Recent Posts

Wednesday, April 15, 2015

Questions Raised By The “Inflation Is The Same As Default” Theory

I quite often see variants of the following statement: “The government will be forced to default because of its debt load, or else pursue inflationary policies, which is another form of default.” In my view, this is a soundbite, not serious analysis, and it is very difficult to reason with soundbites. This article is a series of questions that are raised by this concept.
  • It is not unusual for inflation to be 1% in a month, which represents more than a 12% annualised rate of inflation. For any developed country, 12% inflation rates are politically unacceptable. Did the government default when that happens?
  • If one month of high inflation is not enough, what period of high inflation qualifies? One year? One business cycle? A decade? A "generation"?
  • Why is any form of inflation acceptable? We have had a political consensus amongst mainstream political parties that 2% annual inflation was acceptable. Was this a form of embracing mass default?
  • The price level is highly sensitive to the price of oil. Do bond investors believe that the government has the ability to create unlimited amounts of oil at a fixed price so as to prevent oil price spikes?
  • If there is such a default due to inflation, what is the government supposed to do?  Have Treasury officials make sad faces on television? Track down bond holders and give them extra payments?
For the next questions, I will assume that 2% average inflation does not constitute a "default", but if you object to the 2% level, substitute whatever level you feel is appropriate. 
  • Is an average of 2.01% annualised inflation over some averaging period a default? What average does the inflation rate have to be to constitute default? Why?
  • Why 2%? The number was an entirely arbitrary figure that appears to have been pulled out of the nether regions of the New Zealand Reserve Bank, and other central banks just did what the cool central banks were doing.
  • Why cannot policymakers change their mind what is an acceptable level of inflation? Tax rates change all of the time.
  • If an average inflation rate 1% above the acceptable level represents default, what happens if the average inflation rate is 1% below that level? Are bondholders going to give back their unwarranted incomes?
  • If inflation represents a default, what legal covenants have been breached? Why are sovereign CDS not triggered?
  • One variation is to say that “unexpected” inflation constitutes default. The “expectations” are determined in the bond market. What if the bond market participants are completely delusional about the path of inflation? For example, if bondholders are convinced that there will be deflation, are central banks obligated to engineer a debt deflation in order to avoid “default”?
  • Why is default a property that is only ascribed to government bonds? We do not live in a world where the government sets prices by government diktat. If oil refining corporations raise their selling prices and raise the price level, why are their bonds not considered to be in default?
  • Where in the bond prospectus is there a statement that the government will guarantee that bond holders will be spared any losses to the real market value of their holdings during the lifetime of the bond?
  • Entire economic sectors are routinely thrown under the bus as the result of the shift of economic variables. For example, manufacturers and employees in the United States were crushed by trade agreements and dollar strength in the 1990s. Why are not those other shifts considered "defaults"?
(c) Brian Romanchuk 2015

23 comments:

  1. You did not mention sector-shifts within the economy. Here are three potential sector shifts easily identified:

    Ability level - minimizing the effects of inflation requires mental agility not shared by all economic participants.

    Retirees vs youth - if saving for the future is important, prospective inflation magnifies the amount need for comfortable retirement. Variable prospective inflation injects magnified uncertainty.

    firms vs labor - For firms, today's sales are the capital for tomorrow's output. If inflation is expected, today's prices must be increased to meet prospective future capital requirements. Labor is selling a renewable resource, not a resource built over time.

    The sector shifts caused by inflation are not insignificant.

    ReplyDelete
  2. Brian,

    There are many ways for the government to default.

    Simplest example: the IMF requires a default on private sector holders to lend foreign exchange to the government.

    In the case of inflation, it goes something like this (closed economy):

    The government expands real government expenditure is expanded massively. Inflation is dependent on both costs and prices. So prices rise. Households save more as their real wealth erode. The government tries to spend more. The result is that the public debt/gdp keeps rising. At some point, the government defaults to reduce the debt/gdp ratio. This is an actual default in the scenario not a vague economically defined one.

    The possibility of this is of course very low but you cannot deny this possibility.

    So let's stop this government cannot default with whatever qualifiers one may add because the qualifiers may not be so right.

