In the 2008 comedy Mad Money, three employees of one of the regional Federal Reserve banks begin stealing worn-out cash that’s about to be shredded and taken out of circulation. A good exam question based on this story might be: who is the victim of their theft? The answer isn’t obvious. After all, the cash is going to be destroyed — what’s the big deal if they take it? The problem is that when they spend that cash on actual goods and services, they drive up prices and reduce the purchasing power of everyone else’s cash. That’s how inflation works.

For more than a decade, policymakers have downplayed the risk of inflation, with the Fed keeping interest rates low and the federal government racking up unprecedented levels of debt. Although there are some hopeful signs in the most recent data, we’ve still been facing higher inflation than we’ve seen in decades — 8.5 percent between July 2021 and July 2022 — forcing policy makers to reckon with the consequences of their choices.

In this essay, I consider the impact of the current macroeconomic environment on fiscal policy, the federal debt, and individual well-being. First, I explain that inflation triggers a large transfer from the private sector to the federal government. This “inflation tax” also redistributes income in an arbitrary and opaque way that harms vulnerable groups. Second, I discuss how higher interest rates may affect government borrowing costs. Finally, I argue that the current situation underscores the urgent need to bring the federal fiscal imbalance under control.

The Inflation Tax

In 1919, John Maynard Keynes wrote:

[Vladimir] Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, Governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth.

Inflation imposes two types of taxes.

First, unexpected inflation — of the sort we’re experiencing now — transfers money from lenders to borrowers because it allows borrowers to repay loans using dollars that have less purchasing power. To elaborate, money only has value to the extent that it represents claims on goods and services. By eroding the purchasing power of money, inflation allows borrowers to repay loans with a smaller sacrifice of goods and services than they expected. On the other side of the transaction, lenders who receive the loan payments gain the right to buy fewer goods and services than they expected.

As a borrower, the federal government benefits from this redistribution. Most holders of government bonds receive interest and principal payments that are fixed in nominal dollars. (Although the government issues some inflation-indexed bonds, they account for only about 7.5 percent of the outstanding debt.) Therefore, inflation allows the government to make smaller payments — in inflation-adjusted terms — to its creditors. For this reason, some economists have noted that the government’s decision to permit a higher inflation rate is similar to a partial default on its debt.

This transfer from lenders to borrowers is temporary because it occurs only for inflation that was not anticipated at the time a bond was issued. If lenders anticipate inflation, they will build that into the interest rate they demand from borrowers. Therefore, going forward, interest rates on newly issued debt, including government bonds, are likely to rise to reflect higher expected inflation, unless lenders expect the government to quickly bring inflation under control.

Second, inflation — even when it’s anticipated — functions as a tax by eroding the purchasing power of assets that don’t pay interest and certain types of income that don’t keep up with inflation. Affected assets include cash and zero-interest checking accounts. While the exact mechanism is complex and opaque (and a full treatment is beyond the scope of this essay), the government effectively collects the inflation tax on these assets by using newly created money to purchase goods and services. Affected forms of income include Temporary Assistance for Needy Families (TANF) benefits and the after-tax income of people affected by provisions of the tax code that aren’t indexed for inflation.

Last year, when the inflation rate was 5.4 percent, my American Enterprise Institute colleague Paul Kupiec estimated that these two forms of the inflation tax resulted in the transfer of at least $1.9 trillion from the private sector to the federal government. No doubt that transfer has grown since then.

Like any other tax, inflation distorts people’s choices, incentivizing them to take steps to protect themselves from rising prices. For example, people may be discouraged from keeping their wealth in conveniently accessible forms like cash or checking accounts, searching instead for investments that won’t be eroded by inflation. Unlike many other taxes, unexpected inflation is unpredictable, which further dampens economic activity. Like a well-functioning court system and decent infrastructure, sound money is a public good that is vital to the functioning of the economy.

While the inflation tax impacts everyone, its burden is particularly large for vulnerable groups. For example, inflation disproportionately harms the 5.4 percent of households that don’t have access to bank accounts and must keep their savings in cash, as well as recipients of TANF benefits. Indeed, Austan Goolsbee, chairman of the Council of Economic Advisers during the Obama administration, has argued, “The pain associated with inflation may be the most acute for those at the bottom.”

Interest Costs

The economic burden of financing the national debt depends on the real interest rate — i.e., the interest rate net of inflation. For example, suppose the government borrows $100 at an interest rate of 5 percent and repays the principal plus interest — $105 — the following year. On the other side of this transaction, lenders sacrifice $100 today in exchange for $105 next year. If inflation over this period is 2 percent, the purchasing power of the $105 that the government pays — and lenders collect — next year will be 2 percent lower. In this scenario, the true interest rate that the government faces — in terms of lost purchasing power — is only 3 percent.

For almost a decade prior to the pandemic, real interest rates on government debt (as measured by the yield on inflation-indexed government bonds) had been at historically low levels. Real rates dipped into negative territory when the pandemic began and have recently risen to pre-pandemic levels. The low real interest rates of the past decade kept federal interest costs manageable despite growing federal borrowing. However, financing the debt will become more burdensome now that interest rates have returned to their pre-pandemic levels.

It’s beyond the scope of this essay — and my expertise — to speculate about where interest rates might go over the next decade. But even if real interest rates remain at historically low levels, a large and growing national debt poses a serious threat to the economy by crowding out private borrowing, making it harder to respond to challenges like wars or pandemics, and increasing the risk of a financial crisis in which creditors lose confidence in the government’s ability to repay them.

Another serious concern in the current environment is that even if safe real interest rates remain low, the real interest rates paid by the government may go up because the threat of unexpected inflation causes creditors to no longer view lending to the government as safe. That’s because — as noted above — inflation is very similar to a partial default on any existing debt. If the current inflationary episode causes investors to worry about future inflation risk, they are likely to demand higher interest rates to compensate for that risk. That concern highlights the importance of quickly bringing inflation under control and credibly committing to low and stable inflation going forward.

Fiscal Policy Going Forward

Long before the pandemic began, economists on both sides of the political spectrum had been expressing serious concern about the large and growing federal debt. Economists have also emphasized that bringing the fiscal imbalance under control will require hard choices: higher taxes (not limited to those with very high incomes), lower spending, or some combination of the two.

Although inflation transfers resources from the private sector to the government — much like a tax — it’s a terrible way to deal with the fiscal imbalance. The inflation tax is imposed arbitrarily and without democratic debate. It imposes unfair burdens and creates uncertainty that could undermine the government’s ability to borrow in the future. Indeed, the current economic environment underscores the need to address the growing national debt now, lest investors begin to fear that the government will print money to effectively default on it in the future.

In a November 2020 article in Tax Notes Federal, Alan Viard and I wrote, “The fiscal imbalance remains a pressing problem, which Congress should address as soon as the pandemic recedes.” That time has now arrived.

 

Acknowledgments: I thank Slavi Slavov, Michael Strain, and Alan Viard for helpful comments.