Reducing The Debt Through Inflation: A Wrong Path

Alleviating public debt through a dose of inflation is a widely shared and defended idea, it even seems obvious. But what is it really? A note from the Fipeco website (a French non-profit association) takes stock of the fallacy of this belief.

Already, many people don't know this, but part of the government debt (11%) is indexed to inflation (the OATi, see my 2018 article). The inflation of the eurozone, not even that of France. In the event that it increases, the interest charges on these bonds would skyrocket, negating the expected gains on the rest of the debt.

Secondly, it must be understood that an increase in inflation will obviously push investors to demand higher interest rates, otherwise they will no longer buy bonds. According to the scenario used by Fipeco, which is quite credible, with inflation at 5.0% from year one, the interest rate gradually increases from 1.0% in year one to 5.0% in year ten. Under these conditions, the debt initially falls somewhat (from 120 to 103% of GDP) and then rises gradually. As can be seen, the gain is in fact, very limited.

In effect, the first condition for taking advantage of a return to inflation is to stop all deficits so as not to need to borrow any more, and even to generate a surplus to pay off past loans coming due. In this way, the past debt burden is effectively reduced. But this is an illusion, as deficits have become the morphine of most countries on the planet! On the contrary, this increase in the rate of inflation, which leads to a slight decrease in public debt, will rather encourage governments to further increase their deficits.

On the other hand, the costs of high inflation are numerous. For central banks, keeping inflation under control for a long time is part of the core of their credibility; if it were to rise, they would lose it, and it would be very difficult to rebuild. It is not easy to get inflation going again, but once it has gone, it can accelerate and become very difficult to control. Without even considering hyperinflation, with a rate of only 10%, it is difficult to return to inflation of around 3%. Remember that it took France several years in the 1980s to achieve this.

The eurozone would be under great strain, with the highly indebted countries will want to get the European Central Banks (ECB) to raise its inflation target and will therefore choose their national central bank governors, who sit on the ECB's Governing Council, accordingly, while the other countries will oppose it, especially Germany and the so-called "frugal" countries. The result could be very high tensions within the eurozone.

Economic activity would be hit hard. Significant inflation has the effect of slowing down economic activity, as it makes the future more uncertain for economic agents, and this uncertainty discourages investment. At the national level, high inflation means that companies become less competitive with their foreign competitors, both in the domestic and export markets. Firms lose market share, which translates into lower domestic production and the unemployment that goes with it. In theory, these losses of competitiveness can be offset by a depreciation of the national currency, but this takes several quarters to materialize for exporting companies, while the effect on imported prices is immediate, which reduces the purchasing power of households and reinforces inflation, thereby erasing part of the gains in competitiveness that the devaluation initially allowed. Finally, inflation aggravates the inequalities between well-off households with assets (real estate in particular), which will preserve their purchasing power, and those whose income is spent entirely on food, energy and rent, whose prices are rising.

In reality, high inflation is only a way for the government to manage the debt, temporarily lightening its burden but making households and companies pay the price. This is just to postpone the bankruptcy by a few years, but what wouldn't governments do to get through the next election?