Ricardo Reis on Central Bank Swap Lines, Fiscal Sustainability, and Outlooks for Inflation

Ricardo Reis is a professor of economics at the London School of Economics and a returning guest to the podcast. Ricardo rejoins Macro Musings to talk about central bank swap lines, the importance of fiscal sustainability, and the outlook for inflation in advanced economies. David and Ricardo also discuss safe asset alternatives, and how to think about inflation, debt, and deficits in a more nuanced way.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Ricardo, welcome back to the show.

Ricardo Reis: Thank you very much. I'm glad to be here.

Beckworth: Oh, it's great to have you on, and I was checking as I got ready for the show that you were on this show back in 2017, almost three years ago. A lot has changed since then. And I believe back then we were talking about macroeconomics, defending macro from all the critics coming out of the great financial crisis. You had a nice paper you'd written about this, and it was a great conversation. So I will encourage our listeners to go out and listen to that show, if you haven't already. And also preparing for this show, Ricardo, I was looking at your website and all your papers and man, you are prolific. You write a lot. You have a lot of serious hardcore papers, and a lot of them, just the volume is amazing to me. So, I want to start off today, before we get into the hardcore topics I mentioned and talk about your production function. What is in your production function when it comes to all this research that you're doing?

Reis: Sure, I mean, I would start by saying that I write about many things because I'm curious about many things, and research is very hard and research could be a lot of work and very painful because most of the times you're learning that your intuitions were wrong. And so, it's very important for me that I do research on questions that I care about that I find interesting. So I guess the fact that I write a lot is simply a function of my curiosity. More in terms of if you want my production function in terms of how it gets done, I'd say that there's two approaches possible out there. I know some people who are very good at intertemporal substitution or intertemporal smoothing. They just work on five projects at the same time, and they keep them going, and they're very good at organizing.

Reis: I have to say I'm the opposite. I'm an increasing returns to scale guy. I just get excited about something I work on it like crazy for a week. I don't answer any emails, people get very angry at me, and then I get it done. And then I move to another question that I'm excited [about] and so on. So, I'm a total plunger in terms of my production function. Not to say that others should be like me.

Beckworth: Okay. And so, when you get on a project, you're all consumed in it, and you just dedicate yourself to it. And how have you been able to do that over the past year with the pandemic? I know we've all been locked up at home, you're in the UK, even more so there. I believe here in the US in many places. So, how are you functioning? I mean, what's it like for you? You got Brexit, you got the pandemic? What is life like for you there?

Reis: Well, life has been challenging as for many. At the same time, I think, one, I have to admit that my life is pretty easy. My income didn't fall. So many people have lost income. So many people have had health problems. And I've been fortunate so far in that while we've had some health problems in the family, none of them turned out to be too serious. And income wise, the luxury of having a relatively permanent job that I've been able to keep on doing through Zoom just meant I didn't suffer through that.

Reis: I think the one thing that has been more noticeable is that I've had now to be engaged through school lockdowns on producing human capital at home. And even though I used to think that I was a somewhat competent teacher, at least judging by student reviews and evaluations, I have now learned through two very demanding students that I am an absolutely terrible teacher. Now there is more about pedagogy than content. I've learned that my pedagogical skills are very low. So I hope, I think my college students like it because the content is good, but pedagogically I turned out to be very poor.

Beckworth: Well, that's awesome. So Ricardo, the great macro economist is also a parent learning the ropes of homeschooling, like all of us over this past year. That's great. Well, I have you back on today, Ricardo because you've done some fascinating work on the dollar swap lines that the Fed implemented during this last crisis in March, last year, as well as you've done work on the previous use of them in 2008/2009, and after that. I want to get to that, get to fiscal sustainability, which has been a hot topic now with new calls for additional fiscal relief. And then, time permitting, we'll get to inflation in the advanced economies. But let's begin with the central bank swap lines. And you've written several articles on this. You have a 2020 article titled *Central Bank Swap Lines*, another one, *Central Bank Swap Lines During the COVID-19 Pandemic.* And we'll provide links to those, but maybe just walk us through the basics of it, what are they? How do they work? And what was your assessment of their success overall?

The Basics and Results of Central Bank Swap Lines

Reis: Sure. Look, actually segueing from the previous answer to your question. So I started working on this because a few years ago, I had to discuss a paper on the new international financial system, written by Jeromin Zettelmeyer, I think is now at Peterson and Beatrice Weder di Mauro, and they mention these swap lines, and I had heard of them, and I had seen them and people talk about how they alleviate funding pressures was what everyone wrote. And I had no idea what those three words meant, alleviate funding pressures.

Reis: And so, that's how I started working on that. Partly also spurred by a discussion with Richard Portis, where I thought I knew what alleviating funding pressures was, and he told me that I was completely wrong. And so I spent a few months thinking about it. And I think I figured out what the swap lines do and how they work. So let me share with you. I think the simplest way to think about it is that the swap line is a lender of last resort, discount window type loan by the Fed to a foreign bank. Now, why is this a swap line? Because if I'm a domestic bank, in the US, in New York, and I want to borrow from the Fed, I just go to the discount window, that's just how it works. Or maybe tax savings, 2008 or '09. But if I'm a foreign bank, I don't have an account to the Fed.

Reis: So instead, we came up with the swap lines, which are basically where the Fed lends the dollar, say, to the Bank of England, and the Bank of England then lends them to the UK based bank. Still, it is a lending operation, it is a lender of last resort. What happens when we put the foreign central bank in the middle in my example, the Bank of England, is that now that central bank is going to take on all the default risk from the loan. If the British bank doesn't pay, well, the Bank of England is the one who's on the hook because through the swap line it's given pounds to cover any risk from the Fed. But it also means that the Bank of England is the one doing all the monitoring, choosing who should get a loan, which banks are eligible, which collateral they should give, and so on.

Reis: So you've just introduced an intermediary, which if you think about it makes perfect sense that you would do that. Because after all, the Fed doesn't know if this English bank is reputable, whether it's borrowing for good or bad reasons, whether it will pay back, but the Bank of England does, it's its regulator. So, in some ways, it's a very natural arrangement to do. So, that's the mechanics of how it works. Whenever you hear swap lines, just think of the Fed lending to a foreign bank using the foreign central bank as the monitor, as the guy who bears all the risks.

Whenever you hear swap lines, just think of the Fed lending to a foreign bank using the foreign central bank as the monitor, as the guy who bears all the risks.

Reis: Then in terms of how they work, if you want terms of the economic consequence, the first economic consequence of any lender of last resort of any lending facility by a central bank is that it puts a ceiling on interest rates. If the Fed says I will lend at 5%, then no other similar overnight relatively risk free interest rate among banks will be above 5%. Because why the heck would I borrow from someone at 6% if I can borrow from the Fed at five for, again, equivalent loans, different types. Well, with a swap plan, and this is the insight that Saleem Bahaj and I had was, “hold on, once you understand it's just a lender of last resort, it has to be putting a ceiling on some market price out there.” There's some interest rate there that has a ceiling.

