over time. By 1955, the country’s debt/GDP level had fallen by 40%. A similar level of inflation would have the same effect today.
Inflating your way out of debt is not without its problems. Higher inflation levels may not be easy to achieve – Japan has been trying to do just this for over two decades with little success. Rising prices too can get out of control and erode wages. But a whiff of inflation might be just the thing needed to help us deal with our looming debt dilemma.