George Hall on the Fiscal Consequences of the US War on COVID

George Hall is a professor of economics at Brandeis University and formerly worked as an economist at the Chicago Federal Reserve Bank. George returns to the show to discuss the current fiscal status of the US, how the Big Beautiful Bill will impact the fiscal outlook going forward, the history of running deficits in the US, and much more.  

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This episode was recorded on June 24th, 2025

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: Welcome to Macro Musings where, each week, we pull back the curtain and take a closer look at the most important macroeconomic issues of the past, present, and future. I am your host, David Beckworth, a senior research fellow with the Mercatus Center at George Mason University, and I’m glad you decided to join us.

Our guest today is George Hall. George is a professor of economics at Brandeis University and formerly an economist at the Chicago Federal Reserve Bank. George has written widely on the history of US public finance and joins us today to discuss the lasting fiscal consequences of the US war on COVID. George, welcome back to the program.

George Hall: It’s great to be back, yes.

Beckworth: It’s great to have you on. We had a fantastic conversation previously, I believe in 2023, on your work with Tom Sargent, looking at the history and all the lessons of public finance in the US. This is a great time to bring you back on because the two of you have done really great work. 

I think the first time I ran into you or saw your work was at the Hoover Monetary Policy Conference. I was just really mesmerized by how you took that consolidated budget constraint. You did some decompositions, and you showed how we finance public expenditures. At the end of the day, it has to be paid for some way. I’m going to go back and then talk about that. 

Current US Fiscal Status

Just to motivate our conversation today, why is it important that we talk about your ongoing work on this topic? As listeners will know, our debt-to-GDP ratio is close to 100% right now. Actually, it was a little bit higher. It’s come back down. Maybe we’ll talk about that later, too. Right now, the CBO is projecting at the baseline, $2 trillion deficits every year. 

The One Big Beautiful Bill, which, at the time of the recording, is still being considered by Congress, maybe it will be passed at some point this summer, it’s going to add another $2 trillion to $3 trillion in deficits over the next decade, according to multiple sources. CBO, Tax Foundation, Budget Lab at Yale—they’re all projecting a significant increase. The CBO, over the next decade, was projecting the baseline that we would go from 100% debt-to-GDP to 117%. This Big Beautiful Bill would get us close to 130%. Massive fiscal pressure, structural primary deficits as far as the eye can see. This doesn’t sound good, George.

Hall: No, no, it doesn’t sound good. Tom Sargent’s and my work, we focus on the government budget constraint. No matter what your view on macroeconomics, whether you’re a classicist, whether you’re a New Keynesian, that government budget constraint must hold. Our work is motivated by or driven by Keynes’ observation that what the government spends, the public pays for. 

The government can raise revenue three different ways. All of them involve real resources coming from the public, and then the government, in turn, handing the public one of three pieces of paper. One is the government may take some resources from the public and, in exchange, hand them a tax receipt. We take those tax receipts and we throw them in the trash. It may borrow some resources and hand the public a bond, some debt. An IOU that says, “We’ll pay you back later.” The government may print up some money and go out and purchase some assets from the public.

All three, goods and services, flow from the public to the government. Paper goes back the other way. Bonds and money have value. Tax receipts don’t. The question is, when do bonds and money partially become tax receipts? That’s one way that government can pay its finances. What you see is that after wars, and we’ve seen after COVID, part of the way the government has made these government budget constraints hold is by turning bonds and money into partial tax receipts.

That is, it’s given low returns to bondholders and low returns to those people who hold money. When you give these scary numbers and you say, “How is this going to all work?” one of the things we’re afraid of is that we’re going to take these bonds and these promises that the government’s made and turn them partially into tax receipts, into something that’s worth less than people originally thought they would be worth on that.

Beckworth: I like that decomposition. It’s really nice. They’re all forms of paper you receive from the government. The question is, do the latter two, so bonds or money, do they lose value and become tax receipts that we throw away into the trash? That motivates a question I was going to ask you later, but I want to ask you now. How should we think about inflation? The point is to go from assets that we value, bonds and money, to tax receipts, basically worthless paper we throw in the trash, we have inflation. Should we view inflation as a tax, a form of default, or something else entirely?

What Is Inflation?

Hall: It’s both. It’s both a mechanism for raising revenue through seigniorage revenue, through printing up money and buying goods and services, and as a vehicle for default as well by inflating away the real value of government bonds and other government promises to individuals. Government makes lots of promises to people to pay them. We can lower the real value of those. I will note that in the 19th century, things went both ways. We would run inflations, and we would run deflations. Deflations are a way of giving bondholders maybe more than they thought they might get on that, delivering higher returns to bondholders as well.

Beckworth: Jumping to the big conclusion at the end of your paper, you and Tom are worried we are going to be paying with tax receipts, that we’re going to have higher trend inflation, maybe even?

Hall: Yes. As you started the program, you give these numbers. We can all see them. We say, “Well, look, there’s one of three groups. How are we going to make this budget constraint hold?” There’s one of three groups can pay the bill or some combination of the two. One is we might slow the growth in government spending down. Recipients of government spending might have to take a hit. Those on Medicaid, Medicare, Social Security, veterans’ benefits, defense, we might need to cut that. The other way to do it would be to raise taxes, raise explicit taxes, and tax a little more. The third option is to deliver lower returns to the bondholders and essentially turn bonds partially into tax receipts. 