Reis: What we figured out in that paper is that that ceiling is on the cross currency basis, also known as that covered interest parity deviations. Why? Because what those covered interest parity deviations, what this cross currency basis measures is nothing but the cost for me as a UK bank if I want to borrow dollars, but all I can do is borrow pounds from my Bank of England. Well, those CIP deviations are exactly what I have to add to my cost of borrowing in pounds to get the cost of borrowing in artificial dollars. Because what these cross currency basis measure is precisely my ability to do pick up pounds, turn them into dollars today, and return dollars tomorrow without having any risk in terms of exchanges. So how do they work? They're basically a lending facility of a central bank to foreign banks with the risk all in the foreign banks. What effect do they have? They put a ceiling on CIP deviations.

Reis: Now, if you think about the data, then from this perspective, why didn’t they show up in 2008, and '09? There were almost no swap lines before. Well, precisely because if you recall going back to history. History, I guess, 12 years ago is history now. We had... This was at a time when the Fed had started this TAF program, the term auction facility where it would lend to banks and found that the subsidiary of all these foreign banks were the bulk of the program. So essentially Paribas, and Lloyds, and [inaudible] were borrowing gigantic amounts through their small little branch in the US, which again, is probably not the ideal way to do that, and so far as the big regulator of these banks is abroad. So, that's number one.

Reis: And number two, this was a time when CIP deviations had skyrocketed. They had become very high because of problems in the agents that sell foreign contracts and currency. We had that those costs have gone up a lot. Lo and behold, we do the central bank swap lines. TAF was closed down. We can do the borrowing pushing all the risk into the foreign central bank and we control the CIP deviation.

Beckworth: Is it fair to say then that the Fed effectively set up branch offices across the world in these central banks?

Reis: Yes, in a mechanical way, but not fair to say it precisely on this risk perspective is that the Fed rather than opening a branch office found an agent out there who'll do all the work for it in terms of again monitoring lending to the public who would bear all the risk. In some ways, and perhaps only slightly provocatively, the swap lines are a better deal for the Fed than its own discount window. Why? Because if anything goes wrong, the foreign central bank is the one who bears the risk. Likewise, who does all the work, the foreign central bank. All the Fed does is lend some dollars to the Bank of England, gets a bunch of pounds as part of the swap. If something goes wrong, it turns the pounds into dollars, doesn't lose anything, and doesn't do anything else. It doesn't have to monitor the Bank of England, doesn't have to assess collateral, it gets a very easy job. So I think it's better than a branch. It's more like having someone do your work.

In some ways, and perhaps only slightly provocatively, the swap lines are a better deal for the Fed than its own discount window. Why? Because if anything goes wrong, the foreign central bank is the one who bears the risk.

Beckworth: That's a great perspective, and I've thought about this as a win-win for the Fed and the US in general, and I want to raise this point. By doing what it did with the central bank swap lines, as well as the other liquidity facilities, the Fed was effectively backstopping the global dollar funding system. And it had to, and maybe we can talk about it in a minute whether this is a great arrangement or not, but it had to step in, otherwise, the outcome would have been far worse than what we experienced. But by doing that, and you can correct me if I'm wrong here, but by doing that I think one can argue that on the margin, investors around the world in the future will be more willing to hold dollars in their portfolios or dollar denominated assets in their portfolios because they know the Fed will always be there to backstop the global dollar funding market.

Beckworth: So that increases the demand for dollar denominated assets, which on the margin means more seigniorage flowing into the US. Some people looked at this and said, "Oh, we're going to have maybe inflation. The Fed's out of control. And I thought the opposite, the Fed has actually solidified the global dollar funding system. It increased seigniorage flows to the US financial system. And if you take that point, and the point you made about the central banks overseas bearing the risk, I mean, it looks like a win-win for the Fed.

Reis: It is really a win win-for the Fed, I think. Let me expand a little bit on what you said. Ultimately, why do you need a lender of last resort? Well, you need it when your ability to borrow in the markets, the lenders out there disappear, for some reason. It becomes very expensive to land from them. And so, why again, were these swap lines important both in 2020 as well as all the way back 10 years ago, precisely because this was the time when these money market funds 10 years ago, they usually lend dollars all over the world, stop lending them or simply withdrew some of those loans and made that credit hard. So it was hard to get a dollar loan. And what you had was you had a lot of international investors then, and by the way still now, they borrow heavily dollars from us money market funds to sustain their operations.

Reis: And so, yes, what you said is, I am now much more comfortable borrowing in dollars because I know that lender of last resort, if the market isn't there, the bank isn't there, I can always get it from the Fed via my central bank. That gives me a lot more certainty in being able to conduct all operations. But moreover, let's look at the other side, David, which is why do you borrow in dollars? Well, many cases, because you want to make investment in dollars. You're borrowing in dollars to sustain operations in dollars, that means you want to buy dollar assets. And actually, what I found in the second part of this paper that I wrote with Saleem was that we look precisely at all of these foreign banks, how much they were holding of US assets. We have very good data on corporate bonds. We wish we could have done MBSs because those are so important. But at least in the corporate bonds, we could do, I think, a pretty good job identifying the effects.

Reis: But what we found is that by setting up the swap lines, and in our case, by making them a little deeper, what the Fed did was prevent sales of corporate bonds. We see big effects on how much these UK banks were willing to buy US corporate bonds, hold them, or since 2010 sell less of them. In other words, in 2009 and '10, the Fed prevented the fire sales of MBSs, corporate bonds, and others that were happening in the [inaudible] US financial market, precisely by providing this backstop lending. And so, one, you've encouraged others to use your dollar, dollar loans, to your point. But two, you're protecting your domestic financial markets from a fire sale in a crisis, which is exactly why we have lender of last resorts in the first place to prevent those fire sales domestically. But now we have to take into account this fourth dimension.

Reis: Finally, and still along the lines of what you said. Well, if the Fed in many ways I think it is a win-win, but what about the other side when we look at the other foreign central banks? In here, there it's a little less clear because ultimately, look, what you're doing by offering these swap lines is encouraging your UK bank in the case of the Bank of England to indeed, "Hey, let's invest in dollars and borrow in dollars." But of course, when problems come, you the Bank of England is the one who has to deal with these banks, and when they get in some trouble. You've encouraged them to bear and create exchange rate mismatches in their balance sheet. You're potentially leading to mismatches in your financial system. And at the same time, like you said, you are supporting dollar dominance because you're allowing the dollar market to work. Although there I wouldn't say that's necessarily a loss for the UK or a win, but at least it's more of a win-win for the others.

