 How can it be that we have so much more debt, less prospects for running surpluses for collecting revenues that will pay for it, and yet everything seems to be perfectly fine? My name is Richard Reyes and I'm the A.W. Phillips Professor of Economics at the London School of Economics. Governments have increased the amount of borrowing that they do, a very large amount over the last two decades. This is not just a U.S. phenomenon, it's an O.E.D. phenomenon. At the same time, we haven't really had that many debt crises in most of those countries. Standard economic theory would say that the debt is sustained by the present value of expected primary surpluses. It says that the governments are going to have to collect more in tax revenues that they spend over a long period of time in order to be able to honor and pay that debt. At the same time as debt has grown so much in the last 20 years, you've had that pretty much every forecast of deficits, of how much governments are going to spend versus what tax, and if anything deteriorated. So again, how can it be that we have so much more debt, less prospects for running surpluses for collecting revenues that will pay for it, and yet everything seems to be perfectly fine? Well, the answer turns out to rely on the fact that there is a second source of revenue for governments beyond collecting taxes in excess of spending. And that is the fact that governments, especially over the last 20 years, have started being able to sell government debt at a very high price. As you sell government debt at a very high price, you collect the fact to have revenue from providing that debt. When I borrow or any economic agent borrows, there's a certain market rate which reflects the borrowing cost, how much it is that I need to repay you. Well, the government turns out to be able to borrow at a significantly lower rate than the market. That used to be the case for the US for the last 20 years, not so much for pretty much any other country, but over the last 20 years has become the norm for the majority of countries and has become much larger for the US. That is, the US, as well as many other countries, now is able to borrow at a highly subsidized rate if you want. In other words, you're willing to give the government a lot more to collect a much lower interest rate than you did in the past. In other words, the government is able to collect a big discount on the savers that want to lend to it. Well, that discount, the difference between the rate at which the government borrows and the rate at which pretty much anyone else in the economy borrows, is ultimately a form of revenue, is ultimately says that I need less taxes in the future in order to pay that debt. This is what I've called, and some others have called the debt revenue. It's a revenue that comes from issuing debt. This revenue is one that it was familiar to economists when we think about a very particular form of government debt, and that is money. Money used to pay close to no interest, even when interest rates were high in any of the forms of borrowing, and yet people are happy to hold money because it was so convenient to use it to make payments and others. That even got a fancy esoteric name, senior economists have called it over the years, but that has never been very much. One percent of GDP at the most in the typical economy like the US. That revenue instead, that is how much the government can borrow and the government borrows a lot at this highly subsidized rate, that turns out to be a very large amount, something like five percent per year, which when you think in terms of stock of debt, a five percent per year is able to sustain something like almost 80 to 100 percent of debt to GDP just on account of this. And so you have, you're able to solve this puzzle, this puzzle that of how is it that we're able to borrow too much. But now this doesn't just solve a puzzle. It also, of course, has implications for how to think about that sustainability going forward. If it is the fact that most of the debt is being sustained, is being paid for effectively through this discount on the boring rates that the government gets from everyone else when it lends to it. Then when you start asking debt sustainability questions, in other words, what could go wrong, you are asking what could shrink that discount. Why would people all of a sudden not want to lend to the government at such a subsidized rate? Well, as you think about in those terms, you end up with different insights on how to think about that problem. Let me tell you a few. Number one, is inflating the debt a good idea? Well, in the last year, it's been a wonderful bonus for many governments that with inflation so high, the real value of the debt has declined quite significantly. Pretty much every country in the OECD has had such high inflation that in spite of running a deficit, public debt to GDP has fallen. Why? Because with inflation, the GDP increases a lot more for a fixed amount of nominal debt that you've borrowed. Seems like a great idea, right? Well, it's OK for one year. But if your lenders, the bondholders, say, start expecting a lot of high inflation, they are going to start perceiving the public debt as being much very risky because, after all, they're the ones who lost in the last 12 months, and thus they're going to start offering you less of a discount because your debt is not so good in providing them safety as it used to be. And that says that then moving forward, that discount will fall, that that revenue will fall, and that that will become more sustainable. This is one of the many reasons why it's so important that we control and tame the inflation beast, not just because of direct cost of inflation, but also because an expectation of inflation will make the debt as sustainable. Second reason why it's important to think about it in these terms in terms of debt revenue. What allows that revenue is what makes that special, public that special. When we're thinking about financial regulation and the extent to which financial regulation develops private forms of savings or forces economic agents to save in government bonds, because the government by regulation says you better hold the government bond if you want to engage in a series of financial transactions, then we are again talking about affecting the relative demand for government bonds versus other vehicles of savings. And you end up with conflicts here in that sometimes what will increase the debt revenue will, at the same time, perhaps lead to a worse allocation of investment to the capital in the economy. But