At least when we look at the politics, it’s hard to see how we’re going to slow the growth of government spending down. That seems to be a force unto itself. There seems to be little taste for raising taxes, particularly in any serious way. What option is left? Well, we’ve delivered low returns to bondholders in the past. Bondholders got low returns after World War I and World War II. That was partially the way we paid for those wars and just say, “Well, that might be an option.”

If you look at the CBO projections, and I have a lot of respect for the folks at the CBO, and other projections, they all take as a given that the Federal Reserve is going to hit its 2% inflation target, and that we’re going to take as given. We’re going to pay the bondholders back in full. That’s just as a given. We said, “Well, hopefully, that could happen, but it may not.” It’s a possibility that the Fed may not be able to do that. One way we may get that government budget constraint to hold is by delivering low returns to the bondholders.

Beckworth: We economists, like you say, there is no such thing as a free lunch. It is a real resource being used by the government, and we have to find a way that it gets covered or paid for. You mentioned the bondholders may take a hit. Last time we were together, we talked about this. In fact, listeners, I encourage you to check out George’s amazing data set that he has. He has historical data on marketable US Treasury securities all the way back to what year? Remind us.

Hall: We go all the way back to 1775.

Beckworth: Remarkable.

Hall: Yes, yes, yes.

Beckworth: If you’re someone who loves time series and you want to mess around—in fact, I’ve done that. I’ve run some vector autoregressions with these really fascinating series. What’s interesting, George, you provide this as well as the Dallas Fed. Dallas Fed did this more recently. You actually show the par value and the market value. I’m looking at a chart here in front of me of the most recent data. I went to Macrobond and downloaded it. The market value is still below the par value. It took a huge hit. Going back to your point, we already did do this, right? We imposed losses on US bondholders during COVID.

Hall: Oh yes, if you look from 2022 to 2024, we ran deficits, I think, of about $2.6 trillion in those three years. We imposed $3 trillion in losses on the bondholders. You had mentioned earlier that the debt-to-GDP ratio had gone down in these past years. It went down despite running large gross deficits and primary deficits. The way we did it was by imposing losses on our bondholders. Yes, you can do it both with rising interest rates. You can do it with inflation. Somebody had to take the hit. As Keynes said, “What the government spends, the public pays for.” Somebody had to pay.

Fiscal Consequences of the US War with COVID

Beckworth: So many questions this raises. To get to your paper, though, your paper, Tom Sargent, the one that I want to use to talk about today to assess where we are and where we’re likely to go, the title of it is “Fiscal Consequences of the US War with COVID” with your colleague, Tom Sargent. It’s hot off the press, June 2025. It’s really current. Something just right off the bat that you do in this paper that’s honestly quite depressing, but it’s a good, honest account of where we are.

You have these three charts. I believe it’s Figures 1 and 2. Figure 1, you show the history of the UK in the 1700s. You show how expenditures and revenues, they come back together. There’s deviations, but they come back together. During wartimes, expenditures way exceed revenues, and they come back in. It’s this reversion of these two series or co-integration, maybe we would say in time series. You say that’s the Barro model that tells us how you are able to finance. In the UK, they were effectively doing what was necessary to keep credibility, to keep hope and trust in government finance. 

Then you contrast that with France, and it’s a really striking difference. You see the two series, they diverge. This is, of course, leading up to the French Revolution, which is not a very pretty picture. You have these two very stark, very different examples. The French, who ran massive deficits for a number of years. The UK, the British, who would run deficits but bring them back down, and eventually pay them off on primary surpluses. 

Then you take those two case studies and you compare them to the US as a whole, and you say, “Well, folks, here’s the good news. The good news: Up to 2000, we were like the UK. We ran primary deficits during wars. We brought them down, looked great. Since 2000, we’re looking a lot like the French.” I’m like, “Wow, George and Tom, thanks a lot.” That’s just a very depressing message out of the gate.

Hall: Well, I should say, Tom gave this paper at a conference in December of 2024. His job was not to be boring. You’ve got to come out and be punchy. One point we do want to make is that, for a long time, the US operated under this fiscal rule that looked very much like the British. Tom Sargent and I attribute this fiscal rule—we credit Albert Gallatin, Thomas Jefferson’s secretary of the Treasury.

As you recognize, it’s really just a variation on Robert Barro’s tax-smoothing model. Basically, during peacetime, you run something close to a balanced budget. Then when there’s a large, exogenous expenditure surge, usually due to a war, you want to debt-finance that. Taxes should go up by at least enough to cover the interest expenses on the new debt.

Then after the war, what we tend to see happen, again, it isn’t exactly in the Barro model, but these shocks tend to have a permanent component to them, that spending doesn’t come down to its prewar level, that most of these shocks are both transitory and persistent. After the war, government spending comes down, but taxes remain high enough so that after the war, we run surpluses. We refer to this as a law of gravity, as you mentioned there.

Now, what I’ll note is that after World War I and World War II, we had large inflations. We had to pay for it partly through giving bondholders low returns. Nowadays, this fiscal rule seems to no longer hold. We weren’t running a balanced budget before COVID. COVID hits. It’s a large, exogenous shock. We expect it to be transitory. We debt-finance our response to it, which makes perfect sense.

