bordo under what circumstances can inflation be a solution to excessive national debt

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Under What Circumstances Can Inflation Be a Solution to Excessive National Debt: Some Lessons from History?

Michael D. Bordo

Rutgers University, Hoover Institution, Stanford University and NBER

Paper prepared for the Conference “Paper Money—State Financing—Inflation” Institut fur bankhistoriische Forschung e.V, Deutshe Bundesbank, Frankfurt, Germany, September 18, 2012

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Under What Circumstances Can Inflation be a Solution to Excessive National Debt: Some Lessons from History

Abstract

The strategy of monetizing national debt by purchasing newly issued government debt with central bank

money as well as using inflation to reduce the real value of outstanding nominal debt is fraught with the

peril of creating high inflation. This was the case in several famous episodes of hyperinflation in the

interwar period. But there are some situations where monetizing government debt can be the best thing to

do, for example during a war where a country’s survival is at stake or during a deep depression like the

Great Depression of the 1930s when real output and prices declined by over 30 per cent. In each of these

cases money financed fiscal deficits can be effective but theory and history teaches us that once the

emergency is past the expansionary policy must be reversed.

Introduction

The massive debts that have been built up by the U.S., U.K., and other advanced countries since the

financial crisis of 2007-2008 as well as the large debts of many members of the euro area has led by the

call by some to monetize the debt (or alternatively to reduce it by financial repression).By monetizing the

debt I mean both purchasing newly issued government debt with central bank money as well as using

inflation to reduce the real value of outstanding nominal debt. The strategy of monetizing national debt is

fraught with the peril of creating high inflation. This was the case in several famous episodes of

hyperinflation in the interwar period. But there are some situations where monetizing government debt

can be the best thing to do, for example during a war where the country’s survival is at stake or during a

deep depression like the Great Depression of the 1930s when real output and prices declined by over 30

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per cent. In each of these cases money financed fiscal deficits can be effective but both theory and history

teaches us that once the emergency is past the expansionary policies must be reversed.

Some Theoretical Considerations

Tax smoothing and Revenue Smoothing

In wartime situations when large government expenditures are needed, running a balanced budget would

require large increases in tax rates, which would severely reduce the incentives for economic activity just

when the need for such activity is the greatest. Borrowing from the public allows the government to

smooth tax rates over time. The theory of tax smoothing implies that an optimizing government will set

taxes over time so as to minimize deadweight losses (Barro 1989). In a policy of tax smoothing, if future

government expenditures are known with certainty, then the tax rate will be set to reflect those

expenditures and will remain constant over time. In an uncertain world, taxes will follow a martingale as

the government attempts to forecast expenditures rationally and set the current tax rate consistent with its

forecast of the future so that only unpredictable events will produce changing tax rates. Once the war time

emergency is passed the government must raise taxes, cut expenditures and pay off the accumulated debt.

Following such a strategy will convince the bond markets of the government’s credibility and allow it to

tax smooth in the next wartime emergency (Barro 1989, Bordo and Kydland 1996). Such a strategy was

successfully followed by the British in the Napoleonic wars (Bordo and White 1990).

If it is difficult to raise taxes or issue debt as was the case of the United States in its War of Independence,

an alternative strategy for the government is to use the inflation tax, a tax on real cash balances. The

theory of revenue smoothing considers the case where the government has two fiscal instruments:

taxation and seigniorage (the inflation tax). According to the theory the government would at each

moment of time set each tax rate so as to minimize the deadweight losses (excess burdens) of the

instrument (Diamond and Mirrlees 1971). Over time an optimizing government would smooth revenues

from both instruments and both instruments would evolve as a martingale (Mankiw 1987). Again like the

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issue of debt which is a tax on future consumption, the inflation tax needs to be reversed once hostilities

cease.

Unpleasant Arithmetic and Fiscal Dominance

Maintaining high debt levels once the wartime emergency has passed is fraught with peril. Sargent and

Wallace (1991) posited that unsustainably high debt ratios (where the present value of expenditures

exceeds the present value of taxes) could lead to “unpleasant monetarist arithmetic” which forces the

central bank to use its seigniorage to service and monetize the debt. The recent fiscal theory of the price

level (Leeper and Walker 2011) leads to a similar bad outcome through a different mechanism. According

to this framework, in normal times the central bank pursues active monetary policy—following a low

inflation target—independent of the fiscal authority. The fiscal authority is expected to fully offset fiscal

deficits today with surpluses in the future. In times of fiscal stress like the present, there is a possibility

(for political or other reasons) that taxes will not be raised or expenditures cut sufficiently in the future to

prevent the national debt from ballooning. In that situation, fiscal policy will become active and monetary

policy passive, referred to as a state of fiscal dominance. Economic agents will perceive the increase in

nominal debt to be an increase in their real wealth, leading them to increase their consumption

expenditures and hence raising the price level. Higher prices will reduce the real value of the national debt

and restore fiscal equilibrium. These theories suggest that unless a political deal is worked out to restore

and maintain fiscal balance that future inflation is in the cards.

