(Originally posted here.)
My colleagues Betsey Stevenson and Justin Wolfers provocatively argue that Representative Paul Ryan, the Republican Party’s de facto spokesman on economic policy, is “an inflation nutter” because he is concerned that future budget deficits may lead to rapid price inflation.
Stevenson and Wolfers contrast Ryan’s fears with the market’s expectations of inflation, as expressed by the difference in yields between normal government bonds and inflation-indexed equivalents. This “breakeven” represents the average annualized inflation rate investors would be willing to tolerate to be indifferent between the two types of bonds.
Right now, America’s 30-year breakeven inflation rate is just under 2.6 percent. The Consumer Price Index has not grown that slowly over a 30-year period since the Great Depression. In other words, if the markets are right, there is no reason to worry about inflation any time soon.
But the markets have been wrong before. Ryan’s views, right or wrong, are supported by a very distinguished group of academic economists, including Christopher Sims, who won the Nobel Prize in 2011 for his work on macroeconomics, and Michael Woodford, who is often cited as one of the world’s leading monetary theorists. Starting in the 1990s, various scholars began formalizing the “fiscal theory of the price level.” Woodford described this in a 1995 paper:
Fiscal policy affects the equilibrium price level for a simple reason. An increase in the price level reduces the real value of the net (outside) assets of the private sector, or equivalently, the real value of net government liabilities, assuming that there exists a positive quantity of nominal government liabilities (including, but not limited to the monetary base). This reduction of private sector wealth naturally reduces private sector demand for goods and services, through a straightforward wealth effect. As a result, there will typically be only one price level that results in aggregate demand that equals aggregate supply. Changes in expectations regarding future government budgets have similar wealth effects, that require an offsetting change in the price level in order for equilibrium to be maintained.
One thus arrives at a theory of price level determination in which government fiscal policy plays the crucial role, both because the effects of price level changes upon aggregate demand depend upon the size of the outstanding nominal government debt, and because of the wealth effects of expected future government budget deficits. Furthermore, the effects of fiscal policy changes on the equilibrium price level are largely independent of any changes in the path of the money supply that might be associated with them.
John Cochrane, of the University of Chicago, wrote a very readable essay that tackles these issues in greater detail. Those interested in the full scholarly treatment should read this, this, this, this, this and this.
The interesting question is whether the fiscal theory of the price level actually makes sense. I have three thoughts:
- The distinction between public debt and private debt seems overdone. All debt creates repayment burdens. Highly-indebted private debts often become “socialized,” either directly through bailouts or indirectly through a mix of government transfer payments and accommodative monetary policy.
- Irving Fisher convincingly argued that debt can just as often be deflationary as inflationary because large repayment burdens limit new consumption and investment. That said, deflationary episodes associated with high levels of indebtedness generally end with a surge in prices. America’s CPI soared at an annualized rate of 7.6 percent from 1941 through 1947.
- Inflation is actually a very vague concept. The largest component in the CPI is “owners’ equivalent rent.” It is based on a survey of what homeowners would pay to rent their homes, rather than any price paid in the markets. Armen Alchian and Benjamin Klein argued that the price index ought to include things people buy to save for their retirement. That would produce a very different set of numbers. Another issue with inflation measurement is the way changes in quality translate to changes in value. That is all well and good when it comes to the price of televisions, but the statisticians at the Bureau of Labor Statistics cannot really measure quality changes (in either direction) when it comes to services like education and health care.
Mr. Ryan may be many things, but “inflation nutter” is not among them.
(Matthew C. Klein is a contributor to the Ticker. Follow him on Twitter.)