Reis: Interestingly, David, actually, in the history of swap lines, if you go way back and Catherine Schenk has fantastic work on this. Already when the swap lines appeared in the '60s and '70s, it was the Fed that had to convince the foreign central banks to adopt these things, rather than the other way around. Now, of course, exposed in a crisis when you're in the middle of it in 2009? It is the Bank of England that says, "Let's please do these swap lines because I don't want my bank to fail." But exempted, when you're thinking about the incentives you create, the fact that you are the one bearing the risk, you are the one bearing the cost, then you're much more reluctant to do it.

Reis: And indeed, David, we have even a very recent illustration of this, which was when the Fed back in March extended the swap lines. That worked well, many central banks used them. We saw large effects in diminishing CIP deviation, substituting dollar funding. But the Fed also created this Treasury repo facility, which was another way to say, "I will lend to you now more foreign official sector if you just instead of selling your treasures, deposit them with me." And what did we see? That was essentially, that was a swap like new facility in the sense that it's another lending facility with different features. And what do we see in this FIMA repo facility is that the foreign institutions this time said, "Thank you, but no, thank you." And that was barely used. And in that case, the Fed was not able to convince the others to use that. At that point, we were trying to stabilize not the corporate bond or the MBS market, but the Treasury market itself.

Beckworth: So that's interesting, Ricardo. So from the US perspective, it is a win-win for the central bank, for the Fed. But for central banks overseas in advanced economies, it's a little bit trickier. The costs are a little more pronounced. And let me segue into another observation in question related to this that you've touched on. And that is the dollar swap lines were part of a broader liquidity response, right, we had primary dealer, credit facilities, commercial paper facilities, money market facilities, all of these attempts were to stem a run on what I'll loosely call the global shadow banking system or global dollar funding system.

Beckworth: And so, I've had guests on the show who don't like that. They don't like the fact that we regulate the banks in the US, and they got to have certain capital requirements. They have FDIC, but then you get these shadow banks around the world overseas, maybe even some in the US that have branches overseas. And it's a workaround, and the reason they don't like it is because as you said, it encourages on the margin more dollar holding, investing, and therefore, more susceptibility to a run in the future. The more dollars are used, then the more you're going to rely on the Fed. Unless you get some new Basel arrangement where you can go after shadow banks, it's really hard to see this path going in a different direction. So should we be worried that the Fed is so effective at doing this?

Reis: I'm not sure. Maybe, I mean, it's true that the Fed and the dollar through these and other actions has a very central role in the global financial system. Okay? Now, you may say, "Well, but that means that maybe the dollar is too dominant and that makes the world fragile with respect to the dollar, maybe. But as always, in economics, you have to ask yourself, what's the counterfactual here?

Reis: If it wasn't for the dollar then what would we have? I've always found quite convincing the work by the late Emmanuel Farhi with his co-author Matteo Maggiori where they looked at what if the world was instead a multipolar world with some dollar bits and some renminbi bits and some euro bits and we had more of a segmentation. And is that a better world than the dollar dominated world? And they argue convincingly that likely, it's not because that would actually be a more segmented financial market world. That would maybe be a world in which we'd actually be more prone to crises as you have large flight to safety movement interests responding to shocks in different regions that trigger, again, flight to safety and therefore instability.

Reis: Now, of course, you probably had in mind, or maybe the guests that you were referring to, instead a first best world where we would have one global currency if you want, or the global currency with a floating exchange rate regime, and no disturbing financial flows, and everything would recalibrate by itself without any difficulties. But if instead you take the counterfactual being, like I said, different regional blocks, then it's much less clear to me that this is necessarily a bad side.

Reis: There is one thing though that I would highlight or at least add to your criticism of the current arrangement, which is, as I said, it's a win-win for the Fed, but partly because it's lending relatively small amounts to its balance sheet to, let's say, trustworthy foreign central banks. And importantly, that it's taking as collateral, this foreign currency, such that the chance of default are essentially close to zero. The Bank of England would not default on the Fed. Even if it did, the Fed would have all these pounds, and the pound dollar exchange rate doesn't change that much such that the dollar, essentially, the Fed would almost never, ever lose any money on this.

Reis: But of course, the question arises, but what about India? Or what about South Africa? Or about some other country? The Fed has not had swap lines with these countries? Why? Potentially because it thinks that here the credit risk is higher. That has meant that we have enforced a certain segmentation where now if I'm a South African bank, what am I going to be doing, I'm going to open a branch in London, so that I can access the swap line of dollars via the Bank of England. This segment... Or if not, the branch, like you were saying an intermediary, now Lloyds are going to be borrowing the dollars in the Bank of England, not for its operation, but to lend to the South African guy. And then again, whenever you create these segmentations, you are creating potentially arbitrage opportunities in the sense also things that lead to flights to safety that are dangerous.

Reis: That's why kind of I've discussed before the extent to which the IMF is ultimately the global financial architecture arbiter should get into this. Now, the IMF cannot be the Fed, cannot lend dollars or something else. But perhaps it could show up as the intermediary that takes on all the credit risk that lends to South Africa and says how much South Africa has to pledge as collateral in terms of its own rand, take into account the exchange rate volatility between the dollar and the rand. And therefore, if you want, we add another intermediary to make the Fed really win-win and have it not worry, and have the IMF complete this network. Because right now we have this web of swap lines in the world that's incomplete as holes. And every time there's a hole, as you said, you are creating a source of potential risk.

Beckworth: That's a great point. Don't let perfect be the enemy of good. Do the right counterfactuals. Maybe I'm not doing the right counterfactual here. Look at where we could be in an alternative world where we don't have dollar dominance. That's a great point, something to take to heart. And I want to come back to this point you just made though, the dollar swap line as it is set up. This is another criticism of it is that it is. That there's select countries, as you mentioned that have received and I just want to list the countries here. So pre-pandemic, the existing countries coming out of the last crisis were the Bank of England that had access, Bank of England, Bank of Canada, Bank of Japan, the ECB, and the Swiss National Bank. And then the additions, there's nine of them, I'll run through them quickly, the Reserve Bank of Australia, Banco de Brazil, the Danish Central Bank, Bank of Korea, Banco de Mexico, the Norges Bank from Norway, the Reserve Bank of New Zealand, Monetary Authority of Singapore, and then the Riksbank from Sweden.

Beckworth: And what's interesting, even within this list, you mentioned South Africa, they don't have that access. Maybe they could have gone through that standing repo facility with treasuries if they had the treasuries. I know, like China, for example, China had the treasuries if it really wanted to get the dollars, but it also has reserves so it probably didn't need to. But even within that list, the additional nine had separate terms, not as generous terms as the original. I mean, they had higher cost, the maturity, all these... there are some central banks, and then there's lesser central banks that get to participate in this program. And your suggestion is make it more efficient, smoother. Now, are you suggesting that we extend a dollar swap line to the IMF directly then let them take on, do what the other central banks are doing in other countries or some other mechanisms?

Reis: That would be a possibility.

