Monday, March 11, 2013

Hamilton on the Fiscal Crunch

The third post in a row about this important subject. According to James Hamilton:
A fiscal crunch would force a central bank to pursue inflationary policies, a situation that's called fiscal dominance. If the Federal Reserve does not monetize the government debt (by purchasing it or, in other words, by printing money), then interest rates will rise sharply as private lenders demand a higher rate. These higher interest rates will cause the economy to contract. Indeed, without monetization, the government could end up defaulting on its debt, which would lead to a financial crisis, producing an even more severe economic contraction. The central bank would be forced to purchase ever increasing quantities of government debt by printing money, eventually leading to a surge in inflation.  ... The grave scenarios we outline here do not have to happen. Since the debt-to-GDP ratio is likely to stabilize over the next few years, there is time to avoid the dire potential problems we have highlighted. But with the gross-debt-to-GDP ratio already well above the 80% threshold-- and likely to resume a steady climb by the end of this decade-- the clock is ticking.

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