Snow blankets the White House grounds during a blizzard February 6, 2010.

Global Economics: US public debt as a share of GDP is now higher than at any other time in history except after World War 2 - and rising: US economists of investment bank Morgan Stanley, expect public debt to GDP to increase to 87% by 2020. MS says how policymakers will deal with this fact will likely be one of the main drivers across markets going forward. It asks what are the implications of high public sector debt for fiscal sustainability and inflation? To answer this question, MS looks at how the US economy escaped high debt following World War 2. It then quantifies the inflation risks inherent in today's US fiscal position by asking what would happen if policymakers were to deal with the current debt overhang in the same way.

MS economist, Spyros Andreopoulos, says stabilisation of public debt to GDP at current levels would require average inflation rates between 4-6% over the coming decade - even under much lower budget deficits than currently in place. On MS numbers, even with budget deficits that are much lower than the current (and projected) levels, average inflation over the next ten years would have to be substantially above 2% to keep debt in check. Even a balanced budget would require 3% average inflation over the next decade. With an average deficit as low as 3% of GDP, debt stabilisation would require average inflation above 6%. In the current fiscal year (FY) MS expects a deficit of 9% of GDP, projected to decline to 5.2% of GDP by 2020. Spyros Andreopoulos says: suppose the government were to reduce the deficit to 5.2% from 2011 onwards - rather than by 2020; stabilising the debt at current levels would then require an inflation rate of 9% on average over the next 10 years. The economist asks: "What level of deficit would be consistent with achieving a 2% inflation target, on average, over the next 10 years?" and answers: a 1% of GDP budget surplus.

Andreopoulos says it is clear that inflation risks of this magnitude are not in the price: currently, markets are anticipating inflation to be below 2.5% over the next 10 years, on average. He asks if there should be concerns about ‘debtflation' - the Fed engineering inflation to keep the debt in check? He says a forward-looking central bank may prefer to create a little controlled inflation now to the pressure of inflating a lot later on. And the idea of controlled inflation has influential advocates in policy circles. Former IMF chief economist Kenneth Rogoff and now Harvard University professor, has suggested the Fed announce a 4-6% inflation target for a limited period.

1. The Fiscal Consequences of the Crisis

MS says the financial crisis and the Great Recession have increased US public indebtedness substantially:The debt to GDP ratio has shot up from 37% pre-crisis (fiscal year 2007) to around 60% in FY 2010, on its forecasts. With the exception of the World War 2 peak, this is higher than at any other time in the entire history of the US - including World War 1 or the Great Depression. From a fiscal perspective, it's as if the economy has just gone through World War 3.

And it's likely to get worse, implying fiscal and inflation risks:US economists at Morgan Stanley expect public debt, as a share of GDP, to climb further to 87% by 2020. Given this trajectory, fiscal sustainability remains a concern with investors and the public. Further, given the historical link between high public debt and inflation both in the US and internationally, such a precarious fiscal position may also pose a danger for price stability.

Quantifying these inflation risks with the help of history - and a simple accounting framework:Yet how large, exactly, are the inflation risks inherent in the current US debt position? Could inflation substitute for budgetary tightening in the pursuit of fiscal sustainability? Conversely, what is the size of the budget deficit or surplus consistent with low inflation? In short, what are the options policymakers have to keep debt in check? To answer these questions, MS looks to history for guidance and ask through what mechanisms - the budget balance, economic growth, or inflation - did the US economy escape the record World War 2 debt levels? In other words, what mix of fiscal and monetary policies ensured fiscal sustainability after World War 2? Assuming the same mix is applied to the current situation, MS can then put a number on long-term inflation risks.

2. Looking Back: A History Lesson

War debt burden was reduced not through budget surpluses...World War 2 left the US with a large debt overhang. In 1946, US public debt was 108.6% of GDP. Nearly 60 years later, in 2003, public debt to GDP was just 36%. Within two generations, debt had been reduced by over 70pp of GDP. This corresponds to an average decrease of debt/GDP (‘the debt ratio') by 1.2% every year. How was this achieved? Remarkably, between 1946 and 2003 the federal budget was, on average, in deficit, to the tune of 1.6% of GDP as the surplus in the primary balance (0.3% of GDP on average) was not enough to cover interest payments on the debt (1.9% of GDP on average).

...but through (nominal) economic growth...So how was the debt ratio reduced despite the US government having, on average, run budget deficits? The answer is, of course, through growth in nominal GDP. The denominator in debt/GDP grew faster than the numerator, bringing down the ratio over time. By how much, exactly? Nominal GDP growth reduced the debt/GDP ratio by 2.8%, on average, between 1948 and 2003.

... with the inflation effect larger than the real GDP growth effect!MS says this begs a more important question: how much of the erosion of the debt was due to growth in the real economy and how much of it was due to inflation? MS splits the Nominal Growth Effect (NGE) on the debt ratio into a Real Growth Effect (RGE) and an Inflation Effect (IE). 

MS numbers show that while real GDP growth reduced debt/GDP by 1.3% on average, the effect of inflation on the debt ratio was larger: 1.6%, on average, between 1946 and 2003. (In relative terms, 56% of the total Nominal Growth Effect on the debt ratio is due to inflation, with the remainder being due to real GDP growth.)

