Currently the U.S. federal government owes over $17 trillion dollars to its creditors. That is a big number. It is roughly the size of annual U.S. GDP.
If we as a nation want to reduce this debt as a share of our national output, we need to do some combination of the following three things:

  1. Grow our economy so rapidly that the debt is no longer large relative to the size of our economy.
  2. Increase taxes and/or lower government spending so that we can devote resources to pay down the debt.
  3. Inflate our way out of debt, implicitly defaulting on the government’s creditors by paying them negative real (inflation-adjusted) returns.

Is option 1, growing our way out of debt, realistic? Reasonable people can disagree, but it seems unlikely. What about option 2? Higher taxes and lower spending seem rather unpleasant, and higher taxes in particular seem unlikely given current political realities. So what about option 3?

In a new working paper (which is nicely summarized in a VoxEU article) Professor Jens Hilscher and co-authors Alon Raviv and Ricardo Reis argue that option 3 – reducing the real value of debt through inflation – is an extremely unlikely alternative. Right now, much of what the U.S. owes is due within the next year or two. If inflation rises, creditors will simply demand higher interest rates when the Treasury must redeem and reissue this debt. Further, about $5 trillion of the debt is owed to the Social Security system – so the government would be essentially defaulting on itself! At the same time, investors do not expect the U.S. to default outright on its debt.

If option 3 is off the table, then the only remaining, realistic alternative is that government spending will decline or taxes will increase. The authors conclude that:

Perhaps inflation itself, while not eroding the real value of government debt, will generate fiscal surpluses by decreasing the real value of nominally frozen public sector wages and pensions. Alternatively, perhaps market expectations are inconsistent or they are severely underestimating future inflation. What is sure and inescapable is that, one way or another, the budget constraint of the government will have to hold.


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