Inflating away debt

Inflation has the effect of increasing the nominal value of GDP much faster than debt and also reducing the nominal value of the debt stock, and thereby reduces the debt-to-GDP ratio. In terms of its impact on the public debt, the ongoing bout of inflation may be a god send for the heavily over-leveraged western economies. Against this, there is the erosion of purchasing power than consumers face with inflation.

David Beckworth points to the dramatic decline in US public debt to GDP ratio over the last three years since beginning of 2020,

Public debt has increased by roughly $5 trillion over the last three years. But at the same time, the market value of U.S. Treasury securities has gone from a high of 108% of the economy to its current value of 85%. This is one of the fastest declines in the U.S. debt burden and puts its value close to the prepandemic level... The origins of the dramatic change begin in the spring of 2020. The dollar size of the economy fell sharply as federal spending surged. These developments both raised the debt burden by shrinking the tax base from which the debt could be paid and by increasing the national debt. In addition, interest rates dropped to near 0%, making the existing Treasuries worth more since they paid a higher interest rate... All together, these three developments raised taxpayers’ debt burden to the 108% level.

The dollar size of the economy, however, quickly recovered from the pandemic shutdown and was back on trend by mid-2021. This lowered the debt-to-GDP ratio by about nine percentage points. Next came the inflation surge, which further reduced the debt burden by 14 percentage points, bringing it to the current value of 85%. It did this through two channels. First, the high inflation pushed the dollar size of the economy about $1.89 trillion above the pre-pandemic trend. Second, of course, is that the inflation surge caused the Fed to sharply raise interest rates, which lowered the market value of Treasuries by roughly $1.9 trillion... This remarkable transfer of wealth away from bondholders was not limited to the $24 trillion treasury market. Other fixed-income markets like the $12 trillion mortgage-backed securities market and the $10 trillion corporate bond market also saw big losses in market value.

Another important consequence is that being felt in the banking sector. The banks are a major investor in the fixed income securities markets, and the rapid rate hikes and the consequent decline in bond prices have naturally eroded the valuation of their assets side. A recent study found that US banking system assets are overvalued by $2 trillion due to mark-to-market losses

We analyze U.S. banks’ asset exposure to a recent rise in the interest rates with implications for financial stability. The U.S. banking system’s market value of assets is $2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom 5th percentile experiencing a decline of 20%. We illustrate that uninsured leverage (i.e., Uninsured Debt/Assets) is the key to understanding whether these losses would lead to some banks in the U.S. becoming insolvent-- unlike insured depositors, uninsured depositors stand to lose a part of their deposits if the bank fails, potentially giving them incentives to run. A case study of the recently failed Silicon Valley Bank (SVB) is illustrative. 10 percent of banks have larger unrecognized losses than those at SVB. Nor was SVB the worst capitalized bank, with 10 percent of banks having lower capitalization than SVB. On the other hand, SVB had a disproportional share of uninsured funding: only 1 percent of banks had higher uninsured leverage. Combined, losses and uninsured leverage provide incentives for an SVB uninsured depositor run. We compute similar incentives for the sample of all U.S. banks. Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to insured depositors, with potentially $300 billion of insured deposits at risk. If uninsured deposit withdrawals cause even small fire sales, substantially more banks are at risk. Overall, these calculations suggest that recent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs.

Some observations

1. Adam Tooze describes this as a trillion dollar transfer of wealth from bond investors to bond issuers. For sure, while bondholders have taken a massive hit from the rising interest rates, it should not be overlooked that they were also among the biggest beneficiaries of the extraordinary long period of monetary accommodation. While the likes of Tooze writes about this wealth transfer, nobody was talking about the equal wealth transfer in the other direction from savers to borrowers when rates were low. 

2. The steep rise in public-debt to GDP ratio was deceptive in so far as the increase was due to the steep fall in GDP, which has since reversed as the economies have recovered smartly, thereby regaining a significant part of the rise. 

3. A significant part of the loss suffered by bond investors is borne by the taxpayers through the central bank holdings of treasury securities. But this would be lower in the aggregate compared to the losses suffered by other investors, including banks. 

4. The banks sitting on unrealised losses may be facing a liquidity problem (and not a solvency problem) only if the assets can be nursed back to recover most of their currently depreciated valuations or it can make profits elsewhere to cover these losses. The challenge is to ensure that there are no runs in the meantime. 

5. It's clear that several banks are worse off than even SVB. The Fed's swift announcement of blanket deposit insurance coverage may be the reason why there are no bank runs on them. If so, it should be counted as among a big public policy success. But this success for now should be counted against the long-term moral hazard generated that would incentivise reckless risk taking by deposit taking banks. 

6. An economic rebalancing opportunity exists if the current bout of inflation erodes away a big enough share of the debt and also allows for a soft landing for the economy. That's a hard act to pull off, though not impossible. 

Update 1 (05.04.2023)

Indexation policies on inflation are common in developed countries.