    ReplyDelete
    Replies
    1. Hi,
      " the IMF requires a default on private sector holders to lend foreign exchange to the government."
      I do not put the qualifier "I am mainly talking about developed economies" in every single one of my posts as it seems somewhat repetitive. For a developed country with a free-floating currency, your scenario is slightly far-fetched. More accurately, the government wants to default, and uses the IMF for cover. When restated in this fashion, I would see it as possible, but not likely. Outside the OECD, the IMF acts in a far more capricious fashion.

      " At some point, the government defaults to reduce the debt/gdp ratio. This is an actual default in the scenario not a vague economically defined one."
      Yes, but that's my point. The default occurred when the contractual obligations were breached, not during the inflation process. I would also note that inflation tends to reduce the debt-to-GDP ratio in developed economies, given the action of the welfare state. It's typically: inflation versus default, not both at the same time. (Yes, one could come up with scenarios, but you need some fairly unusual behaviour before the crisis.)

      "So let's stop this government cannot default with whatever qualifiers one may add because the qualifiers may not be so right."

      I am in the MMT camp, but I have not written that the "government cannot default". In my upcoming report (another plug!) I will be discussing the mechanics of default for a floating currency sovereign like Canada.

      Delete
    2. "but I have not written that the "government cannot default"."

      Fine but the omission of the talk itself is noticeable.

      You are right that it is far-fetched but it is far-fetched because governments do not in general expand domestic demand without worrying about balance of payments.

      About your reply to my point about inflation and default, while you are obviously right that it was a contractual default, where in your post did you highlight this?

      "I will be discussing the mechanics of default for a floating currency sovereign like Canada."

      Great. See this: I will be discussing the mechanics of default for a floating currency sovereign like Canada.

      Delete
    3. Damn the link didn't work:

      http://www.concertedaction.com/2013/02/27/so-the-bank-of-england-and-the-uk-government-cannot-default-on-its-bonds-is-it/

      Delete
    4. "About your reply to my point about inflation and default, while you are obviously right that it was a contractual default, where in your post did you highlight this?"

      I referred to "contractual obligations" and CDS triggers within the article.

      In another comment, you refer to slogans; in my view "inflation is a form of default" is a slogan. It is an attempt to equate an adverse economic development - which continuously hit different sectors all the time - to a breach of a promise. Breaking promises is viewed as politically unacceptable, which is why this false equivalence is being advanced.

      Delete
    5. True inflation is a form of default is a slogan but in my scenario there is an actual event of default.

      Delete
    6. But it is *always* voluntary. The government could always default on its bonds whenever it feels like it.

      It could do it today because the winds are blowing from the East, or a volcano has gone off and they are superstitious. All of which are just as good a reason as the debt/gdp ratio.

      It is never *forced* to. It is always a choice.

      Delete
    7. Well in my scenario, the choice is between ouright default or deflating demand. It has to do it at some point. The choice is intertemporal between the two.

      My basic point is what when neoclassicals go "default by inflation", it is a doublespeak for "don't do fiscal expansion". The way you come back in defense of fiscal expansion (which is needed) needs to change. You have to argue that the possibility is quite less. You seem to play around the word "choice".

      Delete
    8. It's just functional finance. The circulation needs to be sufficient to ensure that all the real activity that can be undertaken is undertaken in the current period - and no more. You deal with balancing activity tomorrow, tomorrow.

      You don't concern yourself with it today - because it depends upon saving and spending activity you cannot know in advance due to uncertainty.

      The system should manage current activity, largely via automatic fiscal stabilisers.

      Delete
    9. Below is a link to a paper about the drivers of national and global GDP growth, of which one component is thought to be the average rate of inflation. I think the story about 2% inflation target is that it seems to enable GDP growth in the range of 2-4% for a particular modern economy. It seems government transfer payments and efforts to manage inflation arise from efforts to keep the GDP from falling into an output gap as happened in the US after 2007.

      http://faculty.insead.edu/fatas/wall/wall.pdf

      Certain people like the idea of small government and deflation thinking their money is gaining purchasing power while prices of goods fall, but I have yet read about any real world examples of GDP growth with falling prices (deflation) in economic history.

      Delete
  3. "The possibility of this is of course very low but you cannot deny this possibility. "

    If the government does that then that is their choice. But it is not inflation that has caused that, but a simple choice. There is no reason to reduce the ratio. It isn't causing any problems since people are taxing themselves by saving.

    Government can similarly choose to put up tax rates. Is that a default? Or reduce spending on needed health services or education. Is that a default?

    "Households save more as their real wealth erode."

    If they save more, where is the replacement spending coming from that keeps your inflation going? You have to sell something to get a price.