Tax revenue doesn’t go up at all. That’s like, “Whoa, we don’t raise taxes.” Now, partly raising taxes during a pandemic probably is a bad idea when you’re telling people to stay home and not work. Then afterwards, after COVID, you see that this shock has both a transitory and a permanent component. Government spending has gone up, but tax revenue hasn’t gone up. Unlike the British experience that you point out, unlike World War I or World War II or prior wars, postwar, we’re running large deficits, not surpluses.

Again, just noting that after World War I and World War II, despite running postwar surpluses, we still had to run some inflation to get the budget constraint to hold. How’s this going to play out now when we’re running large budget deficits? Maybe those past experiences aren’t relevant, but we see these patterns. We’re doing a little bit of pattern recognition. These patterns tell us something. Hopefully, we don’t have to resort to revolution or a new constitution or something like that.

Beckworth: Hopefully, we don’t have the French Revolution. I don’t think we will. I think our institutions are firm enough, despite what we’ve been through the past few years, despite COVID. I do think there’s hope. We’re not the French Republic. We’re not going to go down that path, but there will be some cost. There’s going to be some pain, some unexpected changes that maybe many of us are not anticipating at this point. It has to hold. Again, this goes back to your point about the consolidated budget constraint. In fact, George, would you say that’s one of the most important identities in macroeconomics, learning how that works?

Hall: It’s funny in that when you teach sophomores in intermediate macro here in college, the intertemporal budget constraint gets put off until chapter 15, right behind exchange rates. Well, usually, you run out of time before you actually teach any of that stuff. To me, I’ve just thought, “It has to hold.” No matter what model you’re talking about, there’s a government budget constraint underlying it. It often gets ignored. There are many models. You get what looks like free lunches with government spending. That’s because the government budget constraint has been swept under the rug. As you’ve seen on my papers in the last few years, I’ve written a lot of papers where it’s a one-equation paper. It’s government budget constraint.

Beckworth: Yes, but it’s a beautiful one-equation paper because you do multiple versions and permutations of that equation. It’s a work of art. We should give you credit for that.

Hall: Oh, thanks.

Beckworth: I would say, someone like myself in the policy world, that is probably one of the most important identities in macroeconomics. Yes, macro is far more than this. There’s growth. There’s international economics. I love the equation of exchange as somebody who loves nominal GDP targeting. I think this is much more consequential in terms of the policy world. I would say people really do care. We learned from ’21, ’22, how much people dislike inflation.

One of the big reasons we had an inflation is because of this constraint. In fact, you’ve shown us in previous work, this is what happens. I want to throw out another important implication from that equation. I did a Substack on this. There’s been a lot of talk recently here in DC about eliminating interest on reserves. The motivation is really driven by the fiscal pressures we’ve seen. We’ve also seen pressure from President Trump on his social media account toward Fed Chair Jerome Powell that he needs to cut interest rates.

The context is, “Man, you need to cut rates because we’re paying this huge amount on the debt.” Like he said, two or three posts where he explicitly says, if “Too Late” Powell—and that’s his nickname, “Too Late” for Powell—if he would lower interest rates as much as he should, we would save around $800 billion a year. He’s referring to the fact that we’re now paying over $1 trillion in interest payments on our debt annually, which is pretty large.

In Trump’s mind, whatever his reaction function is, you cut the rates enough, and you get down that payment. This is all telling us that, man, there’s fiscal pressures. Now, if you look at the consolidated equation and what I like to do, I did it in this Substack post, is I moved everything to one side that is influenced by the Fed. Interest on debt and then Fed liabilities, money. Then, on the other side, all the things affected by fiscal policy. When you do that, you see this equality. Things have to be equal.

For example, if the Fed is going to raise interest rates—and most of us in this age think, “Oh, the Fed is going to raise interest rates,” and there’s this channel to which that works, it’s going to cause, technically, intertemporal smoothing or maybe simpler story. People quit spending. There’s less borrowing. Aggregate demand goes down. Inflation goes down. We leave it at that. If you look at this equation, there’s another channel at work. The other channel is if you increase that interest term, you’re going to need to run primary surpluses to offset on the other side.

If you don’t, then it’s going to be money creation or borrowing, but borrowing at some point, is a limit as well. One of the implications of the equation is the Fed, when it raises rates, if there’s enough debt out there, it needs to raise primary surpluses as well. If you don’t, then those higher interest payments simply become monetized. It becomes money. Maybe we don’t think about that channel when debt stock is low, when rates are low. Now, it’s becoming more of an issue, more prominent. We need to start thinking about, how are we going to finance these big interest payments?

Hall: The way Tom Sargent and I think about this in our paper is we think of it as a game of chicken. The idea is that, again, there’s three ways to raise revenue: taxes, bonds, and money. Let’s just say there’s some limit to how much people are willing to lend to a government. Then, if the government needs to finance a certain level of government spending and, again, take that as given, the question is, are we going to pay for that with tax receipts? Are we going to pay for that with money?

