Monday, April 5, 2010

Inflating away government debts

The burgeoning deficits (average of all government deficits among OECD economies was 8.2% of GDP in 2009) and public debt stocks across the world, especially among the developed economies, have ignited an intense debate about how to cap and then gradually reduce the debt burdens. In a grim prognosis, the IMF recently warned that even assuming a quick withdrawl of the fiscal stimulus programs, the public debt ratios in developed economies will rise to 110% by the end of 2014, from 75% at the end of 2007, with the ratio expected to be close to or to exceed 100% for five of the Group of 7 countries (excluding Canada and Germany) by then.

Recently, even the unthinkable was being mentioned - all the three major credit rating agencies, Moody’s, Standard and Poor’s, and Fitch, warned that they might have to downgrade the triple-A debt of the United States if it failed to bring its budget deficit under control! Further, as Carmen Reinhart and Ken Rogoff explained in their magisterial examination of sovereign debt and banking crisis across the world over the past 800 years, a precedent of sovereign debt default creates "a high and persistent level of debt intolerance". This reversal of the public debt fortunes of developed and emerging conomies since the late nineties can only be described as stunning.

In the US, apart from its objective of expanding health insurance coverage, the recently passed landmark health care reform bill is being seen as a major step in the direction of reining in the trajectory of growth in public debt.

By any yardstick, the enormity of the debt crisis means that any sustainable solution has to involve addressing both the expenditure and fiscal side issues. In simple language, despite all the inevitable political opposition, taxes will have to increase and inefficient (and wasteful) expenditures will have to be controlled and eliminated. Both this has to be complemented with strong economic growth, which is the easiest and politically acceptable way to boost tax revenues. And even with all of the aforementioned, some form of debt restructuring on generous terms, atleast for the worst affected like those from peripheral Europe, may be required.

On the one hand, in order to prevent an explosion of debts (due to rise in interest rates) and possible sovereign debt-defaults and to buy more time till the economies recover fully and balance sheets (of both households and businesses) get repaired, economists have been advocating continuation of the aggressive monetary loosening through unconventional monetary policies. In the context of nominal interest rates touching the zero-bound and inflationary expectations being firmly entrenched, there have been calls to increase the purchases of long term securities to keep downward pressure on long term real interest rates and thereby keep capital cheap and debt servicing less onerous. n

Apart from all the aforementioned, in the context of the massive debts, there is an increasing chorus of opinion that advocates using a sudden bout of inflation to reduce the effective debt burden. They point to the example of the immediate postwar period when America experienced annual rates of inflation up to 10% which eroded the value of America's war debt by some 40%. Joshua Aizenman and Nancy P. Marion claim than an inflation of 6% for four years would reduce the debt-to-GDP ratio by 20%, a scenario similar to what happened following WWII. They point to the 48% of US federal debt held by foreign creditors that can be more easily inflated away.

This can inflate away public debt that is not inflation-indexed and not very short term (so that the interest rates cannot be reset to much higher rates that would compensate for inflation). The call for a higher inflation target (against the 2-2.5% target across major central banks) has also been made in the different, but related, context of increasing the flexibility with monetary policy (in cutting rates) and pre-empting a possible zero-bound problem by economists like George Akerlof, Olivier Blanchard (on behalf of IMF, called for a higher 4% inflation target) and Paul Krugman.

However, as Alan Auerbach has pointed out (through Economix), inflating away America’s (and probably that of many other developed economies) debt probably isn’t an option since the major share (90% in US as per Auerbach) of the country’s debt is indexed to inflation, either directly or indirectly, and is held within the government itself (eg. as future commitments to scial spending). The exploding entitlement programs are either explicitly indexed to inflation — Social Security — or implicitly indexed (Medicare and Medicaid) because they provide services that will also grow in cost with inflation. He therefore estimates (using the end of November Treasury data) with a sudden and rapid inflation, only about 10% of US public debt can be made to disappear.

It cannot be denied that under normal circumstances, the "sudden inflation" option carries considerable danger of inflation getting out of control. As this debate between Micheal Kinsley (and here) and Paul Krugman illustrates, there is considerable uncertainty about the effectiveness and dangers of a higher-inflation strategy.

However, in this case Kinsley may have over-reached with his fears of hyper-inflation. Given the extraordinary prevailing economic environment (of weak demand and idle capacity), coupled with the availability of effective instruments with central banks to manage a swift unwinding of the expanded monetary base, the possibility of inflationary expectations getting out of control look remote. The bond markets too do not appear to bear out such fears. Finally, as Krugman points out, in the last two decades Japan faced much the same macroeconomic environment - big budget deficits, high public debt, and huge expansion in the monetary base - and enacted similar policy responses, and has ended up not with high inflation but a GDP deflator that has fallen 9% since 2000.

Update 1 (1/9/2011)

Ken Rogoff argues in favor of the "option of trying to achieve some modest deleveraging through moderate inflation of, say, 4 to 6 per cent for several years". Olivier Blanchard, using the pulpit of the IMF, was among the first to call for a higher inflation target. He said, "But there was no very good reason to use 2% rather than 4%. Two percent doesn’t mean price stability. Between 2% and 4%, there isn’t much cost from inflation."

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