Inflation Is Not The Answer

11/02/2011 at 3:54 pm

The policy response to inflation has become a hot topic for equities this year. Emerging markets, whose governments are doing terribly unfashionable things such as running positive real interest rates and trying to balance the budget, have been hit especially hard. If fighting for stable prices is to be punished rather than rewarded, perhaps those who advocate inflation as a cure for government debt are being proved right.

Their argument is simple. If a government finds itself with a debt burden that is beginning to prove cumbersome to service, it can stir up a bit of inflation. The nominal value of its debt will not change, but its revenues will increase in nominal terms, making the debt easier to pay off.

It’s a beguiling idea – but dangerously wrong. While the nominal value of debt will not change, the cost of servicing it certainly can, and for a heavily indebted nation this could easily be punitive.

Take the case of Japan. There is about ¥870trn of government debt outstanding (about £6.5trn, and not far off twice Japanese GDP). Of this debt the biggest chunk comprises short dated liabilities – money market bills and short maturity bonds – with some ¥233trn to be refinanced this year. The rate of interest the government has to pay in the 1-2 year area is about 0.25% at present, putting the cash cost of the refinancing at a manageable ¥0.6trn.

Now let’s turn to the “inflation cure”. Japan runs a budget deficit of some 7.5%, so to use inflation to reduce the level of debt to GDP would require quite a high figure. Let’s assume the Japanese government succeeds in creating price inflation of 10% and real GDP rises by 2%.

On the naive view, the ratio of debt to GDP would start the year at 200:100 and finish it at 207.5:112 – a reduction in debt as a proportion of GDP of 15%. Nine years of this and Japan’s debt burden would fall from 200% of GDP to 100%.

Allowing for an increase in the cost of debt servicing, however, transforms the story. Assuming that real borrowing costs remain unchanged – in this example therefore that they rise by 10% in cash terms – the cost of refinancing Japan’s 2011 borrowing would increase from ¥0.6trn to ¥24trn – about 5% of GDP. This would push the budget deficit from 7.5% to 12.5%, more than eroding the impact of higher nominal growth in GDP and condemning the country to a higher debt burden.

And this ignores the likely increase in the real cost of borrowing, and the need to refinance larger sums of outstanding debt with each passing year (as principal payments on longer maturity bonds fall due). Take these factors into account and Japan becomes Zimbabwe.

The story is similar in the US, where the budget deficit is 8.6% and there is $2.5trn of borrowing to be refinanced this year (of a c. $9trn total). Increase inflation to 10% and assume a similar increase in the cost of borrowing and the deficit would rise to 10.4%.

The situation is not quite so extreme in the UK as a far lesser proportion of our borrowing falls due over the next couple of years, but the same logic applies. For countries with lots of debt, inflation is no alternative to paying it off.


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