What is the relationship between large deficits and inflation in industrialized countries?;

In the aftermath of the recent financial crisis, the U.S. government ran a deficit of 9.9 percent of gross domestic product (GDP) in 2009—an unprecedented level during peacetime. Figure 1 shows the United States’ deficit experience since World War II. Because U.S. history does not provide us with a guide for how fiscal balance will be restored, we look at the experiences of other countries that have faced similar budget shortfalls. In our investigation, we restrict our attention to industrialized countries since 1970. We do this because of the availability and quality of data published on these countries. Also, the institutions and economic fabric of these countries are closest to those of the United States, so their experiences are more likely to be informative for our current situation. In this article, we address the following questions: Is there evidence of a relationship between high deficits and inflation? And how was fiscal balance restored in industrialized countries that experienced large deficits? Did governments do this primarily by restoring fiscal discipline, by defaulting on debt, or by devaluing debt by means of high inflation? In the next two sections, we explain the intuition and then review empirical evidence concerning the first question. Deficits and inflation are mechanically linked because inflation causes higher nominal interest payments and thus swells public spending. However, as we explain in box 1 (p. 85), these large interest payments simply cover the depreciation in the real value of debt and do not increase the real burden of debt. After appropriately accounting for these interest payments, we find that large deficits are not associated with higher inflation contemporaneously, nor are they associated with the emergence of higher inflation in subsequent years. This finding should not necessarily be interpreted as implying that high deficits never cause inflation; rather, it is likely that the countries that can afford large deficits have built solid reputations and institutions that support a sound monetary policy and the reversion to a stable fiscal regime. Having shown that inflation does not appear to be the universal outcome of large fiscal deficits in our main sample, we examine the specific experiences of three countries that ran among the largest public deficits on record while retaining low inflation: Finland and Sweden in the early 1990s and Japan in the 1990s and 2000s. In the case of Finland and Sweden, the fiscal imbalance was short-lived; after a large but brief rise, the level of public debt returned to a sustainable path, thanks to fiscal surpluses and healthy macroeconomic growth. In Japan, public deficits were much more persistent, partly as a result of economic stagnation. Consequently, public debt there has continued to increase over the past 20 years, and a full resolution of fiscal imbalances has yet to occur. One commonality of the Finnish, Swedish, and Japanese experiences is that each nation’s large deficits were the consequence of a banking crisis and the ensuing recession—this is analogous to the current U.S. experience. Our analysis complements Reinhart and Rogoff’s (2008a, 2008b, 2009) broader and more systematic work, which specifically looks at the onsets and aftermaths of financial crises across the world. Reinhart and Rogoff pay particular attention to macroeconomic performance and fiscal policy; our findings confirm Reinhart and Rogoff’s (2009) conclusion that banking What is the relationship between large deficits and inflation in industrialized countries?