Historical Examples When Using Money Financed Fiscal Deficits is Desirable.

Two circumstances where money financed fiscal policy is desirable are in major wars and a situation like

the Great Depression of the 1930s.

Major Wars

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Bordo and White (1990) describe the war finance strategies of Britain and France during the Napoleonic

Wars. On the one hand Britain which had successfully followed a tax smoothing policy in several wars

in the eighteenth century was able to largely finance the Napoleonic wars by debt issue and a minimal

amount of seigniorage. The British had successfully used debt finance in the Seven Years War and the

War of the American Revolution, paying off the wartime accumulated debt with higher taxes after the

war. This strategy gained the British the credibility to finance a much bigger war largely through taxes.

Sovereign bond spreads rose only minimally. Moreover the Bank of England followed an inflationary

policy in the War after it suspended convertibility into gold in 1797. The Bank freely discounted

Exchequer bills and was one of the first central bank to use the engine of inflation. Because the Bank had

credibly adhered to specie convertibility through the eighteenth century, it was able to raise revenue

without triggering a rise in velocity. After the war the debt ratio was successfully reduced from 260% in

1819 to 127% in 1849 and much lower by the end of the nineteenth century. Also after the War the Bank

followed a deflationary policy to restore the gold standard at the original parity. These actions represented

the two pillars of classical orthodoxy—maintaining the gold standard and balanced budgets.

By contrast, France which had defaulted on its debt after the American Revolutionary war and had

generated the Assignat hyperinflation during the French Revolution did not have the credibility to follow

the tax/ revenue smoothing strategy pursued by the British. In 1803, Napoleon founded the Banque de

France and the franc germinal based on bimetallism. They did not have the credibility to either issue

significant amounts of debt or to temporarily print money. Consequently the French financed the war by

taxes and by collecting tribute from their conquered territories—a strategy which in the end was not

successful.

World War I was financed by the belligerents by a mix of taxes, debt and seigniorage. The mix differed

depending on the course and expense of the war with the United States, the last to enter, issuing the least

seigniorage and debt and the Germans the most. Germany was at a disadvantage relative to the other

European belligerents because it did not have access to foreign sources of finance. Germany was at a

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disadvantage to the other European belligerents because it did not have access to foreign sources of

finance. The tax smoothing and revenue smoothing policy worked best for the United States and Great

Britain. Both were able to service and amortize their debts after the war by higher taxes and to offset

most of the wartime inflation by postwar deflationary policies. Germany and France were examples of

unsustainable debt and high inflation to be discussed in detail below.

World War II for the allies was financed with lower seigniorage and debt than World War I yet the larger

scale of wartime expenditures left a large debt burden. The debt burden overhang in both the U.S. and the

U.K. was removed by a combination of rapid growth, inflation and financial repression. The post World

War II experience departed from the classical tax smoothing model. The debt was reduced by inflation

not by fiscal consolidation and deflation (Grossman 1990).

The Great Depression

The Great Contraction of 1929 to 1933 was the deepest recession ever experienced in the United States,

Germany and many other countries. In the U.S. real GDP fell by more than 30% as did the price level.

This is a multiple of the recent Great Contraction. Milton Friedman and Anna Schwartz in their classic A

Monetary History of the United States (1963) attributed the U.S. contraction to a failure by the Federal

Reserve to use expansionary monetary policy to offset a series of banking panics from 1930-33 which led

to a collapse in the money supply. According to them had the Fed offset the panics by expansionary open

market operations the collapse of output and deflation would have been attenuated. Friedman (1960) and

elsewhere posited that had the Fed followed his constant money growth rate rule that the Great

Contraction would have been avoided altogether. McCallum (1990) and Bordo and Schwartz (1995)

backed this up with econometric analysis.

