Global Economy
Could inflation reduce public sector debt burdens?
By Michael Hennigan, Founder and Editor of Finfacts
Aug 15, 2011 - 8:53 AM

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Skewed US debt maturity relative to other nations: Center for Financial Stability (pdf)

With many developed economies facing high public debt, higher inflation can be seen as a panacea to reduce public sector debt burdens.

Former IMF chief economist Kenneth Rogoff, now a Harvard University professor of economics, has advocated a 4-6% inflation target for the Fed, and ex-Bank of England MPC member Prof. David Blanchflower has made similar proposals. US professors, Joshua Aizenman and Nancy Marion, calculate - - in a different framework - - that a "moderate" inflation rate of 6% could reduce the US debt/GDP ratio by 10 percentage points within four years (see "Using Inflation to Erode the US Public Debt," NBER Working Paper 15562).

Olivier Blanchard, currently chief economist at the IMF, has also advocated raising low central bank inflation targets.

Adam Smith, the Scottish philosopher-economist wrote in The Wealth of Nations that was published in 1776: "“When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has been brought about at all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment. The raising of the denomination of the coin has been the most usual expedient by which a real public bankruptcy has been disguised under the appearance of a pretended payment.”

Sir Samuel Brittan, the venerable Financial Times economics commentator, wrote in 2009 that the UK debt ratio has historically been much higher than in modern times - - more than 200% after the Napoleonic wars and again after the World War 2 - -  "without the disasters predicted by prophets of doom."

Sir Samuel cited Lord Macaulay, the famous nineteenth century British historian: "At every stage in the growth of that [national] debt the nation has set up the same cry of anguish and despair. At every stage in the growth of that debt it has been seriously asserted by wise men that bankruptcy and ruin were at hand. Yet still the debt kept on growing; and still bankruptcy and ruin were as remote as ever." Sir Samuel said that Harold Macmillan, as chancellor of the exchequer, quoted Macaulay in his 1956 Budget speech and remarked how the national debt had risen from £6bn in 1914 to £27bn in 1956, representing 27 and 146% of GDP respectively - - about twice what was then in prospect.

A study from the IMF in 2010 said that whether a major country’s debt is sustainable is primarily a function of the interest rate paid on it, not the size of the debt per se.

The US Congressional Budget Office (CBO) says that the federal government’s interest expense is at a historical low of 1.4% of the GDP (gross domestic product) - -  at about half the level in the 1980s and 1990s.

In the CBO's projections in Dec 2010, which assume that current laws remain the same, annual deficits decline from the $1.3trn recorded in 2010, but the cumulative deficit from 2011 through 2020 exceeds $6.2trn. Borrowing to finance that deficit -- in combination with an expected rise in interest rates -- would lead to a fourfold increase in net interest payments over the next 10 years, from $197bn in 2010 to $778bn in 2020. As a percentage of GDP, net interest outlays would more than double during that period, rising from 1.4% to 3.4%.

Economists at Morgan Stanley, said last year that 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? They say that 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).

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 (before interest payments on the national debt) 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.

Can inflation work the magic again?

The big jump in inflation in the 1970s caught bond investors on the hop and sovereign debt maturities were generally over a long maturity profile.

According to the Treasury Department, almost three-quarters of current US debt matures within five years and the FT has calculated that if the UK had the same debt maturity as the US, it would cost an additional £9.2bn per year in interest costs.

So using inflation as a tool, which would be a risky move in itself, would not leave the bond investor unarmed this time; they would strike back in modern times as sovereigns need to go to the lending well much more frequently.


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