You can get into this game of chicken where the fiscal authority says, “Well, we’re only going to raise this much in taxes.” Tell the monetary authority, “You’re going to have to make up the difference by printing money and inflating.” The monetary authority could say, “Well, wait a minute. No, what we’re going to do is we’re only going to print up this much money. We’re going to be tough on inflation. You’re going to have to raise this revenue with taxes.” The question is, who blinks first?

Is it going to be the monetary authorities that eventually are going to have to resort to printing money to cover these deficits? Will the fiscal authority raise the taxes necessary to cover these deficits? As you point out, this unpleasant monetarist arithmetic is that the longer the monetary authority holds off in terms of financing these deficits, then the bigger these deficits it’s going to have to monetize. The higher the inflation is going to have to be in order to monetize that debt, because it’s going to have to cover those additional interest payments of the additional debt that’s there.

Beckworth: The other important insight, there’s multiple insights, but another important insight from that equation—again, the intertemporal budget constraint consolidated, the Fed and the Treasury come together—is that the Fed or any central bank is not truly independent. Now, I think it’s an important myth or illusion of sorts. Again, the world we operate in and we have been in, and most people you ask them, they think, “Oh, the Fed just does its thing and then doesn’t worry about what’s happening.” Realistically, in the background, we should have fiscal policy keep working to keep the US government solvent.

Then, if you get to the case where they can’t do that, then the Fed has to take over. It has to keep the government solvent, and the rules completely flipped. Now, effectively, Congress and Treasury are determining the price level while the debt they’re issuing and the Fed’s just simply keeping us solvent. The Fed loses independence. This notion is useful. I think it’s important. I would never want a Fed official to say, “Hey, yes, we’re going to be subservient to the Treasury here next year because we have to be.” You never want them to say that. That is ultimately the underlying reality that they are only independent to the extent we got our fiscal house in order.

Hall: Oh yes, as you were saying earlier, you take that equation. You can write that equation where monetary policy is on one side, and fiscal policy is on the other side. A useful fiction often is to think about fiscal policy separately from monetary policy. That equation tells you that those two things operate hand in glove. They’re not independent as much as we would like to think of the Fed as being independent.

That budget constraint imposes some interdependence between the two as well. Again, when you look at past wars and you look at COVID, the Federal Reserve is on Team USA. It’s going to support the Treasury market to make sure things—when the government needs to borrow large sums of money very, very quickly, the Federal Reserve is going to facilitate that. It’s not going to just say, “Well, that’s Treasury’s problem.”

Beckworth: Right. We hope so. 

Hall: Yes, generally. 

World War COVID

Beckworth: They did during COVID. That’s the thing. I want to be gracious here to the Fed. Sometimes in the past, I’ve been critical. Maybe this is a mea culpa, an apology of sorts. COVID was a war. In fact, your earlier papers, you have one called “Three World Wars.” You’re like, “Well, what’s the Third World War? Is it talking about the Middle East now? No, George is not talking about some big war starting in the Middle East. He’s talking about COVID.”

COVID was a world war, a public health war, but nonetheless, a war. It was an emergency. It was unexpected. How do we finance it? I do think it’s important to step back and think, “Okay, that was something unusual.” We shouldn’t plug a Taylor rule in 2021 and say, “Ah, Fed, you fell behind the curve.” Now, you can argue, maybe they did near the end. I do think it’s important to understand there’s uncertainty. This was a wartime economy, and give them some grace.

I bring this up because I went to the Board of Governors Framework Review Conference. They graciously invited me. They talked a lot about the inflation surge. I have too on this podcast. I talked about it through the lens of a Phillips curve and all the terms on the Phillips curve. In my mind, what was missing in that conversation was this was an unusual period. If we’re going to evaluate the framework, I think it’s just important to say what happened in ’20, ’21, ’22 was truly a unique wartime exceptional period.

Let’s maybe not use that as something to guide our thinking or to cloud our thinking, because at the end of the day, the Fed had to step in and backstop Treasury—I know they would they would probably resist this—but I would argue that in ’21, I think, effectively, we were in a world of fiscal dominance, at least briefly. I think the Fed was having to really support what Treasury was doing.

Before and After War

Let me go back, George, to this really stark visual that you and Tom provided. You said Tom had to have some shock effect at some conference. What this picture paints is, for many years up until 2000, the US was effectively following the Barro rule where there’d be wartimes, you expand. After wartimes, you run primary surpluses. You bring expenditures and revenues in the line. We saw that with the British. Then 2000, it ends.

 My question is, and this may be beyond an area you want to comment on, but I’m going to throw it at you anyways. Why? Why have we reached this point? I want to go and throw another historian out there, Barry Eichengreen. He talked about the gold standard. Why did the classical gold standard work so much better than the interwar gold standard, which really led to the Great Depression? He argued that a key reason is just enfranchisement, democracy, people getting more of their voice heard.

They don’t want to sacrifice internal macroeconomic stability just to preserve the international system, right? Basically, by the time we get to the 1930s, 1920s, the Fed macroeconomic policy writ large has to keep economic conditions stable internally. They’re going to let the international gold system do whatever. That’s not a priority anymore. That sense of discipline that maybe was imposed in the classical gold standard just wasn’t there. I’m wondering if there’s something similar happening. We just can’t escape political pressures. Why were we able to do it in the past? Why were we able to run these deflationary periods, let alone primary surpluses? Now, we can’t. Any thoughts on that?

