[This is the fourth part of a series (1, 2, 3) on sovereign deficits and debt. The series was started in response to Ed Dolan’s original post detailing agreements and possible disagreements with the MMT approach.]
To recap very quickly, we agreed that sovereign government cannot become “insolvent” and forced to involuntarily default on commitments in its own currency. We moved on to “math sustainability” and agreed that so long as the interest rate paid on sovereign debt is below the GDP growth rate, then government does not necessarily face explosive growth of deficits and debts. And we agreed that the overnight interest rate is a policy variable, so that the central bank could keep it below the growth rate if desired. And we agreed that Treasury could use a “debt management” strategy to ensure that its average rate paid would be “low”—near to the Fed’s target rate, and if the Fed was pursuing a low rate strategy then on likely growth rates usually used in these types of models then the Treasury’s rate paid could be kept below the growth rate.
(Of course in recession the growth rate can go below zero but the interest rate would remain at zero or above; however this argument about sustainability is about the long term, not about cyclical problems.)
Now that always leads to the question: but if the Fed did pursue such a low interest rate policy, we’d get inflation that would force the Fed to raise its target rate above the growth rate to fight the inflation. Here was my one sentence response from last week:
“Here’s the preview: if deficits increase inflation rates, then “g” (GDP growth rate) rises so that even if the Fed raises “r”, we can keep g>r.”
Ed Dolan responded in the comments section this way:
“I think the part that will be more interesting to me is coming in Part 4. It will need to explain two things:
1. Even if it is possible always to keep g>r (both nominal) as inflation accelerates, would we really want to do so? Is there always some steady rate of inflation that guarantees g>r, or does it take continuously accelerating inflation? Are there any conditions under which accelerating inflation itself can undermine real output growth?
2. Suppose inflation is initially triggered not by monetary policy, but by an exogenous shock to real output (say, a natural or man-made catastrophe), or by attempts by the government to increase spending even after the economy has reached full employment (as in the “mission to Pluto” example of your MMT text). How can we be sure that the monetary policy operations needed to hold interest rates at an arbitrarily low nominal level will not induce further inflation?”
So let us begin to answer these questions. Today I’ll tackle question #1, or at least part of that question. continue reading…