Milton Friedman also discussed the use of money financed fiscal policy in his “A Monetary and Fiscal

Framework for Economic Stability” in 1948 and later in his debate with Walter Heller, Monetary versus

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Fiscal Policy in 1968.There he argued that fiscal policy financed by money was the only kind of fiscal

policy that would have much traction in stabilizing the real economy. In that book and in his lectures at

the University of Chicago he showed that the multipliers of money financed fiscal policy greatly

exceeded those of bond financed or tax financed government expenditures or tax cuts. This analysis

suggests that had the Fed engaged in monetizing the debt in the 1930s that the Great Depression could

have been avoided. This is very close to his analogy of a helicopter dropping new dollar bills in his 1969

Optimum Quantity of Money. Ben Bernanke in a speech in 2002 picked up on Friedman’s idea and

argued that the Fed always had the tools to stimulate the economy. At the time he was referring to the

situation in Japan of mild deflation and policy interest rates at the zero nominal bound (Ball 2012). In

actual fact the recovery after 1933 had very little to do with expansionary monetary or fiscal policy

(Romer 1992). It reflected the devaluation of the dollar in 1933-34, President Roosevelt’s gold (and

silver) purchasing policies and later gold inflows from Europe as the threat of war mounted. Thus had the

Fed followed a policy of fiscal deficits the Great Depression could have been avoided and such a policy

could be used again in similar circumstances.

Historical Examples where Monetizing the Debt was Unsuccessful

History suggests a number of examples where monetizing debt in peacetime led to disastrous

consequences. Understanding these cases may have resonance for the situation that the U.S., the U.K and

the Euro area faces today.

Weimar Germany 1921-23

The worst case scenario of fiscal dominance creating inflation is that of Weimar Germany in the 1920s.

The fiscal problem facing Germany after its defeat in World War I was its inability to fund the increase in

its deficit produced by the demands of the Treaty of Versailles reparations, payable principally to France

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and Belgium. The reparations were payable in gold marks and dollars (denominated in gold) and tax

revenues were payable in paper marks. The inability (unwillingness) to raise taxes sufficiently or to

borrow funds to pay the reparations abroad (as was done earlier in 1871 after France’s defeat by Germany

in the Franco Prussian war) meant that the fiscal deficits would have to be monetized (in the conventional

lexicon) or in terms of the fiscal theory—that the price level would have to rises. Rising prices and falling

exchange rates (see figures 1 and 2) led to a burgeoning fiscal deficit and an explosion in nominal debt.

The resulting hyperinflation reflected both a stalemate between France and Germany over the pace and

timing of reparations and political chaos within Germany which impeded a solution to the fiscal impasse.

A comparison between the experience of Germany in the 1920s and the U.S. (or other countries) today

may be a bit too extreme. The political environment in Germany after World War I, involving open civil

war between the communists and the extreme right and then the occupation of the Ruhr by the French was

infinitely worse than today’s bickering between the Republican Tea party and the liberal democrats, and

the postwar disruption in Germany after the war seems very far removed from the aftermath of a

recession , although severe by post World War II standards when compared to the recessions before

World War II , is relatively mild. Moreover the fact that reparations were payable in gold, i.e. that

external debt was payable in foreign currency, is a major source of crisis instability for emerging

countries but not at present for the U.S. which is still the dominant international currency and all U.S.

debt is denominated in dollars.

France 1921 to 1926

The experience of France in the 1920s is much more compelling than that of Germany as an example to

illustrate the pitfalls of rising debt. This is because the political situation in France was not nearly as dire

as in Germany, the French economy was in better shape, French debt was denominated in local currency,

and the fiscal crisis that occurred did not lead to a hyperinflation. The French situation after World War I,

in comparison to that of Great Britain (Bordo and Hautcoeur 2007) has all the elements of active versus

passive monetary and fiscal policies. The British experience could be characterized by active monetary

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and passive fiscal policies whereas the French case was the opposite. Both countries emerged from World

war I with more than a doubled price level (see figure 3), a high ratio of debt to GDP (figure 4), large

fiscal deficits (figure 5) and a devalued exchange rate (figure 6). France was in worse shape than Britain

in all dimensions but not by much. The key difference between the two countries was in their fiscal and

monetary stances after the war. France had a higher debt ratio, more short-term debt and a big monetary

overhang. France had extensive destruction of its physical capital stock but also a faster growth rate than

Britain.

The British were able to pull off a successful stabilization and resumption to the gold standard at the

original parity beginning in 1919 and culminating in April 1925. The French stabilized later and went

back to gold with an 80% depreciation in the franc. More important, France had six years of rapidly rising

prices and as in the fiscal theory of the price level model, the rise in the price level reduced the real value

of the national debt. Fiscal balance was restored in 1926 by a political compromise between the left and

the right involving both rising taxes and reduced government expenditure.

The French fiscal problems are well known (Eichengreen 1992). First, like Britain, France financed

World War I with a combination of taxes, debt and seigniorage, but France didn’t raise taxes as much so

that the deficit and debt was higher (see figures 4 and 5). In both countries the central bank absorbed

short-term Treasury bills and pegged short-term interest rates.