Hall: I think the US role in the world has changed. We did face fiscal discipline in the past. One example would be World War II happens. We borrow a lot of money. Then after the war in the late 1940s, there’s quite a bit of inflation that wipes out 20% to 30% of the debt. The Korean War rolls around in the early 1950s. There is no taste to debt-finance that war. Truman doesn’t want to debt-finance it. Wall Street doesn’t want to debt-finance it.

We financed Korea on a balanced budget. We faced discipline due to the inflation there. Nowadays, we’re off the gold standard. The gold standard ends in ’72 or whenever you want to date it with Nixon. I think it’s ’72. I might have be off a year. We’re on a dollar-based system. I think one thing we learned was that the world was willing to hold more US Treasury debt than we originally thought.

I think a lot of people were concerned about inflation after the debt run-up in 2007, 2008. It seems like there was sufficient demand for US dollars and US Treasury securities then. How much debt can we issue when people will still buy it? People will continue to buy US Treasury debt, but at what price? What’s the upper limit to that? To some extent, that’s a question you don’t really want to know the answer to. It’s a little bit like, how deep can your submarine go? You don’t want to know the answer to that question.

The US is special. The UK can’t pull off what we can do today. That specialness is something we want to preserve and we want to maintain. I don’t think we want to push it. Partly, our concern is that if we deliver low returns to the bondholders, I think we can, it’s plausible, people are willing to hold our stuff, but then will people say, “At some price, I’m not willing to hold US Treasury securities, and I’ll go elsewhere”?

Beckworth: Do you think the return of inflation may be what convinces the public to vote tax increases and spending cuts? Again, we saw in COVID how much the public really disliked inflation. There’s a threshold effect we discovered that people don’t pay attention and then gets near 3% or 4% percent, suddenly, everyone’s very allergic to it. They scream and they point and they blame politicians.

That’s come down some, but maybe it’s going to reemerge. In fact, I think your paper implies it will reemerge, given the realities of the debt we hold and likely hold, and given the realities of what this administration and what Congress is likely to pass. If inflation reemerges and the public again really dislikes it, might that be the motivation for we really are finally willing to address the tough questions and make tradeoffs?

Hall: Let me go back to history. If you take a look at multiple wars, there’s often thinking about the politics of repayment is an issue when the Treasury secretaries are thinking about this, about how do we set up a coalition where people want a robust enough tax base, such that we can repay our debt. Hamilton dealt with this back in 1790. Other Treasury secretaries have dealt with this.

Eric Hilt at Wellesley College and his co-authors have a nice paper talking about how the inflation after World War I influenced electoral results there in the 1920s. Also, I think they’ve got a follow-on paper to talk about World War II as well in terms of looking at who was holding savings bonds after World War II and how inflating away the value of the savings bonds affected the elections.

I think one thing that’s different between those episodes, say 1790 or World War I or World War II, is that back then, almost all the debt was held by domestic private investors. Nowadays, the holdings of the debt are more diverse. Only about 45% of the debt right now is held by private domestic investors. About 25% is held by foreigners. 10%, 11% or so is held by the Fed. Then a lot is held by government agencies and trust funds, such as the Social Security Trust Fund and some other government retirement accounts.

Whether people feel it, whether they see these losses, and whether they say, “Oh, my gosh, I’m looking at my 401(k),” and then I take a look and I say, “Gosh, the government bond fund that’s in some percentage of my 401(k) is done very poorly this past year. Gee, I better vote for higher taxes so that part of my retirement account does better,” it’s not the tight link that you had that investors can see between, “Ah, I’m getting a low return. Maybe I should vote for a more robust tax base so that we   pay for this with explicit taxes rather than turning my bonds into partial taxes.”

I’m not as optimistic about the politics as I see in the past. The messaging at lot of people get is that interest payments are going to be greater than the defense budget. You say, “Well, gosh, if interest payments are greater than the defense budget, it must mean that the bondholders are going to be paid very well. We don’t need to feel bad for them. They’re going to be paid a lot. Inflation is going to be 2%. It should be a good time to be a US government bondholder.” 

What we try to point out is that when you look at the market value of the debt, you look at actually market values rather than par values. You measure debt by its holding period return, which takes into account the capital gains and losses rather than the accounting measure that the Treasury and the US government uses—they use the accounting measure for good reasons—that’s where the losses to the bondholders will show up on that. Whether people see them and whether that creates a political constituency, I hope so.

Beckworth: Remains to be seen.

Hall: Yes.

Beckworth: I guess I’m hopeful that what we saw with the number one concern in Gallup polls and different indicators that they will be very triggered, maybe to use a modern word. Politicians will respond to that, but maybe not. Maybe we’ll end up with, literally, a higher trend rate inflation. We just accept it. I don’t know. That’s one way we pay off some of the debt.

Hall: I don’t see anyone in DC or on Capitol Hill arguing for higher taxes and lower spending.

Beckworth: Yes, no, I don’t either. As you know well, the thing that they really have to address is entitlements. That’s where the lion’s share of expenditures go. We have to touch that. No one wants to touch that.

Hall: We’ve gotten only more generous, post-COVID.

