Slashing Debt: The Role of Inflation in Debt Reduction
Economic Tide: Ally or Adversary?
Governments worldwide are grappling with mounting public debt due to the global financial crisis (GFC) and the COVID-19 pandemic, which has pushed debt levels by approximately 15% of global GDP each. Without a reduction in debt-to-GDP ratios, debt service costs may overwhelm public spending programs, hinder private investments, and curb governments' borrowing capacity to navigate future crises.
In the past, some countries offering a telling historical perspective have employed inflation to lessen their debt burden. However, the role of inflation in debt reduction is context-dependent, with its effectiveness varying between periods of high and moderate inflation.
In this reinterpretation, I delve into the historical debate surrounding inflation as a debt reduction tool, examining its role in these processes over the past 220 years. By conducting joint research with Barry Eichengreen, we scrutinize sustained debt reduction periods where the public debt-to-GDP ratio dropped by at least 10% of GDP, dissecting the factors involved, such as inflation, primary surpluses, and economic growth.
Our findings reveal that inflation has played a vital role in many debt reduction episodes. However, its success is highly dependent on factors like the maturity structure of the debt, fiscal framework, and currency denomination. Moreover, it has been more frequent than other methods like defaults and debt forgiveness—and more effective, achieving an average debt reduction of 32% of GDP.
In times of chronic high inflation, such as the 1970s, the benefits of inflation were quickly neutralized by rising nominal interest rates. Even where inflation contributed initially to debt reduction, the positive effects were often short-lived as interest rates eventually caught up. Countries that achieved substantial debt reduction beyond defaults or forgiveness did not necessarily experience higher inflation than their peers. In fact, the opposite was often true, except for the interwar period.
Countrifies managing to pull off such debt reduction did not rely solely on inflation but demonstrated savings efforts alongside. For instance, the U.S. under the Clinton administration reduced its debt-to-GDP ratio significantly, due to primary surpluses, stable financial systems, and modestly high inflation. In the post-WWII era, many countries achieved considerable debt reduction thanks to dirigiste measures like capping interest rates and mandating domestic banks to purchase government bonds.
To effectively employ inflation as a tool for debt reduction, it is crucial to maintain moderation and stability. The maturity structure of the debt, fiscal framework, and currency denomination should be carefully considered, as inflation can only contribute if the average maturity of the debt is high, and the debt is not denominated in foreign currencies or indexed to inflation. A credible nominal anchor, like the gold standard in the 19th century or inflation targeting today, is essential to prevent markets from demanding a high inflation premium, increasing the cost of debt reduction.
In conclusion, inflation can serve as a tool for efficient debt reduction, provided it is employed judiciously and in combination with sound fiscal and monetary policies. The ultimate success remains challenging, as it requires political sensitivity, ensuring balance, and addressing economic and institutional contexts that enable effective large-scale debt reduction.
- In certain periods, inflation has been employed by countries as a means to alleviate their debt burden, though success varies based on factors such as the maturity structure of the debt and fiscal framework.
- Effective debt reduction through inflation often occurs not solely due to inflation, but through a combination of factors such as savings efforts, stable financial systems, and moderation in the use of inflation.
