Friday, October 26, 2012

Would Inflation Help Cut Government Debt?

When teaching about the effects of an unexpected surge of inflation, I always point out that those who borrowed at a fixed rate of interest benefit from the inflation, because they can repay their borrowing in inflated (and less valuable) dollars. And sometimes I toss in the mock-cheerful reminder that the U.S. government is the single biggest borrower--and thus presumably has a vested interest in a higher rate of inflation. But presuming an easy connection from higher inflation to reduced government debt burdens is actually a more problematic policy than it may at first appear.

Menzie Chinn and Jeffry Frieden make a lucid case for how higher inflation could ease the way to a lower real debt burden in an essay in the Milken Institute Review (available on-line with free registration). They point out that after World War II the U.S. government had accumulated a total debt of more than 100% of GDP, but that it cut that debt/GDP burden in half in about 10 years with a combination of economic growth and about 4% inflation. They are at pains to point out that they aren't suggesting a lot of inflation. But as they see it, given the fact that debt/GDP ratios are extremely high by historical standards in the U.S. and in a number of other high-income countries, a quiet process of slowing inflating away some of the real value of the debt is far preferable to the messy process of governments threatening to default. They write:

"Creditors, of course, receive less in real terms than they had contracted for – and probably less than they expected when they agreed to the contract.  That may seem unfair. But the outcome is little different than what happens to creditors when they are forced to accept the restructuring of their claims through one form of bankruptcy or another. ...It’s important to remember, though, that
we are not suggesting a lot of inflation – certainly nothing like the double-digit rates that
followed the second oil shock in 1979 to 1981. Rather, we believe the goal should be to target
moderate inflation, only enough to reduce the debt burden to more manageable levels,
and adjust monetary policy accordingly. This probably means something in the 4 to 6 percent
range for several years. ... We’re not claiming that inflation is a painless way to speed deleveraging. We are claiming,  though, that it is less painful than the realistic alternatives. ... Unusual times call for unusual measures."

The counterargument, which holds that inflation may not do much to reduce debt/GDP ratios, starts from this insight: Yes, inflation reduces the outstanding value of past debt, and in a situation like the aftermath of World War II when large debts were incurred, but the borrowing then stops. For example, the U.S. government ran budget surpluses four out of the five years from 1947-1951. But if fiscal policy is on an unsustainable path of overly large deficits, then inflation isn't going to fix the problem. In an essay appearing in the Annual Report of the Federal Reserve Bank of Richmond, "Unsustainable Fiscal Policy:Implications for Monetary Policy," Renee Haltom and John A. Weinberg make an argument that inflation would not actually offer much hope of reducing the current U.S government debt burden.

"It is useful to consider how much inflation would be required to adequately reduce current debt levels. ... To consider how much inflation would be required today to address current debt imbalances, Michael Krause and St├ęphane Moyen (2011) estimate that a moderate rise in inflation to 4 percent annually sustained for at least 10 years—in effect a permanent doubling of the Fed’s inflation objective—would reduce the value of the additional debt that accrued during the 2008–09 financial crisis, not the total debt, by just 25 percent. If the rise in inflation lasted only two or three years, a 16 percentage point increase—from roughly 2 percent inflation today to 18 percent—would be required to reduce that additional debt by just 3 percent to 8 percent. Such inflation rates were not reached even in the worst days of the inflationary 1970s. The reason inflation has such a minimal impact on debt in Krause and Moyen’s estimates is that while inflation erodes the value of existing nominal debt, it increases the financing costs for newly issued debt because investors must be compensated to be willing to hold bonds that will be subject to higher inflation. This effect would be greater for governments such as the United States that have a short average maturity of government debt and therefore need to reissue it often.

"With these estimates in mind, it is worth recalling the CBO’s projection that debt held by the public may triple as a percent of GDP within 25 years. The estimates cited above suggest that inflation is simply not a viable strategy for reducing such debt levels. In addition, it is important to remember that inflation is costly on many levels. Inflation high enough to significantly erode the debt would inflict considerable damage on the economy and would require costly policies for the Fed to regain its credibility after the fact. Inflation that was engineered specifically to erode debt would provide a significant source of fiscal revenue without approval via the democratic process, and so would
raise questions about the role of the central bank as opposed to the roles of Congress and the executive branch in raising fiscal revenues. Ultimately, the solution to high debt levels must come from fiscal authorities."
In a similar spirit, the IMF wrote in Chapter 3 of its most recent World Economic Outlook that inflation at low levels often seems to have little effect in reducing government debt: "The relationship between inflation and [government] debt reduction is more ambiguous. Although hyperinflation is clearly associated with sharp debt reduction, when hyperinflation episodes are excluded, there is no clear association between the average inflation rate and the change in debt."

In short, if federal deficits are first definitively placed on a diminishing path, then a quiet surge of unexpected inflation could help in reducing the past debts. But on the current U.S. trajectory of a steadily-rising debt/GDP ratio over the next few decades, inflation isn't the answer--and could end up just being another part of the problem.