    ReplyDelete
    Replies
    1. "Government can similarly choose to put up tax rates. Is that a default? Or reduce spending on needed health services or education. Is that a default?"

      Fine. It's a choice between outright default and deflating demand and output in my scenario.

      Again, not saying this inflation/default dynamics is a likely event but just pointing out scenarios where it may happen instead of just making slogans.

      Delete
  4. Brian,

    I think there is an important sense in which inflation is comparable to a default. If inflation is higher than it would otherwise be, then it represents a redistribution of relative wealth from private sector bondholders to the public sector. As would a default.

    There is also a parallel between hyperinflation and default in terms of the failure of state finance. A public sector without a sovereign currency fails by defaulting; one with a sovereign currency fails when its currency collapses.

    But you are right that there are lots of ways in which default and inflation are different.

    ReplyDelete
    Replies
    1. Sure, they are comparable in that both are damaging to the interests of bondholders. But then again, so would be any decision by bondholders to buy bonds at crazy levels.

      My objection is to the redefinition of terms that is quite often being resorted to. I have not been involved in a conversation like this, but I have seen things like it. (There was a recent version of this conversation on the internet, but I was not involved.)

      Person X: The debt levels are too high, and the government will be forced to default!

      Brian: Not really, [Insert 30,000 word analysis] In conclusion, default is largely a "voluntary" political decision.

      Person X: But the government will inflate away its debts! That's a default!

      That sort of a discussion is essentially Calvinball.

      Delete
    2. Very good point Brian and my point too. Almost.

      Although I agree that the discussion is essentially Calvinball, except you cannot dismiss it with:

      "Brian: Not really, [Insert 30,000 word analysis] In conclusion, default is largely a "voluntary" political decision."

      Delete
    3. And the reason is that there are various things you and the other person are assuming together in the conversation. The other person has an inflation mechanism that is reasonably probable and in that case the choice is between two bad outcomes not an absolute choice like the way you present.

      So he is right in a way under his assumptions. You have to tell the other person that the inflation mechanism is quite wrong or distant.

      Delete
    4. Ramanan:
      "Although I agree that the discussion is essentially Calvinball, except you cannot dismiss it with:
      'Brian: Not really, [Insert 30,000 word analysis] In conclusion, default is largely a "voluntary" political decision.'"

      My point is that I would expect a response to the arguments in the [30,000 word analysis], not a redefinition of "default"

      Obviously, people could disagree with that conclusion; I stuck "voluntary" in scare quotes as there are missing nuances to my views. (And since I have not completed that 30,000 word analysis, perhaps my views may change.)

      Delete
    5. I agree it's sad that the definition of default is changed but it's just that the person isn't good enough to argue through his own mechanism. My point was that the inflation dynamics should also be corrected. The reason is that if there's a high chance of inflation in that model, then the default question makes sense (although not articulated well by the other person, never mind his own incorrect inflation model).

      Delete
    6. Ramanan:
      In your opinion, what condition or conditions would constitute "a high chance of inflation"?

      Delete
    7. There is only a 'high chance of inflation' if there is spending. The saving in R's scenario negates the spending, because saving is essentially 'voluntary taxation' and has the same effect.

      Delete
    8. There are two models in my comments here.

      The first one is a non-neoclassical in which public debt/gdp rises because of high growth of government expenditure. This arises because the nominal saving rises even though the propensity to consume doesn't rise. While household saving does act as a drain on demand, higher government expenditure more than compensates it.

      The chance of this is low.

      The second model is a neoclassical model in which there is a high chance of inflation. THIS IS NOT THE MODEL I AM ENDORSING. The reason I used the second is that when you discuss this with neoclassical guys, you have to to tell them that this mechanism is wrong. You can't convince them by saying that default is just a political decision.

      Delete
    9. That doesn't really answer MA's question. What level of government expenditure would be required for what is (as of this point) ambiguously referred to as "inflation"? How much spending sustained for how long to generate a "bad" continuous rise in the general price level as opposed to a "good" continuous rise?

      Delete

Note: Posts may be moderated, and there may be a considerable delay before they appear.

Although I welcome people who disagree with me, please be civil.

Please note that my spam comment filter appears to dislike long "anonymous" posts. I get no warning about this, and only go through my "spambox" infrequently. The best bet it to keep comments short, and if you think the spam filter struck, let me know with a short comment.