Stimulate Now: On Inflation and Deficits

The debate about deficits continues (see Ezra Klein for a handy breakdown of 4 different perspectives) with Paul Krugman recently outlining his view, followed by an exchange between ND20 contributor James K. Galbraith and Krugman. Below, Roosevelt Senior Fellow Jeff Madrick, also an ND20 contributor, gives his take.

Some have suggested that if a country nears the point that it must consider default, that is, it can’t generate enough tax revenues to pay debt and meet other minimal commitments, then all it need do is create reserves if it has a sovereign (aka ‘fiat’) currency.

But in most such circumstances, such a thing will incur inflation. Now, the level of inflation is part of the issue, if is high enough. But the direction of the level of inflation is more important. That is, does it suggest ever higher inflation?  Paying back the debt in devalued dollars amounts to a de facto default. The government might not incur trouble from a legal standpoint, but if the financial squeeze of the country is great, the markets will react as if it is a default and creditors will demand higher rates for the next round of debt and a tragic spiral of further money printing and inflation could ensue.

To believe that creating of reserves can work if a country is nearing default requires a belief that nations in such circumstances will retain confidence in their currencies and not incur inflation.  How do we know that? Paul Krugman’s response to James Galbraith on this point is, in m view, basically correct. Galbraith has expressed concern that those who do not subscribe to the view that long-term big deficits will almost never be a problem are potentially threatening Social Security. But the real issue is whether the US will get close to default threats. In my view, it only will if we do not stimulate now. Our energies should be focused on that, and I would like to see more macro models with various Keynesian multipliers and accelerators to show how much growth we need to reduce long-term debt, and not just rely on the CBO model.

Roosevelt Institute Senior Fellow Jeff Madrick is the author of The Case for Big Government.