The Feldstein Lecture, Fiscal Dominance, and the Five Ways Out

Why Debt Arithmetic Always Wins: A Reflection on Mankiw’s ‘Fiscal Future’ and the Limits of Policy Imagination

N. Gregory Mankiw’s Feldstein Lecture, “The Fiscal Future,” is a sober tour of the limited menu policymakers face when debt keeps climbing and politics won’t let arithmetic win. What struck me most is how closely his typology mirrors the framework Arnold Kling and I laid out in our 2022 Mercatus brief on “the five channels of debt reduction.” The overlap is real—and the few divergences are interesting.

Where we agree

Debt arithmetic is unforgiving. Mankiw opens with the core fact: under current law, CBO projects federal debt will march to about 156 percent of GDP by the mid-2050s. That’s not a cyclical bump; it’s a trend born of primary deficits and aging-driven entitlements. Our paper starts from the same premise: once the debt ratio is high and rising, the choices narrow, and each choice has costs.

Five basic paths. Mankiw’s list—extraordinary growth, default, large-scale money creation (inflation), substantial spending cuts, and large tax increases—maps almost one-for-one to our five channels: growth; substantive fiscal adjustment; explicit default/restructuring; surprise inflation; and financial repression paired with sustained inflation.

Growth. Both Greg Mankiw and we agree that strong, sustained economic growth would be the most desirable way to reduce the debt-to-GDP ratio—but also the least likely. Like Mankiw, we view the idea that artificial intelligence or biotechnology will suddenly double or triple long-term growth as wishful thinking. History offers little basis for such optimism: despite revolutionary innovations like the internet, growth has steadily declined since the 1960s, with the Congressional Budget Office projecting a modest 1.5 to 2 percent annual rate going forward. In this light, it would be irresponsible for fiscal policymakers to assume that a technological miracle will rescue the nation’s finances. The sober reality is that while extraordinary growth would be the most benign path out of debt, it is also the least plausible, and prudent fiscal policy cannot rest on that hope.

Inflation = fiscal temptation. We and Mankiw agree that monetizing debt is an implicit default that damages the economy. He frames this through the lens of “fiscal dominance,” when monetary policy bends to Treasury’s financing needs. He points out to President Trump’s recent demands about the Fed needing to reduce rates to lower interest payments as evidence that fiscal dominance is upon us. He notes that “It is unclear whether future Federal Reserves will have the fortitude to stand up to a demanding and belligerent president. So, I wouldn’t rule out the high-inflation scenario.”

We, on the other hand, documented how negative real rates can “liquidate” debt—historically achieved with repression plus inflation—and why that path erodes credibility and punishes savers. Since we wrote the paper, I will say that I believe this is one of the most likely paths but maybe for different reasons. Under the Fiscal Theory of the Price Level, the price level adjusts to ensure that the real value of government debt equals the expected present value of future primary surpluses. When fiscal policy is dominant — meaning that the government issues debt without credible plans for offsetting surpluses — the adjustment must come through prices rather than interest rates or output. In other words, if investors doubt that future taxes or spending restraint will stabilize debt, inflation does the work of reducing the real value of outstanding liabilities.

The COVID inflation episode fits this logic neatly. Massive deficit-financed transfers increased nominal debt, and because markets did not expect commensurate fiscal tightening, the real value of that debt fell via higher prices, an inflationary adjustment consistent with FTPL.

So without entitlement reform or credible fiscal consolidation, and even if monetary policy doesn’t maintain rates artificially low, we can expect repeated bouts of inflation as a mechanism for restoring equilibrium between debt and expected surpluses.

Default is not unthinkable. Mankiw reminds readers that the U.S. has effectively defaulted before, most notably by voiding gold clauses in contracts, showing that politicians can rationalize partial default in times of stress. Our brief also treats explicit restructuring as a live, albeit extremely costly, option that advanced economies have employed.

Substantial budget cuts. Mankiw reprises a line by Peter Fisher, a Treasury official in the George W. Bush administration, that the federal government is “an insurance company with an army,” and shows how Social Security and health programs now dominate federal outlays. We argue that lasting consolidations come from reforms to those programs, not from nibbling at discretionary edges.

Where we lean differently

The instrument of last resort. Mankiw concludes a sizable tax increase is “inevitable” and points to a VAT as the natural solution, noting OECD peers raise roughly 7 percent of GDP from VATs. Kling and I agree that a tax increase will be tempting. But we urge against it. A VAT may well raise revenue; but as Jack Salmon has shown the influx in revenue boosts government by about 7 percent of GDP too. The adoption of a VAT will lock in a permanently larger state while relieving the political pressure to reform the programs driving the debt. We believe it would be a big mistake. The better first principle is to fix the spending problem at its source. The international record shows spending-based consolidations are more likely to stick, less recessionary than tax-led packages, and better for long-run growth. More importantly, they are better at achieving debt reduction as a share of GDP.

Financial repression is likely. Our framework explicitly treats “repression + steady inflation” as a channel because it’s how many countries shrank WWII-era debts (capital controls, rate caps, captive demand for government bonds). Mankiw emphasizes inflation and fiscal dominance but gives less attention to the modern, subtler tools that recreate repression via regulation and bank capital rules. Ignoring that temptation understates the political appeal of off-budget debt liquidation and the damage it inflicts on savers and private investment.

The takeaway

Mankiw and I largely agree on the diagnosis and on the ranking: growth is best but unlikely to save us; default and inflation are costly detours but sadly very likely; the sustainable path runs through fiscal reform. Where I diverge is on the preferred instrument. Before we copy Europe’s tax architecture, we should do what works: anchor a multi-year, spending-based consolidation that tackles the drivers of debt—Social Security and healthcare programs—backed by budget rules with teeth. Of course, there are many ways to raise revenue without raising marginal tax rates: close tax expenditures that aren’t meant to alleviate the double taxation of income and are really government-granted privileges to special interests. Here is how we would do it.

Arithmetic won’t wait for courage to appear. The only question is whether we opt for deliberate consolidation—growth-friendly and spending-led—or let markets decide for us. Mankiw is right that the latter would be “unpleasant for nearly everyone.” He’s also right that a better-educated public can demand better policy. Consider this our contribution to that education and a plea to pick the path that actually lasts.