Fiscal stress and inflation.

• Author: Leeper, Eric M.

There is growing concern that inflation worldwide is rising. Among the factors that are cited as potential contributors are expansionary monetary policies in the United States, the United Kingdom, and the Euro Area; rapid economic growth in emerging economies; and increases in value-added taxes and commodity prices. In a sequence of recent papers, I suggest another potential culprit: looming fiscal stress and uncertainty about how policies will adjust to resolve that stress.

Populations in advanced economies are aging and governments have promised substantially more old-age benefits than they have made provisions to finance. The table below summarizes the "unfunded liabilities" problem that countries face. Overall, the G-20 countries have made spending promises that exceed financing plans and reach as much as 400 percent of their GDP. When the Congressional Budget Office rolls spending commitments and current revenues into debt accumulation, its debt projections are similar to those shown in the figure below. (1)

What happens next is uncertain. Some policies must adjust, and the fact that bondholders continue to value U.S. federal debt implies that investors expect that policies eventually will adjust. The eventual adjustments will be large. My coauthors and I are therefore pursuing a line of research with three key features: 1) policy regime changes can and do occur; 2) the timing and nature of future regimes are uncertain; and 3) a complete picture requires studying fiscal and monetary policies jointly. (2) Each factor operates strongly through expectations.

To motivate this research, some background on monetary-fiscal interactions is helpful. At a general level, monetary and fiscal policies have two tasks to perform: control inflation and stabilize the value of government debt. There is a beautiful symmetry between the two policies. The conventional assignment--call it Regime M--tasks monetary policy with controlling inflation and fiscal policy with stabilizing debt. But an alternative assignment--Regime F--has monetary policy maintain the value of debt and fiscal policy control inflation. Regime F characterizes the U.S. policy mix leading up to the 1951 Treasury Accord and, arguably, describes recent policies. (3) Many economists regard Regime M as the normal state of affairs and have studied it extensively.

Macroeconomists often equate Regime F to Sargent and Wallace's (1981) "unpleasant monetarist arithmetic" regime. They infer that...