Second, France, unlike Britain, didn’t have the political commitment to stabilization and resumption that

the British did. There were three issues; a) reparations--the belief that German reparations would pay for

reconstruction; b) a struggle between the left and the right over who would cover the fiscal deficit once it

became apparent that the Germans would not pay. The left wanted to impose a capital levy and the right

wanted to raise excise and other taxes; c) the French had monetized more of their short-term debt than did

the British and consequently had a larger monetary overhang which required more deflation to get back to

the pre war gold parity. Moreover the government had to repay its short-term debt to the Banque de

France which in turn would raise the deficit and the debt.

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The political tug of war continued for seven years with several changes of government and many finance

ministers. Instead of raising taxes and cutting expenditures sufficiently to balance the budget, the

government kept issuing short-term bills which they had difficulty selling and rolling over and hence

they were absorbed by the (passive) Banque de France leading to inflation and a depreciating exchange

rate.

An equilibrium which solved the political impasse was finally achieved in July 1926 when a revolt by

left wing deputies in Parliament led to an invitation by Raymond Poincare (center right) to take over the

government and rule by decree. He raised taxes, cut expenditures and was able to borrow dollars from JP

Morgan and Lazards and use the funds to conduct a bear squeeze on speculators selling francs short. This

stabilized the franc which was then pegged to gold at a greatly devalued rate in December.

Bordo and Hautcoeur (2007) simulate a model of the French economy in the 1920s and show that it was

impossible for France to engineer a British style stabilization and resumption. This is because following

the British route of consolidating debt and deflation would have increased French nominal debt to

unsustainable levels. See figure 7. This suggests that France had to have a huge increase in the price level

and a major devaluation to achieve fiscal equilibrium. We also show that economic circumstances could

have allowed stabilization two years earlier, in early 1924 when an earlier Poincare government was in

power, with a much smaller devaluation and less inflation than ultimately occurred. It did not happen

because Poincare lost the election in the spring and it became impossible to work out such a deal.

The Great Inflation 1965 to 1979

The run up in inflation from 1965 to 1979 in the U.S. and other countries was closely connected with

fiscal dominance. In the U.S. beginning in the early 1960s in the Kennedy and Johnson administrations

Keynesian ideas began to overtake fiscal orthodoxy. Walter Heller, James Tobin and Arthur Okun,

leading economists in the Council of Economic Advisors, encouraged the use of activist fiscal and

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monetary policy to tame the business cycle. They also believed in the Phillips curve tradeoff that

expansionary monetary and fiscal policy could reduce the unemployment rate at the expense of higher

inflation. In that environment the Federal Reserve began active policy coordination with the fiscal

authorities. It also followed a policy of “even keel” in which the central bank would suspend monetary

tightening while the Treasury was funding government debt. As Meltzer (2010) points out once the

expansionary Vietnam War and the Great Society programs were underway that the Fed often deferred to

the Treasury and held off from monetary tightening.

In the UK the Bank of England was not independent from the Treasury until the 1990s. In the 1960s and

1970s the stance of monetary policy was largely dictated by the state of the government budget. During

this period the growth of the sterling M3 money stock was driven largely by the public sector borrowing

requirement (Laidler 1976 and Ahktar and Putnam 1979). As in the U.S., fiscal and monetary policy was

dedicated to maintaining full employment. Moreover the Treasury did not believe that the rise in inflation

was related to monetary expansion but rather reflected the exogenous union driven rise in money wages

(DiCiccio and Nelson 2012).To arrest inflation, the Treasury encouraged the use of incomes policies.

In both countries inflation burgeoned until deliberate policy actions were undertaken in 1979 and 1980 to

drastically tighten monetary policy and keep it tight at the expense of a serious recession until the back of

inflationary expectations was broken by the early 1980s.

Some Policy Lessons for Today

The German and French cases are cautionary tales about how bad things could get if the high debt ratios

that the US and other countries presently have are not resolved. There are also some similarities with the

1970s since the Subprime Mortgage Crisis and Great Recession were resolved by central banks engaging

in credit policy and other fiscal actions to preserve the solvency of the financial system. There is a

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temptation to inflate away the debt as was done in the U.S. after World War II when the debt to GDP ratio

was reduced by two thirds from 120 % in 1945 within two decades (Aizenman and Marion 2010). But

unlike the 1950s and 1960s the rate of growth is much lower today, the term structure of the debt is much

shorter and the extent of financial repression considerably less (Reinhart and Sbrancia. 2011). Thus the

amount of inflation required to reduce the debt ratio would be much greater than in the postwar period.

