By Steven K. Beckner
If taxes do not rise to pay for increasing debt or if spending is
not reduced, a different, more inflationary scenario can emerge, he
warns.
“An expectation that transfers (transfer payments) will rise in the
future reduces the household’s assessment of the value of the government
debt they hold,” he explains. “Households can shed debt only by
converting it into demand for consumption goods; hence, the increase in
aggregate demand that leads to higher prices.”
“In the current policy mix, a higher nominal interest rate raises
the interest payments the household receives on the government bonds it
holds,” he goes on. “Higher nominal interest receipts, with no higher
anticipated taxes, raise household wealth and trigger the same
adjustments (in consumer spending). In this sense, … monetary policy
has lost control of inflation.”
“When agents believe that at times fiscal policy will not respond
systematically to stabilize debt, then … monetary policy’s ability to
control inflation will be curtailed,” he warns.
“Heading into an era of fiscal stress, as many advanced economies
are, it may be reasonable for individuals to ascribe some probability to
a future fiscal regime in which fiscal policy is no longer able or
willing to target government debt,” he adds. “And the longer that
governments delay making the fiscal reforms that will anchor
expectations on the fiscal behavior … the more likely it is that
central banks will be unable to control inflation.”
Bringing the interaction of monetary and fiscal policy closer to
home, Leeper talks about the current and prospective configuration of
Fed policy and Obama administration policy.
“So far the Federal Reserve has signaled its willingness to
continue its passive behavior by keeping the federal funds rate low,” he
writes. “Eventually, though, as the recovery gains strength and
inflation picks up, it is likely that the Fed will return to its usual
active policy stance.”
“In the absence of a coordinated switch in fiscal policy to a
passive stance, both policies would be active, at least for a time,” he
continues. “If regime were permanent and both policies were active, debt
would explode and there would be no equilibrium.”
“Doubly active policies mean that no one is attending to debt
stabilization and this produces markedly different paths for macro
variables … : inflation rises and remains well above its initial
level; output and consumption boom even though the real interest rate
rises; government debt grows with no tendency to stabilize.”
Leeper says this prospect “should be disturbing to central bankers.
A switch in monetary policy to fighting inflation is doomed to failure
if fiscal policy does not simultaneously switch to raising taxes to
stabilize debt. Although the economy experiences a boom, it does so by
generating chronically higher inflation and a growing ratio of
government debt to GDP.”
Policymakers face a grim set of choices in what Leeper calls “the
coming era of fiscal stress.” He notes that Social Security, Medicare,
and Medicaid “are projected to grow exponentially” and that the federal
government’s share in GDP almost doubles over the projection period:
from an average of about 18% in 1962 to between 31% and 35% in 2083,
excluding interest payments on outstanding debt.
State and local fiscal crises add to the prospective debt burdens,
“raising the likelihood of a federal government bailout of defaulting
states,” he warns. “Greece’s recent experience may portend U.S.
events.”
As bad as the U.S. fiscal situation is, other countries, including
Canada and Korea, are even worse, he says.
For now, the fact that investors in U.S. debt are still “happily
buying federal government bonds” means “they must believe that in the
long run, policies are sustainable because current policies will not
remain in effect,” Leeper writes.
But he goes on to warn of a looming “fiscal limit” — an upper
limit on how much tax revenue can be raised and a lower limit on the
level of government spending.
“If a country is approaching its fiscal limit, then it no longer
has the fiscal flexibility to adjust surpluses to stabilize debt,”
Leeper says. “But (a regime) in which monetary policy targets inflation
and fiscal policy targets real debt, requires fiscal flexibility, so
fiscal limits can undermine the efforts of inflation targeting central
banks to accomplish their prime objective.”
“The more likely people believe it is that the limit will be
reached, the harder it will be for central banks to retain control of
inflation,” he adds.
Leeper maintains that the U.S. is “well below” its “fiscal limit”
in the sense that it has more room to raise taxes than nations in Europe
with much higher tax rates. There is less room to cut spending, he says,
although that is a political choice.
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