Will we inflate away our soaring high federal debt to GDP ratio??
Some people have raised the possibility that we will simply inflate our way out of debt. They say we have strong incentives to do so and they point to the years following World War II as an example of how we did it once before.
Joshua Aizenman of U.C Santa Cruz and Nancy Marian of Dartmouth published a timely paper on this subject in November entitled, Using Inflation to Erode the U.S. Public Debt. It’s worth your attention. This blog has used some of Aizenman’s and Marian’s data.
At the end of World War II, the ratio of publicly held debt to GDP was 108.6 percent. Currently it is over 50% and is projected to reach 100% in ten years.
From 1946 to 1956, the ratio was reduced 40% by inflation alone. The inflation rate over this period was 4.2%. Inflation turned bonds into certificates of confiscation.
Will this happen again? Are the comparisons of the two periods valid? My answers to these questions are “no” and “no”.
First, it needs to be said that the 4.2% inflation of 1946-1956 was not a conscious policy choice. As early as 1948-49 economists recognized that the Fed’s commitment to pegging the Treasury Bill rate at under 1% made the Fed “an engine of inflation”. Monetary policy was rendered impotent by the pegging. It was finally abandoned in 1951.
Also, the wage and price controls of the war years had suppressed prices. When abandoned, prices rose very rapidly for a short period of time, and accounted for a significant part of the inflation of the first post-war decade
The average maturity of the debt in 1946 was 9.2 years. It is now 3.9 years. Inflation does its nastiest work over extended time periods, so the shorter average maturity creates less incentive to inflate today than in 1946.
In 1946, an inconsequential amount of our public debt was held by foreigners. Today about 48% is held by foreigners; China and Japan account for 44% of that 48%. One the one hand it is much easier politically to let inflation confiscate foreigners’ wealth than our own. But, at the first whiff of inflation, foreign debt holders would act fast to protect the real value of their dollar holdings. The dollar and financial markets would crash.
While Treasury Inflation Protected Securities (TIPS) certainly detract from the temptation to inflate the debt away, but only 7.5% of the debt is in TIPS.
In 1946 there was a huge backlog of demand for goods, created by both the depression and the war. Additionally, there was a very low level of private debt, and an immense store of liquid savings available to activate that demand. The situation is quite different today. The store of savings is low, and debt is high. There is no great demand backlog.
Today, the Federal Reserve has considerable ability to become restrictive. I believe that, if necessary, the Fed will consider fighting inflation a priority, even if it were to restrict economic growth. For the time being, when we are operating the economy at well below capacity, inflation is not going to happen, and the Fed will not face that kind of unpleasant choice. But at some point in the decade, choosing between growth and inflation will be on the table.
There probably is some long-term rate of inflation that is compatible with reasonable economic growth, perhaps even necessary for growth. What that rate is is just a guess, but let’s say it’s 2%, and that any rate above that would be the result of either purposeful monetary policy or irresponsible fiscal choice at a time when excess capacity was no longer present. (By the way, a 2% inflation rate raises the inflation index 22% in ten years and 4.2% raises it 51%.)
My conclusion? Inflating away the debt load is not likely to tempt the Fed or Treasury. But Congress is another story. If they try it, either consciously or unconsciously, the markets would turn chaotic very quickly. The dollar would collapse and interest rates would soar. That’s why a credible plan to deal with the deficit is so crucial.