The Next Age of Uncertainty by Stephen Poloz

Author:Stephen Poloz [Poloz, Stephen]
Language: eng
Format: epub
Publisher: Penguin Canada
Published: 2022-02-22T00:00:00+00:00

The Debt-Inflation Interaction

The long history of the relationship between government debt and inflation is pretty clear: large build-ups in government debt have historically been followed by outbreaks of inflation. Obvious examples of the relationship can be seen in individual countries, such as Germany in the 1920s or Argentina in the early 1980s. The intimate relationship between a government and its central bank always raises concerns at such times. A central bank is the banker for its government and has the power to create new money. Central banks create new money all the time, by buying newly issued government debt and giving the new money to the government to spend. Provided this is done in pace with the rate of economic growth, inflation will remain low and stable. But if the government is issuing debt at a rate faster than financial markets believe is sustainable, markets can get indigestion, interest rates rise, and the government can hit the wall at some point and be unable to sell more debt to the market. If the central bank relieves this constraint by purchasing a rising share of new government debt, the creation of new money can easily outpace the economy’s need for it. If this happens, Milton Friedman’s parable of “too much money chasing too few goods” plays out, and inflation rises.

This intimacy of the relationship between a government and its central bank is necessary: the government owns the central bank, the central bank is the banker for the government, and their balance sheets are intertwined. To create new money for the economy, the central bank must purchase government debt—that is how its balance sheet balances. But the potential for danger in this relationship arises not only when government debt is rising unsustainably. Governments are always looking ahead to re-election, and happy voters tend to keep incumbents in office. What makes voters happiest is a strong economy, where jobs are plentiful and wages are rising. This gives governments an incentive to try to boost the economy with extra spending in the period leading up to an election. If the stimulus is too great, and inflationary pressures rise, chances are the voters will not know until after the election.

This tension is why central banks in most advanced countries are given operational independence to pursue targets for inflation. As an extra safeguard, the terms of central bank governors are generally independent of the electoral cycle. If a government stimulates the economy excessively just before an election, an independent central bank with its eye on future inflation pressures will raise interest rates, keep economic growth steady, and essentially offset the government’s efforts. Governments are generally accepting of this system of checks and balances—but not always and definitely not everywhere.

As discussed in chapter 5, global government debt has been rising steadily in the last twenty years and ballooned during the COVID-19 crisis. Central banks worked closely with their governments during the crisis, often purchasing extraordinary amounts of government debt in order to stabilize financial markets and counter the collapse in economic growth.

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