This would raise the risk of an elevation of inflationary expectations which could then become persistent

leading to a repeat of the events of the 1970s Great Inflation.

Moreover even if central banks don’t explicitly engage in expansionary policies to reduce the debt

overhang, the fiscal theory of the price level predicts that prices will rise to ensure present value balance.

Thus there is a strong case for cutting government expenditure and raising taxes to restoring sustainable

fiscal balance in the near future.

These historical examples suggest that if the debt ratio gets high enough, then a rise in the price level is

pretty likely. However recent history also suggests that a political deal is a good possibility before such an

outcome was to be reached. Two pertinent examples tell how such a deal can be worked out without

leading to inflation.

Canada in 1995 worked out just such a deal with fundamentals not too much better than presently in the

U.S. (Barnes 2011, Redish 2011). Pierre Eliot Trudeau’s Liberal government ran increasingly higher

fiscal deficits and debt ratios from the 1960s to 1980s to finance a massive expansion of the social safety

net, with the debt ratio reaching close to 50% by 1984. The succeeding conservative government under

Brian Mulroney tried unsuccessfully to restore fiscal balance but rising debt service costs pushed the debt

ratio to close to 70% by the early 1990s. After a down grade of its debt ratings by Moodys and two

scathing articles in the Wall Street Journal, the succeeding Liberal government, under the guidance of

Finance Minister Paul Martin, successfully restored fiscal balance. Martin’s 1995 budget drastically cut

government expenditures across the board combined with minimal tax increases. Provincial governments

followed suit with major spending cuts. Fiscal Stringency was maintained for three years. The result was

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that the deficit declined from over 7% in 1995 to a surplus by the end of the decade and the debt ratio was

cut by more than half.

Similar but less dramatic consolidations were put in place in the U.S. first by the George Herbert Bush

administration with the Budget Enforcement Act of 1990 and then by the Clinton administration’s

Omnibus Budget Reconciliation Act of 1993.These two acts reduced fiscal deficits from close to 5% to a

surplus by the end of the twentieth century with a combination of cuts in government spending and rise in

tax rates. The successful fiscal outcome of the 1990s was most likely aided by the Peace dividend after

the collapse of the Soviet Union and by rapid productivity advance.

Although the political climate is considerably more polarized in the U.S. today than it was in the 1990s

and the real economy is in much worse shape, a deal may be worked out sooner rather than later to

reverse the burgeoning debt following the Great Recession and the future rise in debt expected from the

growth of entitlements to an aging population. This will likely occur in the short-term to avoid the

immediate threat to the economy of the ‘fiscal cliff” and in the longer term because of a potential threat to

the dollar’s “ exorbitant privilege” and the losses that would entail for the U.S. economy (Eichengreen

2010). The exchange rate is a forward looking variable which could easily telescope a future fiscal

impasse to the present. A dollar crisis in 1978 triggered President Carter’s appointment of Paul Volcker in

1979 to engineer his famous shock which ended the Great Inflation—a similar fiscal event could happen

in the U.S. in the not too distant future. In the case of the U.K which is a much smaller and more open

economy than the U.S. and where sterling lost its reserve currency status decades ago, the financial

markets forced it to consolidate before substantial recovery from the Great Recession occurred. Debate

continues over whether it consolidated too soon. Time will tell which strategy is best.

Postscript on the Euro area

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The Greek debt crisis is a different story than is the case for the advanced countries after the recent

financial crisis and Great Recession. Its story is very close to the 1920s examples discussed above. Absent

the ability to inflate away its debt, default is the only option unless it continues to be bailed out by the rest

of the Euro area. The other peripheral countries are closer to the Great Depression story but EMU

prevents them from using expansionary monetary policy or devaluing and the absence of a fiscal union

prevents fiscal transfers from aiding in their adjustment. The EMU authorities are moving closer towards

a fiscal union with a central government with some taxing authority and the ability to make inter member

fiscal transfers, as well as a banking union. The history of other fiscal/monetary unions suggests that a

credible no bail out clause is necessary for them to work without creating a climate of moral hazard,

transfer dependence and the monetization by the union of the deficit members’ debt. ( Bordo, Jonung and

Markiewicz 2012)

Figure 1

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(Source: Velde 2012)

Figure 2

(Source: Velde 2012)

Figure 3: Price Level (1910=100)

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(Source: Bordo and Hautcoeur, 2007)

Figure 4: Debt to GDP


Figure 5: Budget Deficit (% of GDP)

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Figure 6: Nominal Exchange Rate


Figure 7: Nominal Public Debt

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