you start having difficult trade offs there between having a growing economy and develop financial markets with trying to sustain the government's ability to borrow at a very discounted rate. Financial repression is often the big word used to describe these type of trade offs, which with the increasing relative to that revenue term become increasingly more important. And finally, a third one, a third trade off or third implication of thinking through debt revenue terms. Think, for instance, about the desirability of running deficits in recessions or during COVID or others. Think about a situation like we had in 2020. Well, in that situation, there is a very classic argument that we should run deficits in order to stimulate the economy and in order to try to get people to continue to be able to spend and to go to work and so on. And in doing so, being able to keep economic activity. But at the same time, these are also times often in recessions where there's a big demand for the safety, the convenience, the protection offered by government bonds. The fact that by running deficits we're also increasing the supply of those government bonds may actually be itself a very stimulative effect. Why? Because it absorbs that desire to save without affecting interest rates and spilling over to private investment in different ways. And so you get here again a different perspective on stabilization policy that is less about the flow, how much you spend or not, and more about are you providing the assets that allow people to save or not. So these are just three examples of how you end up with quite different perspectives by thinking about it that way. You end up with desisting analysis by organizations like the IMF and others where you have to consider different trade-offs beyond different measures of what is a sustainable debt or not. What makes government bonds special? Well, one thing is that government bonds are safe. What is the main risk on the government? Default, of course, which tends to be a remote possibility for countries like the U.S., but the major one is inflation. With inflation in control for 20 years, government bonds have been very safe. And why now the current bout of inflation is worrying for desisting ability insofar as it jeopardizes that safety? Number two, what makes government that special is that it is used as collateral in financial transactions. It is a very important grease that keeps the whole financial system going. In fact, some of the specials that debt of last 10 years can be due to post-crisis regulations as well as the desire of agents for being able to better collateralize loans of different type as increased the demand for those government bonds. Third reason is that because they have such deep markets, they're very liquid. They're very easy to buy and sell. Well, all the discussion we had in 2020 about how the Treasury market works, how it doesn't work, how central banks have become much more active at keeping it working in some ways. Well, all of that feeds into making the government bonds particularly special. Insofar as you can always rely that if not the dealers and the entire structure set up for Treasury's markets, it will be the Fed ultimately that will step up and make sure that this continues to be a very liquid security. So these are some of the reasons why that discount exists and therefore some of the reasons why we may think of what could jeopardize them, what could make that less sustainable into the future. Inflation is the big news of the last 12 months. Inflation is an aggregate risk. It's something that you can't diversify away. It affects all of us. We can't say, oh, it's not like when your house burns down and mine doesn't and we enter an insurance contract as we all do. It's something that affects all of us. But while it affects all of us, it affects all of us with a very differential impact. Inflation brings winners and losers. Society as a whole loses, but very importantly, and what makes inflation such a costly shock is that it really leads to a very stark difference between those who win and those who lose. So let's talk about some of the ways in which who wins and who loses. First, unexpected inflation, inflation that we do not anticipate hurts very much creditors and benefits borrowers. Why? Because I promise to pay you back a hundred dollars with inflation is a hundred dollars is just worth less in terms of real goods. I'm better off because I have less me the borrow and better off because I have to give you less real goods. You're worse off because you receive fewer of the big winner of the last 12 months of this bout of very unexpected inflation, which really two years ago, those who lent to the government and bought a five-year bond five years ago really didn't see this coming. They are the big losers, those bondholders. The big winner is the government. However, and has the experience of every country that has gone through a persistent bout of inflation is that that unexpected game lasts one year. That was 2022, 2021, maybe, but very soon those lenders, those borrowers start expecting inflation, start demanding a higher interest rate to compensate them for the risk that inflation is going to come again, and in the end the loser ends up being the borrower, in this case the government, that now faces a higher borrowing cost, less of a discount, less of a specialist of its government bonds in terms of when it borrows in the future. So that's an important distinction, the unexpected versus expected inflation where you think about the winners and losers in the craters and borrowers. But there's more than that. Let's think a little more broadly in terms of some other of these distributional impacts of inflation. Let's think about the fact that over the last 10 years, 20 years, a novel phenomenon, a novel feature, is that we started trading a lot of this inflation risk. We now have very active markets inflation swap contracts and others where you and I make bets on what inflation is going to be or not. Well, beyond the makes bets, let's make it less about bets and more about insurance. Some agents in society, some financial institutions really suffer with high inflation that is persistent. And for the most part, who are they? Insurance companies and pension funds. Why? Because they promise you a certain amount to pay a certain amount at a very long horizon. Well, because inflation cumulates over the years, persistent bouts of inflation are going to come with very big changes in how much pension fund and life insurance are going to owe you or not. So they tend to be big