Beckworth: Yes, I was on a plane flying here to DC. There was a congressman on the plane, who will remain unnamed. We started talking about this very thing. He goes, “No one wants to touch it. No one wants to touch it, but we have to.” Everyone’s unwilling to go there. There has to be something that leads us to this to this point. Otherwise, it’s going to be some form of higher revenue, whether it’s taxes or inflation.

Financing with Inflation

Real briefly, George, though, in your paper, you do mention there’s a limit to how much we can finance with inflation. You talk about anticipated, unanticipated. Maybe, also just bring up the inflation Laffer curve. I know this isn’t really the Laffer curve, but people call it the inflation Laffer curve. Maybe talk about that as well. Why we need to be careful when we think, “Well, we can just inflate away our debt.”

Hall: Yes, actually, let me just, I can’t help, but just step back. One of the way I think about this is we’re going to have to break some promises. We’ve promised people low taxes, going forward. We’ve promised people high government spending, going forward. We promised government bondholders high returns, going forward. The question is, which one of these promises or what combination of these promises are we going to break?

Breaking a promise on these entitlements is you’re breaking promises on people who are 75 years old, who have made a lifetime of decisions that have brought them to this point. They don’t really have any recourse. Breaking promises on low taxes. You and I might just have to work a little harder and maybe work a little longer or something. Breaking promises to the bondholders. Again, maybe I’ll just have to save a little more in my retirement account on there. I am sympathetic to the, no one wants to break the entitlement.

Which one of these promises we want to break? Nobody wants to break entitlements. Which one is it going to be that we break or some combination? Getting back to the Laffer curve. Yes, so again, well, we think about money. There’s money and there’s bonds. Bonds pay interest and money doesn’t. If you raise the inflation rate, you’re raising your interest rates will rise. The opportunity cost of holding money is going to go up. If the cost of something goes up, you hold less of it.

As the inflation rate goes up, people are going to hold less money. Higher inflation has two effects. One is you collect a little more revenue because it’s a higher tax rate on the tax base, the balances, the money that people hold. It also has a countervailing effect in that people are going to conserve on their money balances and will hold less of what they’re getting taxed away. As a source of revenue, the seigniorage part of what you can collect through inflation, there’s definitely limits because people will just stop holding it. I will say as a vehicle for default, you can default away almost everything, as a vehicle if you’re willing to go there, which I don’t think we want to go there, but we might go just a little bit there.

Beckworth: I’ve read an article by Charles Calomiris. He wrote this a few years back, but he’s talking about fiscal dominance and speaks to what you’re raising here. You’re saying, look, this inflation Laffer curve, there’s the tax base and there’s the tax rate of inflation. You raise inflation. Effectively, you’re getting real resources from the public. As people see, it’s, “Man, why am I holding these dollars? They don’t do me any good. They’re losing value.” You shrink the tax base. What happens, what he suggests will happen, and you can speak to this maybe as a historian, is you’re going to force that tax base to stay wide.

You’re going to force somehow people to hold on to their money. What he thinks would happen is this, that we will get rid of interest on reserves. He wrote this up long before the recent conversations. You get rid of interest on reserves, banks aren’t earning any money. There’s a lot of reserves out there right now. Second, you bring back the reserve requirements. Banks are forced to hold reserves. That’s one way to keep that tax base from shrinking any faster than it otherwise would. Any thoughts on that?

Hall: That’s sort of one way. When you think about, how are we going to deliver low returns? There’s a variety of different ways it could play out. One of them is this, a financial repression type story where you use regulation of the regulatory state to basically tell largely your taxing banks usually is, you say, “You’ve got to hold some of these assets, force you to hold these assets, and then we’re going to run an inflation and deliver low returns. You’re just going to have to hold this stuff.” We’ve done that in the past and other countries have done that as well. There’s just a lot more sort of substitutes. Not everything’s within the sort of regulatory structure. Increasingly, the more you sort of put the regulatory pressure on these institutions, competitors in grayer areas will emerge.

Beckworth: We saw that in 1970s. The emergence of money market funds is exactly because we were forcing banks to have really low deposit rates. I think of today, yes, fintech. When we talk about substitutes, ways to escape. That would lead to an even stronger form of financial repression, which would be the Fed just lowering the yield curve. If you control the benchmark rate, no matter where you go, that would be another option, which is a nice segue into something I want to ask you about.

World War II Period vs. Today

That is, let’s compare the 1940s, World War II period, to today where we are and going forward. You do that in a paper, including what the Fed holds now, what they held back then. I think another great analogy is back then, I think, 1942 to 1951, they did a form of yield curve control. They pegged lower rates and long-term rates. That could be, again, in the cards going forward if push comes to shove. Walk us through how these things are similar. Maybe they’re not so similar. Maybe that’s not a good comparison.

Hall: Let’s just remember what the Treasury and the Fed did. Yes, so Pearl Harbor is December 1941. We enter the war and it’s clear we’re going to have to borrow large quantities of money to finance the war. The Treasury recognizes this. Everybody else recognizes this. One thing that happens during wars is that interest rates tend to rise during wars and during crises of various things. Investors realize this. Often investors are reluctant to invest early on. They’re worried that, “I’m going to buy some government bonds, interest rates are going to go up. That’s going to cause the value of my bonds to fall. It’s better off for me to wait.”

