Remember the 1970s? Stagflation like we saw then could return to the U.S. if unsustainable public debt levels trigger a selloff of government bonds and dollar-denominated holdings, according to a recent study by John C. Cochrane. Cochrane, a finance professor at the University of Chicago’s Booth School of Business, is president of the American Finance Association and is perhaps best known for his response to Paul Krugman’s article in the New York Times on why mainstream economics failed to anticipate the financial crisis.
Currently, U.S. central bankers worry more about deflation than inflation. At its September policy meeting, for example, the Federal Open Market Committee stated that underlying inflation measures are still below the rates associated with maximum long-run employment and price stability. The committee also declared its belief that continued slack in resource utilization means inflation will remain "subdued for some time" before reaching target levels.
The current U.S. inflation rate is 1.1 percent, according to the latest consumer price index report – quite low. The core index less food and energy is even lower, at 0.8 percent.
Meanwhile, Keynesian economists like Paul Krugman are encouraging bigger fiscal deficits, arguing that the slow inflation of the past two years supports the idea that the government's fiscal stimuli haven’t been large enough. The U.S. economy grew at an anemic 1.7-percent pace in the second quarter of 2010, compared to the 2.5 percent most economists say is normal. During this slow growth, Krugman and others note, total government payrolls have actually shrunk. Data show that 350,000 jobs have been lost across all levels of government since President Obama took office in January 2009, as state and local cuts have dwarfed a small increase in federal employment. Government purchases of goods and services rose just 3 percent per year over the past two years – an even slower pace than before the recession. It isn't that economic stimulus hasn't worked, Keynesians say, it's that it hasn't been tried.
Cochrane replies that Keynesians underestimate the risk of sovereign default, not to mention the inflation it could cause. Echoing the arguments of austerity-minded policymakers on both sides of the Atlantic, Cochrane writes that, even though the current situation is bad, a default on U.S. federal debt – or even a threat of one serious enough to set off a panic in the Treasury bond market – would be a "nightmare." Countries such as Greece, Portugal and Spain have already demonstrated that the threat of sovereign default is real, as are the consequences in the bond market for countries that fail to control their debts. If our economic growth rates continue to lag, the U.S. could be next.