Beckworth: That's one possibility. Okay. Yeah, because the existing framework, I mean, is the IMF... Why is the IMF not able to do that now, I guess, is my question. What's limiting the IMF from doing it?

Reis: Well, the IMF doesn't print dollars.

Beckworth: Okay, sure.

Reis: To be the lender of last resort you have to be able to print dollars right?

Beckworth: Fair, fair, I guess is their capital not enough? I mean, that is in their mission, though, to step into the country and they have in some cases, but you're saying not on this scale.

Reis: There's a reason why the lender of last resort in every economy is the central bank, right? Because the last resort, you can create and lend immediately and very quickly. You have to be the central bank. I mean, theoretically, again, you and I can write models where the lender of last resort in any economy is not the central bank.

Beckworth: Okay. So they need to have access to the dollar swap lines just like every other central bank.

Reis: By the way, also even my suggestion is not easy for the IMF as it stands today. So the IMF nowadays primarily provides loans against conditionality. And pretty much it mandates its members [to] only allow it to do that. A lender of last resort operation is not a loan against conditionality. It doesn't come with a program, meaning right now the IMF could not just say, "Well, I'll lend some amount to South Africa, these dollars that their banks need. And here's a program of measures you have to do to deserve the money," which is really what they're set up to do. So it'd be quite different from what they do, one.

Reis: Two, the swap lines I've described them, certainly the dollar swap lines are about lending to financial institutions. The IMF lends to governments not to financial institution. So I don't want to make it sound too easy that it could be done tomorrow. This would be a very different function for the IMF. I'm saying that it's a possibility and could be considered and I think shouldn't be strong considered because as you said, right now we have a cobweb with lots of holes on the web of different swap lines. And that could be creating lots of points of stress in it.

Beckworth: So this could be the future of the dollar swap line going forward, extend the network, patch the holes, and make it more efficient. Okay, well, that's been fascinating, Ricardo. Let's switch gears and talk about fiscal sustainability. And you've written several interesting papers that we will draw from including one titled, *The Constraint On Public Debt When R Is Less Than G, But G Is Less Than M.* And another paper we will draw from, *Inflating Away The Public Debt: An Empirical Assessment.* But before we get into the weeds here, let me just get to the very basics. Probably most of our listeners know this, but some may not. But why care about fiscal sustainability in the first place? What's the big deal?

What is Fiscal Sustainability and Why is it Important?

Reis: Look, there's a simple flow constraint, which is, in order to pay for the current debt, and particularly the interest that's due on it both principal and interest, you can only do one of four things. You can either issue more debt. You can either default on the debt and say, "Forget it, I'm not paying." Or you can collect fiscal surpluses, more taxes than revenue, say, or finally, you can inflate away some of that debt that is have enough inflation so that even though you pay nominally in real terms you do less. But this is a matter of identity. I mean, this has to be the case now. As usual as you know identities in economics, especially in macro get very much abused because then people move terms up and down to identities as you want. But at the same time, they are still important. They are still there. These identities are there.

Reis: Now, when it comes to the rolling over of that forever, you have to realize that you can only roll over that forever insofar as you have a sucker on the other side who's willing to let you run the Ponzi scheme. You have to all reward the holder of the debt for them to be wanting to lend to you. And so, the sustainability question is always ultimately that one. The sustainability question is to what extent are people willing to keep on lending to you, especially since governments have debt coming due every single month, or certainly, and in often in very large amounts given that they have relatively large volumes of debt, and relatively short maturities.

Reis: And so, as a result, sustainability is ultimately always a question of, can I have someone who's going to keep on rolling over the debt? And then it becomes a relevant question because any person, pretty much any person, not any person, most people outside of the US have lived in countries where at some points you had a fiscal crisis, and these are not happy affairs. If at some point the creditors, whoever they are, the massive creditors in the world stops wanting to roll over your debt, then usually you find yourself in dire straits, in that either you have to default, be excluded from financial markets, and go through a very prolonged period of very strict austerity. Or initially you do austerity right away by raising taxes, cutting spending in ways that are often because they have to be done very quickly, are very distortionary, very painful to several groups in your population.

Reis: So, ultimately, sustainability is about avoiding unexpected, sudden, and costly austerity, which, of course, leads you to the usual economists on the last half full glass half empty on the one hand, on the other hand. Some austerity in the sense of some fiscal responsibility now is nothing... In order to guarantee fiscal sustainability is nothing but the way to prevent very painful, very sharp, very distortionary austerity coming through a debt crisis.

Ultimately, sustainability is about avoiding unexpected, sudden, and costly austerity...In order to guarantee fiscal sustainability is nothing but the way to prevent very painful, very sharp, very distortionary austerity coming through a debt crisis.

Beckworth: Okay. Let me play devil's advocate here. Let's take the US view. So, you mentioned all the other countries of the world. I'm going to take a very US centric view here. What's the worst that could happen? I'm going to play, in fact, not devil's advocate, MMT advocate here. They would probably say, "Worst thing that would happen is we have higher inflation. We don't outright default. We just monetize the debt in some form." And so, why worry about that? Why get choked up? I mean, we haven't had high inflation since the '70s. If anything, we've been having low inflation. So convince me. I'm a young millennial who's all eaten up with MMT. Why should I still care about fiscal sustainability?

Reis: Let's focus down on inflation since you raised that one. So, let me give you a two part answer. First of all, how much inflation do you need to pay for the debt? So this is the topic of this paper that you mentioned that I wrote with Jens Hilscher and Alon Raviv many years ago, and it's finally coming in print, coming out in print in the journal. What we did was try to calculate how much inflation do you need in order to lead to a substantial dent in your debt? How much inflation can you produce to reduce that debt? And the simple answer we came up with is actually that a little inflation doesn't take you very far at all. The reason being that the US if you look…

Reis: Actually, if you look not just at the total debt, but the debt held in private hands, and that turns out to be very important meaning because a lot of the US debt is held by a branch of the government or by the Fed, by the way. A lot of it is a very low duration. What that means is think about it as the duration of the debt is in how long will I have to pay you back? Not rich, but the maturity? In how long will I have to pay you back? Imagine that is one day, David. Imagine that whatever you do for inflation, inflation is only going to come five days from now. Well, then you're not going to able to inflate any of the debt. Because in one day, today you say, "I'm going to inflate the debt." The inflation will be coming five days time. Well, but tomorrow, you still pay in full the investors and tomorrow they say, "Hold on, in four days you're going to inflate me away. I'm now going to charge you a 50% interest rate in order to accommodate for that higher inflation."

