Eric Leeper on *A Fiscal Accounting of COVID Inflation*

Episode Summary

Executive Summary: Eric Leeper argues that the COVID inflation was primarily a fiscal phenomenon: roughly $5 trillion of unbacked federal transfer spending boosted aggregate demand, altered relative prices, and—combined with passive monetary policy—created fiscal dominance. He uses accounting and fiscal-theory frameworks to show how inflation, bond prices, and debt dynamics reflect expectations of future primary surpluses, and warns that current U.S. fiscal projections remain unsustainable without credible consolidation.

Main Topics: COVID inflation as a fiscal event (Priority: 5/5): Leeper argues that supply shocks and relative-price changes affected inflation’s path, but the core cause was large, unbacked federal spending financed by borrowing and transfers that raised household purchasing power. Fiscal theory of the price level and fiscal dominance (Priority: 5/5): The discussion frames inflation through the fiscal theory: the price level adjusts so government liabilities equal the present value of future primary surpluses. During COVID, monetary accommodation plus unbacked fiscal expansion created a fiscal-dominant regime. Relative prices vs. overall inflation (Priority: 4/5): Leeper stresses that supply chain disruptions and demand shifts mostly moved relative prices (goods vs. services), while general inflation required the broader aggregate-demand impulse from fiscal transfers. Accounting for the debt increase (Priority: 4/5): A backward-looking decomposition attributes the rise in debt/GDP mainly to large primary deficits, with inflation and negative real bond returns also reducing the real value of debt. Bond markets, interest rates, and delayed inflation (Priority: 4/5): Higher rates and exploding interest costs may have shifted some inflation into the future. Bond-price declines and weak Treasury auctions are treated as warning signs about future fiscal stress. CBO long-term projections and policy design (Priority: 5/5): Leeper criticizes CBO forecasts as accounting exercises that ignore macro feedback. He urges a model-based framework that can show how alternative tax/spending changes would stabilize debt and what their macro effects would be.

Key Arguments: Inflation is not explained by supply shocks alone; those shocks mainly change relative prices, while sustained inflation requires households to have the nominal income to spend. COVID-era transfers increased perceived permanent income, so consumers shifted spending toward goods when services were constrained, pushing up aggregate demand and prices. The CARES Act and ARP were effectively unbacked because future tax offsets were not credibly promised, meaning the spending would be paid for partly through inflation. COVID was a natural experiment in fiscal dominance: the Fed held rates near zero while Congress financed massive spending with borrowing and little immediate concern for repayment. The fiscal theory of the price level says the price level adjusts to reconcile government liabilities with expected future primary surpluses; if surpluses do not rise, the price level must. Raising interest rates can reduce inflation temporarily but also increases debt-service costs, potentially postponing rather than eliminating inflation unless fiscal consolidation follows. Bond-market behavior—falling bond prices, weak auctions, and reduced foreign demand—signals that investors are pricing in future fiscal stress and/or higher inflation. The debt burden can be reduced through inflation because higher prices lower the real value of nominal government liabilities. CBO’s long-term projections lack feedback from debt and fiscal policy into macroeconomic outcomes, making their explosive debt paths analytically incomplete. Eventually, political pressure from rising interest costs may force a fiscal response, though the form of that response could include spending cuts, tax increases, or both.

Data Points: COVID-related federal spending: ~$5 trillion - Leeper and Beckworth cite this as the amount of unbacked spending tied to COVID fiscal response. Nominal GDP gap during shutdown: about -$3 trillion below trend - Beckworth cites the economy falling roughly $3 trillion below trend in Q2 during the shutdown. Nominal GDP gap after recovery: about +$2 trillion above trend - Beckworth notes GDP later rose roughly $2 trillion above trend, suggesting large injected demand. CARES Act size: over $1 trillion - Leeper notes the initial CARES Act was passed by voice vote and involved more than a trillion dollars. Debt outstanding increase since 2019: upwards of $7 trillion more government debt outstanding - Leeper uses this to argue that debt revaluation and inflation matter for real debt burden. Treasury financing need in 2024: about $10 trillion - Leeper says roughly $9 trillion in maturing debt plus over $1 trillion deficit must be financed, offset somewhat by QT. Treasury debt due in 2024: about $9 trillion - Part of the total financing burden Leeper says markets must absorb. Deficit financing need: $1 trillion plus - Additional annual deficit that must be financed alongside maturing debt. Debt/GDP forecast horizon: 75 years - Leeper references his 2010 criticism of CBO-style long-term projections extending 75 years. Treasury bond portfolio price level: at levels not seen since the 1970s - Leeper says the market value/par value ratio of the government bond portfolio is back to 1970s-like lows. Inflation measure: PCE under 3% - Beckworth notes inflation has come down to under 3% in PCE terms.

Pivotal Quotes: "When American inflation began its upward march in 2021, economic analysts lined up the usual suspects... Many of these candidates affected the evolution of inflation, and none caused it." — David Beckworth reading Eric Leeper's paper: Opening framing of the episode, emphasizing the paper’s core claim that fiscal spending was the main cause. "What the theory tells us is the Fed's increase in interest rates serve to reduce inflation at the time by pushing it into the future." — Eric Leeper: On why higher rates can delay rather than permanently eliminate inflation when fiscal backing is absent. "What we really need is to put all of this into a coherent economic model that ensures that there actually is an equilibrium." — Eric Leeper: On why CBO-style long-run accounting projections are insufficient for policymaking.

Implications: The episode suggests COVID inflation should be seen as a warning about unbacked fiscal expansions, weak budget institutions, and the limits of monetary policy alone. Future inflation control likely depends on credible long-run fiscal consolidation, not just rate hikes.