The Memory Palace of Andy Drucker
Alfred and Mary Marshall and the Confidence Fairy: Annals of the History of Economic Thought

Yes, the Composition of the Government's Liabilities Matters

A history lesson from Paul Krugman:

France in the 1920s: France came out of World War I with very large debts, peaking at 240 percent of GDP… unable politically to raise enough taxes to cover the cost of servicing that debt… investors lost confidence in the government’s solvency. Various expedients were tried, including — late in the game — creation of monetary base, which was advocated by a finance minister on the (very MMT) grounds that the division of government liabilities between currency and short-term bills made no difference. But it turned out that it did: the franc plunged, and the price level soared.

Now as it turned out this was just what the doctor ordered: because France’s budget problem was overwhelmingly the debt overhang rather than current spending, inflation eroded the real value of that debt and made possible the Poincare stabilization of 1926.

So what does this say about the United States? At a future date, when we’re out of the liquidity trap, public finances will matter — and not just because of their role in raising or reducing aggregate demand. The composition of public liabilities as between debt and monetary base does matter in normal times — hey, if it didn’t, the Fed would have no influence, ever. So if we try at that point to finance the deficit by money issue rather than bond sales, it will be inflationary.

And unlike France in the 1920s, such a hypothetical US deficit crisis wouldn’t be self-correcting: the biggest source of our long-run deficit isn’t the overhang of debt, it’s the prospective current cost of paying for retirement, health care, and defense. So such a crisis — again, it’s very much hypothetical — could spiral into something very nasty….

Now, all of this is remote right now. And notice too that France in the 1920s stabilized with debt of 140 percent of GDP — far higher than the numbers that are supposed to terrify us now. So none of this is relevant to the current policy debate.