Reis: Inflating away the debt requires the inflation to come in bulk before the debt is due. What you can do is if the debt was due in five days, and you create the inflation tomorrow, and the next day, and the next day, by the time I get paid my lonely dollar, that dollar's worth nothing in real units in terms of chicken and beef, and the things I like to buy. Well, if you look at the debt maturity of the US it is incredibly short. Moreover, in the US, inflation is very sticky. Inflation is very sluggish. It takes a while for inflation to takeover. Indeed, and I could throw back at you the argument you made and say, "Well, inflation is not much of a problem. It's kind of sluggish. It's been low." Well, yeah, and that's exactly why you can't inflate away the debt. Because most debt in the US, more than half of it comes due within two or three years. It takes you at least three years to raise inflation all that much. By the time you raise it, you haven't inflated any of the debt away.

Reis: So inflating the debt away is much harder than it seems. And actually, if you look at the historical record, David, what you end up finding is that even outside of the US, but also including the US in the '70s, by the way, whenever there's been some significant inflation of the debt, it came with financial repression understood... Financial repression is often a term very widely used in many ways. But let me tell you the way in which I'm using it here, financial repression means nothing but forcing institutions to lend to me long term, even though they wanted to lend to be short term. Force them to have required reserves at the Fed. And therefore, to rollover the short term overnight deposit with the Fed for years on end. Force them through regulation to hold a lot of long-term government bonds.

That's exactly why you can't inflate away the debt. Because most debt in the US, more than half of it comes due within two or three years. It takes you at least three years to raise inflation all that much. By the time you raise it, you haven't inflated any of the debt away...So inflating the debt away is much harder than it seems. 

Reis: And so, once you forced a lot of financial intermediaries to hold the long-term government debt, then yes, you can inflate it away. By the way, then as in the same as the US, of course, going to pass it to the depositors and to poor depositors who are going to be the ones that again, inflated away. So that's the first answer. If you want to inflate away the debt just realize that it's not so easy, and almost always comes with financial repression. You're going to have to force some guy out there to hold the debt because he's going to be running to sell it before the inflation comes. And the sluggishness of inflation is not going to allow you to do much of it. So that's the first argument.

Reis: The second point and once you embrace this first one is to realize that not only inflating away that that comes with repression and is difficult. But moreover, if you're able to achieve it, it comes with quite a bit of inflation. Of course, David, everyone, I can very easily tell you that the right level of inflation is exactly 5.7% whereby I would just be able to trade off Phillips Curve trade-offs and [inaudible] trade-offs and get just the right amount of debt inflated away. The problem is that the experience suggests that once you go from one, two, to 5.76, six becomes 60 very quickly. It's not so easy to control inflation. It's harder than you think. It took us 25 years of anchoring expectations for really to be convinced that it was 2%. So when you say, "I want to inflate some of that away," realize you're not saying two or 2.5. You're saying six, eight, or 10.

Reis: And the road from 10 to 100 is a very, very fast one. Why? Because part of the reason why we were able to control inflation to two was because we spent 20 years telling people two, two, two, two, two, doing everything it takes to do two, two, two, two, two. And people's expectation have anchored it at two. If not let's say, "Let's have a couple of years of eight. But don't worry, we'll get back to two." Well, let's see if that happens where people start thinking, "Well, now that you said eight ones, it's going to be 20 and 25, and 80." And then the whole thing then comes into hyperinflation, including possibly in the US.

Beckworth: Those are all great points and it creates an image in my mind, there's a dashboard of policy levers. And maybe the naive impression is there's this lever called inflate away the debt. But you're saying that lever doesn't exist. It's broken, it's cumbersome. If anything, it can blow-

Reis: Much smaller than people think.

Beckworth: Yeah, it's much, much harder. And then the other point that you brought about financial repression, I think that's another great point that there is no free lunch here. There's a cost one way or the other that's going to be incurred if you try this route out. I bring this up because I can hear the popular MMT view listeners out there responding and saying, "Hey, we'll just get the Fed to start controlling the yield curve. We will have the Fed start issuing its own securities or doing some kind of yield curve control. So that it suppresses all the rates. And that way we can continue to function." But I think that what you're arguing is that's financial repression, one. And two, inflation will still take off. You can repress as much as you want, you still get inflation.

The problem is that the experience suggests that once you go from one, two, to 5.76, six becomes 60 very quickly. It's not so easy to control inflation. It's harder than you think. It took us 25 years of anchoring expectations for really to be convinced that it was 2%. So when you say, 'I want to inflate some of that away,' realize you're not saying two or 2.5. You're saying six, eight, or 10.

Reis: Let me just add couple of sentences, David, not to belabor this point, which is that, look, if you're saying the government is not going to pay for its debt, what you're saying ultimately, forget about all the accounting of the different balance sheets. At the end, there has to be a transfer of resources from some people to some other. That it has to be that the ones who lent you are not going to be paid back. They're going to be sending you something back. Now, when you come to the US on the one hand, people say, "Well, we're the US. Why don't we do this? Let the bondholders, let's extract resources from them, real resources." Forget about money. Again, we're talking about real resources here. Well, but in the case of the US, again, what you're saying is, A, a lot of those resources, who are the bondholders are they the foreigners?

Reis: So, what you're really saying is, "Hey, let's just tax the foreigners to pay for our deficits."  One, I'm not sure that, again, if you have an equitable view of the world, you would say that the richest country is getting paid by the poorest countries in the world. I'm not sure that's something that would be consistent with at least a utilitarian, if not fair view of the world. But second, those foreigners don't owe you anything. They're going to sell as fast as they can. And they're going to try to get away from this as fast as you can. So when you talk about repression control here and there. Just remember, on the other side, those guys are going to withdraw.

Reis: And second, when you're talking about the domestics. Again, note, if I'm saying that you, David, US citizen, are now as a bond holder of the US, you now need to transfer to the US your resources. Note that the alternative to this is the US government would come and tax you for your resources. Why do you object so much to one and not so much to the other? You may argue and some say, "Well, but I like the redistribution side of it. I like to tax the bondholders instead of the people or the taxpayers." But here again, be very careful, because decades of studying economics will show you that when you try to do these things indirectly through distributions, what you find is that people adjust, markets adjust, and you often end up with the poor people suffering the ones who can adjust the less.

Reis: Look again to the 1970s inflation where sure you can say, "Well, it was those rich fat bondholders that lost." No, it wasn't. Through regulation Q it ended up being inflation [as] the cruelest tax. It was the poor people who could only save in checking accounts, which had a 0% interest rate that suffered with the eight and 10% inflation in terms of negative returns on their already small savings. So, be careful with unintended consequences of trying to extract resources from different groups in a population. At least taxation is transparent on who you're taxing.

Beckworth: No, I'm very sympathetic with everything you said there. I'm just trying to play the devil's advocate here. If you look at the polls from the 1970s. I brought this up on the show before and I've looked at it because I interviewed a guest who mentioned the number one concern in the 1970s was inflation. Not the whole period, but at different points of time. If you look at the Gallup poll, it was more important than other big issues. If you look at a history of the US you look at the 1970s you see Watergate, Vietnam War, but the polls shows the number one issue was inflation when it was surging. People were really concerned. It's almost like an alternative universe when you look at people being so concerned. So, I think it's a real issue that it's easy to take for granted maybe given where we have been during this time.