Treasury often has various strategies to deal with that. During World War II, that strategy was, we’re going to just commit to a fixed yield curve. They told the Federal Reserve, “You’re going to fix the yield curve.” In particular, what they decided to do is fix an upward-sloping yield curve. Treasury bills were fixed. The yield on Treasury bills was three-eights. The yield on 30-year bonds was 2.5%. They fixed some of the intermediate points so that you got a nice upward-sloping yield curve. 

They also fixed the price. They did price controls to fix the price level. They said, “Look, there’s no interest rate risk. There’s no inflation risk. Go ahead and invest in US Treasury securities. Actually what’s sort of interesting is they actually set the yield curve ever so slightly higher than it was right before Pearl Harbor. It wasn’t that they were lowering the interest rate immediately, but they recognized that interest rates might rise and they didn’t want interest rates to go up on that. In that way, they were lowering the interest rate.

What happened was investors realized, “Okay, there’s no interest rate risk. There’s no inflation risk. Why would I invest in a Treasury bill that’s paying a yield of three-eighths when I could buy a 30-year bond that gets a yield of 2.5%?” The private market all went into the long stuff. And I should point out that the Treasury secretary also wanted to issue stuff all along the yield curve because he wanted to make repayment smooth after the war in anticipation. He’s issuing both short-term stuff, medium-term stuff, long-term stuff.

The private investors say, “Well, we’re going to go into the long-term stuff because that’s where the higher yields are.” It left the short-term stuff unsold, and the Federal Reserve went and purchased a lot of the short-term stuff. They soaked that up. What happened was it meant that the Treasury held a lot of the short-term stuff and the private investors held the long-term stuff, and it tilted the maturity structure held by private investors to the long end. When that inflation in the late 1940s hits, it’s really those private investors who are holding that long-term stuff, they get really hit really hard.

When, of course, the interest rate controls get released in 1951 and interest rates go up, those people still take some big losses as well. Today it’s different in that the Federal Reserve during COVID bought a lot of Treasury securities. What they were trying to do was buy stuff on the long end and take debt on the long-term debt. They want to take that off the market. The Fed’s portfolio of Treasuries is overweighted on the long end, and they’ve been removing duration risk from the public.

The public is more concentrated in the short-term stuff, which means that if and when another bout of inflation were to hit or if interest rates were to go up, it’s going to hit the Fed harder than it will hit the private sector on there. Let’s say during both wars, the Federal Reserve was active in the Treasury market, but they were holding sort of different parts of the maturity structure on there. That had implications for when the postwar inflation hit on there.

Beckworth: Does this mean going forward it’s going to be harder for the Fed to play a similar role? Could the Fed step in and buy up debt to facilitate something like fiscal dominance, set interest rates to a level below where they would otherwise be? What do you think would happen?

Hall: The Fed is trying to shrink its balance sheet, but there’s no reason why it couldn’t further expand its balance sheet and buy more Treasuries if it feels it needs to. That, if for some reason, say, Treasury is having trouble selling its securities, the Fed could conceivably step in and take some off the secondary market on that.

Beckworth: What you mentioned about the Fed, taking on duration on its balance sheet, taking on long-term treasuries, and long-term treasuries are more sensitive to interest rate movements than short-term ones. World War II, the public was holding a larger share of long term, so they took the hit. As rates went up, their bond value went down. Today, the Fed’s holding disproportionately more of these long-term Treasuries. It’s taken the hit, and we’ve documented this on our show. We talked about it, how the Fed is currently actually, it’s generating a loss and persistently generating a loss. Although I’ve seen forecasts that are expected to turn around here pretty soon.

Who Bears the Fed’s Losses?

The question that comes to my mind, and I’m asking this maybe from a general equilibrium perspective, who really is bearing that loss? If the Fed’s bearing that loss, it’s being passed on to the taxpayer, who in turn is bearing the loss. One way or the other, is the public bearing the loss? I’m almost invoking here Wallace neutrality, Modigliani-Miller theorems, that at the end of the day, who is the bondholder? Who’s a taxpayer? I know this is not perfect one-to-one mapping, but it seems like a lot of these losses would be borne by the public in any way we slice or dice it.

Hall: One thing about the government budget constraint, if you think about the Federal Reserve as part of the government, then its losses are just gains for the Treasury. I think in terms of, it’s a borrower and a lender, and one’s the winner and one’s the loser, but they’re both part of the US government. I think in terms of the losses that the Fed is taking on its balance sheet, those are just gains for the Treasury. Those net out.

Having said that, the Fed owns a lot of private mortgage-backed securities, to which it’s a little harder to get a handle on what those things are actually worth, but those things have clearly taken losses. That’s going to be a transfer between the US taxpayer and the private sector. Those losses on the private part of the Fed’s balance sheet are a transfer from the taxpayer to the private sector.

Beckworth: That’s a fair point. I had Peter Stella on the show. The point he raised, I think you’re alluding to, is there are distributional questions here. Who holds the mortgage? I, for example, I refinanced my mortgage at a really low rate in 2021. I’m benefiting today from this, and some taxpayers out there are helping foot the bill for that. So in that case, maybe the benefits are concentrated. It’s not just like we’re passing one-to-one from bondholders and taxpayers. There are actual differences here, so we need to be mindful of that.