buyers and sellers of these inflation insurance. On the other side, who is their banks? Or if you want the ones who are happy to sell that insurance against the pension funds. And then there's a series of different actors there, but those are two of the fundamental ones. Well, if you look then at the last year, what you have is that you have a whole industry that over the last 15 years has been selling inflation insurance and that has been making nice profits every year as they should for selling that insurance. They now have to pay. And so right now in 2022, you are seeing very large payments across different parts of the financial sector having to do with those who had bought inflation insurance versus those with sold inflation insurance. That comes because this is unexpected because you had insurance and then it didn't happen. Of course, expected inflation should come with none of that. This is an old topic that I had been thinking a lot. And indeed, INET had funded my work on this almost a decade ago, which was seeing to what extent was in the financial sectors we had expected inflation coming or not. And what was very interesting in that work was to note that when we looked at the government bond market as well as others and you try to infer what people were expecting inflation, the events of the last year were really unexpected. People really didn't see it coming. What that means now is that, of course, these transfers across different agents, different institutions are going to be much larger. They weren't really initially anticipated. However, what we had seen as well is that they are very large, but also at the same time, you had seen a shortening of the duration of loans and of different financial contracts. What does that mean? That means that when you have an inflation shock, the current contract gets affected by it. We didn't see it coming. You win or I lose. But as soon as that contract ends, I'm going to be writing a new contract with you. And I'm going to put there the inflation that I expect, and so are you. And therefore, that unexpected inflation leads to very large movements for a year or two. But as soon as they're done, what you're left with is instead this higher risk of inflation being priced in, hurting borrowers and hurting others. And so you have, again, this unexpected, expected distinction, which you're showing up much more through the maturity, the duration at which the borrowing and lending happens across the different agents. Still, in terms of the winners and the losers, we have what we're seeing right now in terms of workers versus firms. What we're seeing in 2022 is that prices are being adjusted up and wages much less so. As a result, over the last 12 months, there are, and we're going to start seeing this more and more as as profits start being reported for firms from last year, is that firms had a very good year and workers had a very bad year. Real GDP has increased in the last 12 months, Gonzalez. So why is it that we see people saying, Oh, this inflation has been terrible. I feel so much poorer. Well, because workers are poorer, because wages have increased very little, even as GDP has increased so much and incomes increased. What's the difference between them? Capital income has increased quite a lot. In other words, capital income and those who live for out of from profits have had a great year. Workers have had not such a good year this year. That happened because of an expected inflation and an expected inflation is after all prices going up when wages haven't kept up. What does that mean, though, as now we expect the inflation part? Well, over the next year or two, workers are going to have to have their wages brought back. I want to have some catch up relative to how much I lost as a wage earner relative to my bosses. Well, we're therefore going to have a process of adjusting higher wages. That is natural. That should happen. That's what we would expect to happen. That's how the workers are going to recover some of the lost ground that they've had in the last 12 months. But the process by which that happens comes with wage price dynamics that can make the inflation not just as we move to the expected inflation stage to an inflation that persists and an inflation that leads to an interaction with monetary policy on how to bring it down. So a big challenge right now for monetary policy and not only is it trying to understand where this inflation bubble persists, is whether precisely how this needed adjustment upwards of wages, how is that going to really play out? How is that going to interact with the adjustment of prices? And is this going to engender a more persistent inflation episode than any of us wish? And this is in some ways the large challenge of the Fed. So even when we think about monetary policy today, of controlling inflation over the next few years, of bringing it down, the big priority today, it is indeed very much about winners and losers of this inflation bout. In this case, relationship in wages and capitalists. In my previous example, between different elements of the financial system who are making longer and shorter loans as well as buying and selling sugar contracts and finally on the government versus the bondholders. How do we see if inflation is expected or unexpected? Well, all of these agents that are winning and losing are everyday trading contracts so that we can see the price of which they buy and sell to try and figure out at least what they're expecting. That is what inflation swap markers give. Now, this data is tricky because you really have to treat it with a lot of care. Why? Because it's not just the inflation expectation but also the risk about those predictions that come into them. In some other work, what I have done is to say, well, let's try to focus on the tail events. Let's look at the disasters. Let's look at how much people are willing to pay in order to buy some insurance against inflation going really far off. And what's interesting there is that those prices that had to be close to zero as of two years ago, no one was willing to buy insurance against inflation being 4% on average between 2027 and 2032, say, again, a far horizon. And today, they're willing to pay some. And that is very worrying for institutions like the Federal Reserve because you see probabilities of 5%, 10% as reflected in these desire for insurance that these prices are revealing and therefore say that there is a little bit of a risk here. By far not an expectation of it but a little bit of a tail risk and that I think is what keeps policymakers awake at night.