Beckworth: So, Ricardo, I think also us driving this conversation is what's before us right now, and this is calls for more fiscal relief under the new Biden presidency. So 1.9 trillion. I mean, depending on how you measure is 9, 10% percent of GDP. We have debt already at 100% debt to GDP ratio. So, this has some people concerned.

Beckworth: I think you take a standard view, I think you just described the intertemporal government budget constraint. We've talked about flows and stuff. When you think through this, it does make you worry at some level, or at least think about these. You need to think about these issues. How far can you go? I think it's important, and again, the skeptic might say, "Okay, Beckworth, what is the market telling us? If you look at treasuries today, the 27th of January, 10 year treasury is down to 1%. Breakevens are really low. So the markets themselves don't seem terribly worried about this Biden proposal, assuming they've priced it in already. They're not terribly concerned about the Biden proposal.

Look again to the 1970s inflation where sure you can say, 'Well, it was those rich fat bondholders that lost.' No, it wasn't. Through regulation Q it ended up being inflation [as] the cruelest tax. It was the poor people who could only save in checking accounts, which had a 0% interest rate that suffered with the eight and 10% inflation in terms of negative returns on their already small savings. So, be careful with unintended consequences of trying to extract resources from different groups in a population.

Beckworth: So maybe we should walk through the tools we have in the mainstream macro to think through this. So you have this paper where you talk about R versus G, which is a standard metric, but you also bring in M, which is the marginal product of capital. So maybe walk us through how to think about these issues carefully and with nuance so we can come to the right conclusion. And you also have some interesting insights you draw from this paper, but maybe walk us through step by step what we should... How we should think about this issue?

How to Look at Deficits and Inflation from a Nuanced Perspective

Reis: Sure. Let's do this in over three steps. Step number one, which is one that is, I hate using the word consensual among economists, but let me say at least one that seems to me to be a strong case that has been used and should have been used. During an emergency like we've had in the last nine months, and probably for the next six months, governments should, and I say should borrow heavily. They should borrow heavily in order to provide the social insurance that is needed for the many people who have suffered tremendously with this recession. They should borrow heavily because private markets in response to this aggregate shock, make it very hard for privately all of us on aggregate to borrow from the future, which some of that governments can do very well. And we should borrow heavily, because that is the right way to be able to smooth also the large expenditure that we have now, and in order to be able to keep us going.

Reis: There's even a fourth argument why you may want to borrow heavily, more of a Keynesian argument. But in the very valid one, which is if you're a macro economist and our field was born during the Great Depression, what was the very big insight that John Maynard Keynes had was that if you see that people start increasing their private savings a lot. He called it animal spirits. After 100 years of economic theory, we call it instead because they're afraid of the future, because of precautionary savings, because of the scars of the recession and not. Well, when you see this very large increase in private savings, you have to be worried that we're going to be stuck in a depression. The right way to respond to a huge increase in private savings is to have some public dis-savings. And the last six months… so an enormous unprecedented increase in the savings rate in the US.

Reis: Now, you may argue that was because we were locked at home and couldn't spend. And so, we're going to dis-save it right away in 2021. Nothing to worry about, Mr. Keynes, go back to the grave, no big depression coming. But you have to put at least some probability that people are doing this because they're scarred from the recession because they're afraid, and avoiding the Great Depression is the number one job of any macro economist. You should definitely run some deficits now for the Keynesian reasons. So there's a lot… I gave you four reasons why we should be running a deficit, a large deficit now like we did.

During an emergency like we've had in the last nine months, and probably for the next six months, governments should, and I say should borrow heavily. They should borrow heavily in order to provide the social insurance that is needed for the many people who have suffered tremendously with this recession.

Reis: Crucially, though, these are temporary deficits. These are temporary deficits, and moreover, and that you're going to be able to pay over time. And this is what these R minus G comes up. you're going to be paying them on the one hand at the rate R, while on the other hand your economy itself is moving at a rare G making the burden of that lower. Now, because over the last 10 years, R has falling, sorry, we think because of global factors, having to do with demographics, having to do with secular stagnation and others. What we have is that the R has been falling. It's become particularly cheap and easy to this transitory spending and to pay it off over a longer rise. And so, doing that seems just right, and that's the first part of the answer. Absolutely go and run very large debts in 2020, maybe 2021, R is low. Let's pay for it over the next 10 years. And that's in many ways the right thing to do.

Reis: But now, second step of the argument. What you see, and what you see already in many books being sold very popularly in I guess not airports, but on Amazon and others is a combination of proposals for increases in permanent government spending. Not temporary but permanent meaning, "Oh, here we are. A crisis is the chance to change things, and to pursue a different kind of society, a different kind of government, a different kind of safety net, whatever you want."

Reis: When it comes to permanent spending, the argument is not quite the same. When it comes to permanent spending R minus G matters only insofar, and this is where the M comes in, only insofar as for some reason people are willing to lend to the government at a rate R, that is lower than the rate that they would get if they invested in the economy, which is what you call M, let's say. Now, insofar as people are willing to lend to the government cheap, less than they are willing to lend to others, controlling, of course, for risk, maturity, and all those kind of characteristics, insofar as there's a gap between R and M what that’s saying is that the government by selling government bonds is satisfying some demand.

Reis: Well, if it's satisfying some demand, what does R minus M give you? The payment that it's getting the factor for that demand. Well, the fact that R is less than G and G is less than M, by the way. but really, it's R minus M they should be thinking about is telling you what is the revenue that the government is giving. You may call this, some people like to call this a seigniorage revenue. I don't like that name so much. I prefer to call it the bubble premium. Because an asset that pays a lower interest rate than the one at the margin in the economy used to be known as a bubble. That is there's a bubble component to that. The bubble driven by something.

Reis: And so, given that you have an R minus M what that says is, "Aha, not only can I temporarily spend, and that was the first part, but maybe if R less than M persistently, I can also permanently spend more because I have the source of revenue, printing bubble, creating more of this government debt that people love to have." So I try to explore that argument in my research. The first argument, I think, has been well established. I mentioned in the first couple of pages, but it's really the second argument I tried to explore. And for that there are two parts of it, David.

Reis: The first one let's just put some numbers into it and try to understand how big this is. And very quickly, you realize, and I did some back of the envelope here, and I'll share with you which is simply, look, there is a limit on how much debt there is, which is given by the total amount of assets in the economy. In the end, the debt has to be held by someone, and that person is either consuming, buying debt, or having income. That's just a constraint. Well, at best, we can see the debt to GDP of the US going up to, I don't know, 300% of GDP, which is the total assets in the US net are roughly 300% of GDP. Maybe that could increase but it can't increase that much more. Well, with an R minus G of 2%, and with 300% debt, then you end up with a 6% persistent deficit that you potentially could run.