The largest contribution of inflation to debt reduction came in the decade immediately after World War 2 (1946-1955). Despite a primary surplus of 1.2% of GDP, overall the budget was in deficit by 0.3% of GDP on average. Yet, the debt was reduced by 4.9% of GDP a year, through a nominal growth effect of 5.2% annually, as nominal GDP growth averaged 6.5% over the period. This very large nominal growth effect is mainly due to a substantial inflation effect - inflation averaged 4.2% over the period - which reduced debt to GDP by 3.7% every year, and to a much lesser extent to real GDP growth, which on average contributed 1.5% of GDP to debt reduction. The 1970s - the time of the Great Inflation - also exhibited a sizeable inflation effect. MS asks how come inflation was so successful in eroding the debt? It sees three main factors. First, outlays were not closely linked to inflation. Second, bondholders were surprised by inflation both after the war and in the 1970s. Third, in the first post-War decade, the average maturity of the debt was - at more than 100 months - exceptionally high.

3. What If? Looking Ahead

Suppose policymakers deal with the debt now in the same way they did after WW2: Assuming the same relative roles for inflation and real economic growth as in the post-War period, how much inflation is needed, for a given budget deficit, to keep the debt ratio from increasing? Conversely, assuming a given inflation target - say 2% - what is the size of the budget deficit or surplus required to keep debt from increasing?

The assumption for the policy objective is stabilising the debt ratio at the MS current estimate for FY 2010 - 60% of GDP - rather than it increasing to 87% by 2020, the  long-term projection. On the fiscal policy side, policymakers control the primary deficit - the deficit excluding interest payments on the debt - rather than the total deficit (at least in the long run). Hence, the choice between inflation and the budget deficit is really a choice between inflation and the primary deficit, given the size of interest payments (as a share of GDP).

Primary surpluses of at least 2.4% of GDP are required to achieve a 2% inflation target:According to MS numbers, with inflation at 2% on average, a primary surplus of 2.4% of GDP is required in the benchmark case of debt stabilisation at current levels. Given 1.4% interest to GDP, this implies that a 1% budget surplus is required. After World War 2, primary surpluses of the required level have been achieved during one period only: 1996-2003.

A balanced primary budget would imply inflation of 4.7%:If government expenditure other than interest equals revenue, the primary balance would be zero. (The budget deficit would then be equal to interest expenditure.) In such a case, the inflation rate required to keep debt stable is 4.7%. What inflation rate would be consistent with the primary surpluses we have seen historically? The average primary surplus as a share of GDP over 1946-2003 was 0.3%. Stabilising the debt ratio at 60% with this primary surplus would require inflation of 4.3% on average. A primary deficit of 1.2% - the 1915-2003 average - would imply an inflation rate of 6.1%.

Caveats: The framework does not take into account the following factors: First, a given level of inflation may not have the same effect on the debt because the average maturity is shorter - though rising quickly towards, and above, the historical average on the forecasts. Second, by now almost half of federal outlays are de facto indexed to inflation. What does this mean for the inflation risks? Essentially, that possibly even more inflation is needed to erode a given level of debt - at least mechanically. And finally, MS doesn't take into account the potential effect of higher inflation on real GDP growth in the medium term - or of the potential repercussions of an inflation spiral. Nevertheless, these caveats do not substantially affect the main message. The level and trajectory of the debt imply tough choices between fiscal rectitude and price stability.

4. Debtflation Nation?

This leaves one question open. Why would the Fed - in principle an independent institution - want to generate inflation? Independence means the Fed cannot be forced to inflate - at least not directly. Recent threats to its independence aside, for inflation to take hold it must be because the Fed allows it to happen. Surely, this is inconceivable?

Maybe not. Spyros Andreopoulos says consider a Fed that faces the prospect of an 87% debt ratio in ten years' time, with population ageing and all its negative budgetary consequences imminent. In that case, a rational central bank may prefer to create a little inflation now rather than having to create a lot of inflation later on (see "Debtflation", The Global Monetary Analyst, October 21, 2009). The forthcoming increase in the average debt maturity will help.

Andreopoulos  says last but by no means least, note that the range of inflation rates used in the MS calculations - around 5% for the case of a roughly zero primary balance - are already being debated in policy circles. Former IMF chief economist Kenneth Rogoff, now a Harvard University profesor, has advocated a 4-6% inflation target for the Fed, and ex Bank of England MPC member David Blanchflower has made similar proposals. And Professors Aizenman and Marion calculate - in a different framework - that a "moderate" inflation rate of 6% could reduce the debt/GDP ratio by 10 percentage points within four years (see "Using Inflation to Erode the US Public Debt", NBER Working Paper 15562).

Last Friday, the IMF published a paper, “Rethinking Macroeconomic Policy,” part of a series of policy papers prepared by staff of the 186 member international institution that reassesses the macroeconomic and financial policy framework in the wake of the devastating crisis.

In an internal interview, IMF chief economist, Olivier Blanchard, one of the authors answered questions:

Morgan Stanley says investors should take note - and buy TIPS (Treasury Inflation-Protected Securities), rather than CDS (credit default swap), if they are worried about ‘default': while hard default is inconceivable, soft default through inflation is a clear risk.

Whatever about the Fed becoming more tolerant of inflation, it's hard to envisage the European Central Bank, built on the German Bundesbank model, being prepared to loosen the levers, in the absence of much tougher Eurozone fiscal controls.

Above-target inflation might not actually be a bad thing and central banks should not be concerned about it, Professor Ken Rogoff from Harvard University told CNBC, Nov 2008:

Finfacts article, Sept 2009 on "This Time It’s Different: Eight centuries of financial folly; conceit and money" - -  book by US economists Carmen Reinhart and Kenneth Rogoff

Growth in Time of Debt Rogoff/Carmen paper