Hall: Yes, when you think about your mortgage, so you timed it well. The market price of your mortgage has fallen as interest rates have gone up. You win, and your lender has lost. Who is that lender? It might be that it got bundled into some mortgage-backed security that’s now held by the Fed, and that’s ultimately held by the taxpayer. That would be the transfer from the taxpayer to you. You’re welcome.

Beckworth: Thank you, my fellow Americans. It makes it hard for me, George, to want to move. Honestly, I’d like, until I pay my mortgage off, I have little incentive to move because I’m getting this great investment. This is really like, the way I look at it, it’s a fantastic investment vehicle for me. Housing, I understand housing values aren’t growing as fast now. There’s a growth in housing inventory, but over the medium term, it’s a great deal for me.

How to Foot the Big, Beautiful Bill

Let’s circle back, though, to your paper here. We’re close to the end of our show. Let’s land this plane, and maybe it’s going to be an ugly landing, but where do you see this going? We’ve touched on it, but going forward, how are we going to pay for what appears to be a significant growth in our public debt, given the One Big, Beautiful Bill being passed through, given even the baseline CBO projections before that? There’s just these structural primary deficits, as far as the eye can see. What do you think is the most realistic steps, in terms of us paying for these, going forward?

Hall: Yes. The way I frame this is, what promises are we going to have to break? Are we going to break the promises to the folks who are recipients of entitlement spending? Medicare, Medicaid, Social Security, veterans’ benefits, those things. Are we going to have to cut back on defense? Are we going to have to raise taxes? Are we going to have to deliver low returns to the bondholders? My preference is to do some combination.

We don’t need to pay bondholders exorbitant returns. I think taxes are going to have to go up. With some sort of glide path, younger people are not going to get the promises when they’re 70 and 80 that we’re going to promise them. What I’m afraid of is that it’s going to be the bondholders. I don’t see anything, any sort of political constituency—there’s no Alexander Hamilton this day saying that the debt needs to be well funded. If it’s well funded, there’s lots of benefits to having well-funded debt. There’s no one like that making those arguments today. 

Again, this was an after-dinner talk and Tom was told not to be boring. We finished it with a quote from Milton Friedman, where he says, “Governments don’t deal with problems until they become crises.” We really do hope that we deal with it before it becomes a crisis. We don’t wait until things become a crisis. We’re not in a crisis right now, but we hope not to get there.

Beckworth: Yes, well, I think we’re seeing some early warning signs that we’re headed into a crisis. The fact that the Fed’s being called on to lower rates to help pay for the debt, the fact that there’s talk about getting rid of interest on reserve balances as a way to increase flows to the federal government from the Fed, even if that’s a misguided notion. To me, those are warning signs. The interest amount we pay on the debts is a warning sign. That CBO projections are warning—all these things are warning signs. Just to be clear, what you said is you think the bondholders, like they did during the pandemic, will likely, the path of least resistance politically will be the bondholders. In plain English, that means inflation. We’re going to have higher inflation.

Hall: Higher inflation. You could imagine some years in which we have 4 and 5% inflation. We say, “Oh, it’s due to tariffs or it’s due to transitory stuff.” I’ll point out that, after World War II, they lift the price controls in ’46, but we’ve got inflation in ’47 and ’48. Inflation still, I remember the Treasury-Fed Accord happens in ’51 because the Fed is saying, “Look, we need to get control of inflation.” That’s, well, six years after the war was over.

I think this inflationary pressure will be with us. I don’t think the Fed can fight inflation on its own. I think it’s going to need help from the fiscal authority, some cooperation. I don’t think we need to balance the budget to the dollar. We need much smaller budget deficits than we’re running, or than we anticipate running for the next 10 years.

Beckworth: For Fed watchers, one big takeaway from this conversation and where we’re landing the plane is that the Fed’s inflation target might be a little softer than we think. I think another early warning sign will be when the rhetoric begins to say, “Well, we’re close enough to two,” and next will be, “Oh, we’re close enough to three, or four isn’t so bad.”

Hall: It’s because of supply chains, or it’s because of tariffs, or it’s because of this or something. It’s some other thing. Whatever this transitory thing goes away, the price level doesn’t come back down. The price level stays permanently higher so that it has a permanent component to it as well. We preach a great deal of confidence that the Fed can hit its inflation target. I think, though, in order to do that, that’s all predicated on assistance from the fiscal side. It’s just not getting any help from the fiscal side. Will the Fed be able to hit its target? I hope so, but not everything’s under its control.

Beckworth: We may be living through an historical period where people who have only known a regime of monetary dominance get their first taste of a fiscal dominant regime. Again, maybe this will be the medicine that slaps us all into place, that puts us into a place where we want to bring meaningful structural reform to the fiscal trajectory of our economy. 

With that, our time is up. Our guest today has been George Hall. George, thank you so much for coming back on the program.

Hall: Oh, thanks so much for having me. It’s been a lot of fun. It’s a real pleasure.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. Dive deeper into our research at mercatus.org/monetarypolicy. You can subscribe to the show on Apple Podcasts, Spotify, or your favorite podcast app. If you like this podcast, please consider giving us a rating and leaving a review. This helps other thoughtful people like you find the show. Find me on Twitter @DavidBeckworth, and follow the show @Macro_Musings.