Reis: Again, this is in the absolute limit, David. We all have no firms, no capital stock, all we do is put in the debt, and we have a 6%. Indeed, I actually argue that 5% is a better number. Well, what is the CBO projections before 2020 for the deficits in the US all the way to 2050, 5% already. So, all of whatever bubble R minus G, R minus N existed, we already spent it in the last 10 years. So there's nothing new about this in R minus M that says, "Oh, now in 2021, I can completely reconfigure the government and exploit my R minus M revenues." So that's the first point that I try to make, work through this, figure out that the R minus M shorts... Even if, well, it's there, but let's not also get carried away with it.

Reis: But then the other part is, okay, but if you are going to try and exploit it, then you have to start thinking of well, but will this R minus G minus M persist or not? What's driving it? You need ultimately, a model of where the R, the G, and the M come from. Because one, if you try to exploit it too much, what if it disappears? What if the R switches? And then both the permanent, and the transitory come back hard. By the way, David, in 2020, R minus G was positive 2%. It was not negative because remember G was really low this year, So, on this R minus G, let's not get too carried away. After nine years of R minus G being super negative actually it was super positive.

Reis: So, let's see what happened. And remember, and the 10 year rate in the last six months has gone up by 60 basis points. So let's not get too carried away on relying on R minus G being less than zero as a law of nature. But anyway, but let's try and endogenize it. Let's try and model and see what drives it. What are two of the main stories of why there's this bubble? Why there's this service that the government that provides? One of them is to say, "Look, government that provides a safe harbor. There's a lot of demand for safety. I have a lot of idiosyncratic risk in my investments, in my life, the government provides me one of the few, maybe the only truly safe asset. I'm willing to earn very little return on it to pay a high price for it in order to get that safety." So, that's one argument.

Reis: The second argument is a very old argument that, for instance, Olivier Blanchard exploits in his presidential address building on work by Peter Diamond many, many decades ago, which is liquidity. Government debt allows you to transfer money, transfer resources over time in a way that our overlapping generation structure of people makes it very hard. And so, maybe it's actually this liquidity of going into the future, or simply because private assets don't provide me enough stores of value for me to efficiently transfer liquidity.

Reis: And so, I try to think through, okay, if it's safety and liquidity, can we make sense of why an R minus M emerges? And again, R minus M is really the key thing, not so much the R minus G because that's what the term is in these bubble revenues, and what could potentially affect them. And when you work through that you end up again with kind of... The nice thing about writing models or theories, you come up with some perhaps unexpected predictions, which of course, once you write the model seemed obvious to start with. Let me tell you an obvious one, just to link back to the inflation before. What happens if we start discussing, let's inflate away the US debt? Well, the more we start discussing it, the more we start admitting it, the more we start saying that's a possibility, that makes the US debt less safe.

Reis: It makes the US debt less safe, that hurts precisely, the main source of the R minus G. It means that the R minus G will turn on you temporarily and permanently, and therefore make you worse off. So in that sense, it says, this perspective of the R minus G tells you, "Please don't talk about inflation, please don't consider it. All you're doing is making US debt riskier." But there's a second one that perhaps is slightly more shocking or provocative, but that's what economic theory is for to get you to think of things. If you think through the liquidity instead, you think of, well, financial markets are limited in their ability to provide liquidity. This is why government debt is there for.

Reis: So, here's a simple exercise or a provocative exercise. To be taken not too seriously, but again, because it forces you to think through the R minus M so this is not a policy prescription of any kind. But think about it. on the one hand, imagine that we were to redistribute, take from the rich and give to the poor. And imagine you think that what do financial markets do? Well, ultimately, there are ways for the poor to put their meager savings at the disposal of perhaps the more productive or whatnot, members of society, so they can invest them and get higher returns and higher income.

Reis: Well, if we did some redistribution, then you would ask the private financial markets to be doing more of this burden. But if you're asking the private financial markets to be doing more of it, less of it will be done by the government. And in particular, the M minus R will need to use the bubble debt, government debt component less because we're going to be having the private markets do more of this reshuffling of liquidity [inaudible]. So then if we do that redistribution, what we're doing is we're actually reducing the R minus M, and therefore making the bubble premium that the government collects lower. But that means that now the government can spend less in total.

Reis: Well, that leads to a very nice trade off, which goes back to something that I learned from my also sadly deceased, one of my graduate advisors, Alberto Alesina, which is you can have a polarization. Or if you want to fight between two sides of government. One of them cares about the size of the government, size of spending, they want a big R minus M, they're okay with having a very unequal society if you want because that generates, again, this gap. The other one wants a more equal society. But that more equal society also means less bubble premium and less total spending by the government. You end up with an opposition between those two because precisely these policies affect where that R minus M comes from. And that's, sorry for the very long answer-

Reis: But that's how thinking through the R minus M rather than taking those different, can lead to surprising conclusions. You may like some of them, hate some of the others. But before you go and say, "Let's finance a whole new government, a whole new view of society based on R minus M." Let's think about what determines it, how different polls can affect it, how much can come out of it. And that's what I tried to do in this research.

Beckworth: So, just to restate that, in a world with less inequality, more and more equal outcomes, R minus M…

Reis: That will play a lower role, and therefore R minus M will be smaller.

Beckworth: Yeah, so the bubble shrinks, and the private sector is taking some of that and using it in this process. So, I know you said you don't like the term seigniorage, but if that R minus M, if you call it that roughly, it's effectively the private sector is taking that seigniorage and using it to its end, and because-

Reis: I call it a bubble premium instead of seigniorage because seigniorage tends to be associated with central banks and so I find that confusing. We can call it seigniorage.

Beckworth: Yeah, yeah. That's very interesting and pretty, I think powerful result to think that there's always tradeoffs. I mean, there's no free lunch, again. Let me ask this question then. So, I think implicit in what you're saying is that there's an alternative to government debt, right? That if it's no longer risk free... I mean, the first scenario, if you try to inflate it away, so it becomes less of a safe asset. So, here's the challenge I have and seen that all the way through. I agree at one level. But then I look at and I ask this question, well, what's the alternative to US government debt out there? So if you're an investor, and you begin to worry about them? And I would say, just in general, going back to earlier conversation, what's the alternative to safe dollar denominated assets? Because it is US government debt, but there's also some private financial assets that we export to people, bank deposits, commercial paper? Where would these investors run to, realistically, because that's a huge number?

Safe Asset Alternatives

Reis: Absolutely, David, but I think I would disagree a little bit with the posing of the question that way because you're asking me, what is the perfect substitute? When you say alternative, you've asked me what's the perfect substitute? And I will gladly admit that there's none. There's no perfect substitute to the dollar in terms of safety, liquidity, and all other features. But ultimately, across financial markets, what we have is a series of imperfect substitutes, perhaps.

