How Increasing the Deficit can Reduce National Debt – Inside Money and the Inflation Effect

I’m setting down here a counter-intuitive proposition.  That a medium term intense burst of increased public spending deficit can dramatically reduce national debt – even if you (falsely) believe in a Friedman-Phelps version of expectations and ricardian equivalence.

It is a simple exercise in debt dynamics and relies on a proposition that MMTrs and believers in the fiscal theory of the price level such as Williamson and Cochrane could agree on. That proposition being that a fiscal deficit only ever has an inflationary impact if matched by accomodative monetary policy by a central bank.  Otherwise treasury/bond creation is just a transfer payment.

The impact of a deficit increase on the present value of the national debt is simply the NPV of the interest payments of that deficit.

Lets say an increase in deficit was matched by creation of inside money leading to inflation.

Then the change in the present value of the national debt is equal to the NPV of the interest payments on the current debt at current interest and inflation levels minus the NPV of the interest payments on the current debt at the  interest and inflation rate following the change in fiscal and monetary policy + NPV of the interest payments on the new deficit following the change in fiscal and monetary policy.

If the increase in deficit is relatively small to the overall level of debt, if increase in inflation is relatively high, and less than any change in interest rates (and in a sovereign currency  CB can achieve any interest rate it likes in the debt markets) then the NPV of the debt will decline not fall.  This is before you have considered ANY effect of the debt on national income and growth and any multiplier effects.   Factor those in and the fact that debt is nominal whilst growth effects are real and over time the debt pays for itself.  This I think was what Abbe Lerner was getting at.  Even if the level of deficit is relatively high compared to the level of debt keep such a policy up for several years and the debt will rise sufficiently for this inflation effect to kick in.  What we are doing is is using the underlying monetary dynamics to force you back onto a benign phillips curve relationship, even when you are off it.

After a number of years the shrinkage in the real value of the debt through inflation would be sufficient to pay for payments to losers in such a policy (elderly savers) ensuring pareto optimality.  One of the best ways of doing so would be to use the deficit to pay for a basic income scheme that increases as people age.

Do the math, work out the debt dynamics.   A short bout of inflation ensures that debt pays for itself.

One thought on “How Increasing the Deficit can Reduce National Debt – Inside Money and the Inflation Effect

  1. Congratulations Andrew for acknowledging in print that you are a nascent Social Crediter by virtue of suggesting half of Social Credit’s monetary mechanisms. Your scheme however will not work because even if you leave the economy completely alone it will still create a higher rate of flow of costs/prices than it creates a rate of flow of individual incomes….and so we’ll be right back in the soup of erosive inflation and debt build up. Oh, and of course in addition to this internal systemic effect, innovation and artificial intelligence which are actually just getting started, will acceleratingly reduce aggregate demand as well. You and Keen and every other economist and pundit are all nascent Social Crediters.

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