Reis: When we make the dollar debt less appealing, it doesn't mean that everyone's going to rush away from the dollar debt and go to something else because the something else is not a perfect substitute. But there's plenty of imperfect substitutes. And that means I'm just going to want the margin to hold a little bit less of this and a little bit more of the other that are now more desirable relative to the dollar or not. And it is exactly those shifts that affect the equilibrium R and why the R minus M is going to shift if you want gradually, continuously rather than otherwise. If government debt was a perfect substitute for the private assets, then R would always be equal to M. And then R and M would have to move in lockstep. And if anything happened to government debt that made it a little worse, immediately, everything would go into M, into the private economy.

There's no perfect substitute to the dollar in terms of safety, liquidity, and all other features. But ultimately, across financial markets, what we have is a series of imperfect substitutes...When we make the dollar debt less appealing, it doesn't mean that everyone's going to rush away from the dollar debt and go to something else because the something else is not a perfect substitute.

Reis: In fact, instead, we have an imperfect substitution. As we hurt the safety and liquidity of government debt, we'll potentially be wanting people to hold the lesser of it. If they hold a lesser of it, the price of it will fall, the interest rate will rise. And we'll get some if you want, some more less drastic than what you said. You were talking about, well, what if we get the drastic where we have a run, a real shift where we all want to run from the debt, and where do we go to? And there I agree with you, there isn't an alternative in the world. But there again, the difficulty is that what we may end up though, is with again, going back too Farhi and Maggiori, we end up with a polarized world with different poles where no the US doesn't disappear, but all of a sudden, people in Asia prefer to instead use the RMB pole and stay there as opposed to investing so much in treasuries. Maybe in Europe, we start having more Euro wide debt, and we have some more use of it.

Reis: What I can tell you is, and this from my studying of the Euro crisis 10 years ago, is that if you live in a region that has no safe debt, which was the case of the Euro in 2010, 2012, what you're going to end up with is with large imbalances in that all flights to safety come with current account imbalances because in the US right now when we get worried and the risk premiums go up, we leave stocks and go into bonds, and say, "Fine." That has implications, of course, but nothing that hurts the country as a whole.

Reis: In Europe in 2010 to '12, when people risk aversion went up, people left Portugal, and went into Germany in terms of investments. That comes with current account surpluses and deficits. It comes with enormous macro consequences. And the Euro area has suffered a lot in the last 10 years and especially during the crisis from the absence of an EU wide safe asset. And again, if the US Treasury were to be challenged, definitely would be that then we'd have regions and with regions come very abrupt flights to safety across regions, and those can be very destabilizing.

Beckworth: Well, Ricardo, in the time we have left I want to segue to a related point, and that's inflation because this all has a bearing on inflation, what we've been talking about, and you've done some recent work on this. I'm just wondering what are the implications for inflation in the advanced economies which has been low over the past decade over the next five years or so. What do you think is going to happen?

Implications for Inflation in Advanced Economies

Reis: Look, I think... I've been studying inflation for many years. It's actually one of the things that I've spent more of my intellectual energy on. And I can tell you, David, that right now I expect inflation to be roughly what it is on average. But I have never been more uncertain about inflation than I am today relative to the last 15, even 20 years. I think there's a lot of risk. I think there's a significant probability inflation will shoot up, but it's just bounced by a similar probability that it will shoot down towards deflation. And that's why the two cancel out so that my expectation is maybe 2%. But I put a lot more weight on both high inflation or deflation.

Reis: Why is that? Because when I think through the theories that I use, and these are the theories in my work with Laura Castillo-Martinez where we summarize these theories in terms of the main theories that we use to teach, to understand inflation, there's basically four camps of theories, all of which consistent with each other, by the way, but all putting emphasis in different things. The first one, if you want is the interest rate view. Wherever we set interest rates, we'll be able to control inflation by setting interest rates. Well, right now, David, interest rates, it's hard seeing them going much lower.

I have never been more uncertain about inflation than I am today relative to the last 15, even 20 years...I think there's a significant probability inflation will shoot up, but it's just bounced by a similar probability that it will shoot down towards deflation. And that's why the two cancel out so that my expectation is maybe 2%.

Reis: And second, with the amount of debt we have, any abrupt increase in interest rates would have such a huge fiscal blow on the Treasury that I think that many would hesitate to do it. And moreover, the Fed itself has pretty much tied its hands and committed not to do anything to raise interest rates. Well, if you're not going to raise them, and if you can't lower them, then we are in [an] interest rate peg, which as Milton Friedman and others taught us, leads to inflation indeterminacy. You can either have inflation shoot up or shut down. If you're not going to change the interest rate, you're not going to be able to do anything about it.

Reis: Second, if you're more of a monetarist, and you live by MV equals PY, then what you see is there's been a very large increase in the size of the bank's balance sheets. That is reserves, it's not money. But it means that at some point, depositors may want to run to their banks and say, "Please give me some currency or payments so that I go and buy things." Those banks are going to go to the Fed and say, "Please exchange the reserves for currency." And we could have indeed M growing very fast towards inflation. Or we could have the other way around in which we are happy like we've been in the last six months where the government sent you a big check, David, you deposit it at your bank, your bank deposits to the Fed, the Fed bought a government bond, and everything was fine, and inflation was actually too low.

Reis: Third, Phillips Curve theories of inflation, all that matters is how much slack there is. Well, you can say we're in a recession now that's going to push us towards inflation. But you can also see how the economy can easily, depending on what happens with COVID and the recovery, the economy overheating or not, because I don't know how much as this recession affected potential versus absent employment going forward. So again, the Phillips Curve can tell you, "Look, I can go up or down."

Reis: And finally, fourth, set of theories of inflation, fiscal theories. Those who would say, "Look, a lot of debt, expect inflation to come." But on the other hand, a lot of debt with a low R minus M means maybe not so much of a fiscal stress at least in the next few years, in which case, we won't have to do it, and this inflating away the debt seems to be out of the picture. So, whatever, whether I look at the Wicksellian interest rate view, the monetarist view, the Phillips Curve Keynesian view, or the fiscal view, for all four of them, I can tell you very plausible stories whether we'll have deflation, or very high inflation. And that really disturbs me that all these theories are telling me a lot of uncertainty rather than one direction.

Reis: But actually, when I look at even market prices, and you look and weigh out options on inflation being high and low, actually, the probability of inflation shooting is actually increased quite significantly. It's actually not that small anymore. We could end up with either way. But on average, inflation is probably going to be two because both the upside [inaudible] are high. But I think it's important to think in terms of second moments, to think that there's actually a lot of risks on both sides, and that the inflation may be more unanchored than we have been used to thinking about it over the last 20 years.

Beckworth: Well, that is an interesting note to end on, Ricardo. We'll have to come back together in a few years and see what actually happens to inflation. But with that, our time is up. Our guest today has been Ricardo Reis. Ricardo, thank you for coming on the show.

Reis: Thank you very much. This was a pleasure.

Photo by Olivier Douliery